Component Auditors Research Articles

Do investors differentiate between types of component auditors? Evidence from auditor ratification voting

Do investors differentiate between types of component auditors? Evidence from auditor ratification voting

Group Audit Risk and Component Auditor Use: A Difference-in-Differences Analysis

SUMMARY This study examines the association between group audit risk and component auditor use. The audit risk model defines audit risk as a function of the risk of material misstatement and detection risk. We use the revelation of an internal control material weakness (ICMW) as an event that increases the risk of material misstatement. Since higher risk of material misstatement requires the lead auditor to reduce detection risk, component auditor use could change after an ICMW. We find that the likelihood of starting component auditor use significantly increases after an ICMW. We also find an increase in the number of large component auditors used after an ICMW and such increase is concentrated in more pervasive entity-level ICMWs and higher-quality component auditors. Our evidence indicates that lead auditors perceive component auditor use as decreasing group audit risk. Our findings should inform the debate on the costs and benefits of component auditor use.

Implications of Divided Responsibility in Audits Involving Component Auditors

SUMMARY This article summarizes and reflects on the practical implications of the published study “Are Referred-To Auditors Associated with Lower Quality and Efficiency?” (Krishnan and Li 2023). Audits of companies frequently involve the participation of auditors (who audit components of clients) other than the lead auditor that signs the audit report. In general, the work of these component auditors is assimilated in the lead auditor’s report. However, uniquely in the United States, the lead auditor sometimes formally divides responsibility with the component auditor and refers to the component auditor’s work in its audit report. These component auditors are “referred-to” auditors. Krishnan and Li (2023) examine factors associated with the use of referred-to auditors as well as the associations between the use of referred-to auditors and measures of audit quality and audit efficiency.

How do lead auditor instructions influence component auditors' evidence collection decisions? The joint influence of construal interpretations and responsibility

AbstractRegulators have raised concerns about the quality of component auditors' work. Of particular concern is that component auditors often do not adequately perform procedures and gather enough quality evidence. This failure is likely caused by component auditors' different interpretations of lead auditor instructions and by their lack of responsibility. Our interview findings suggest that component auditors tend to interpret lead auditor instructions concretely because they often receive detailed instructions from lead auditors. We propose that a responsibility prompt reminding component auditors to be aware of their obligations to the group audit engagement can improve their evidence collection. In two experiments, we find that our proposed responsibility prompt can effectively improve component auditors' evidence collection decisions and that this finding holds across different cultural settings. Our third experiment provides evidence that a responsibility prompt improves component auditors' evidence collection when provided to auditors who receive instructions that prime low‐level (but not high‐level) construals. Overall, our findings suggest that prompting component auditors to internalize the responsibility of a group audit engagement is a viable way to improve the quality of group audits.

An examination of comment letters on suggested Part 10: audits of groups' financial statements in the proposed ISA for less complex entities

PurposeThe purpose of this paper is to investigate the comment letters (CLs) in the standard-setting process of audits of less complex entities (LCEs). The objective is to gain insight into the overall picture of the CLs and to report on areas where comment providers agree or disagree with IAASB's Part 10.Design/methodology/approachA content analysis of 60 comment letter (CLs) was conducted to investigate the suggested additional Part 10 on audits of groups' financial statements in the proposed ISA for LCEs. Hence, this study examines three specific topics: (1) the views related to the use of the International Standard on Auditing (ISA) for LCEs for group audits in which component auditors are involved, (2) the proposed group-specific qualitative characteristics to describe the scope of group audits and, finally, (3) insights into the content of the proposed Part 10 and related conforming amendments. The Gioia method is used to provide a holistic approach to concept development of the arguments about the new Part 10.FindingsThe CLs stated that, while the proposed Part 10 has some weak points, it still provides a solid and practical structure within which to undertake an LCE group audit and a promising basis for further development. For instance, when discussing the improvements, the CLs stated that Part 10 should allow for more auditor judgment when determining when the involvement of component auditors renders a group audit complex. In addition, the CLs asserted that professional judgment should be engaged when considering the qualitative characteristics and the complexity of the group.Originality/valueThis study contributes to the very scarce research about the ISA for LCEs and the role of lobbying in shaping the audit standard-setting process.

Component Auditor Use and Lenders’ Perception of Audit Quality

SUMMARY While component auditors audit a significant proportion of public companies, lenders may not be aware of their involvement before Form AP disclosure. We study whether the disclosure of component auditor use and the extent of their involvement is useful to lenders. We find that the loan spread is higher when firms’ lead auditors use component auditors relative to engagements without component auditor participation. Further, for firms whose lead auditors use component auditors, we find a positive association between the extent of such participation and the loan spread. However, the positive effect of component auditor use on the loan spread is mitigated for firms with a high level of foreign operations, consistent with the notion that the use of component auditors is more beneficial for firms with significant foreign operations. Overall, our findings suggest that the disclosure of information on component auditor participation in global group audits is useful to lenders. Data Availability: All data used in this paper are publicly available. JEL Classifications: M42; G32.

Herbal Pharma Inc.: Conducting an Effective Group Audit*

ABSTRACTAs the relative weight of global economic activity continues to shift toward non‐OECD countries (OECD 2018), audit firms are more likely to encounter clients with significant business operations in foreign jurisdictions. The associated need to engage and oversee local component auditors in these jurisdictions can lead to challenges arising from different business cultures and the resulting intra‐audit miscommunications. Audit deficiencies related to these challenges have been detected by regulators (PCAOB 2011, 2010; CPAB 2012, 2015). Standard setters such as the IAASB and the Auditing and Assurance Standards Board (AASB) have responded by issuing an exposure draft proposing revisions to ISA 600 (IAASB 2020) and CAS 600 (AASB 2020) to strengthen the auditor's approach and provide enhanced guidance to practitioners. In light of this evolving area of assurance, this case was developed to deepen students' understanding of both group and component audits in an international context. The case takes the perspective of the group auditor and features an audit senior in a specialized role overseeing the component audit of a client's increasingly material Chinese subsidiary. Deficiencies in the prior year component audit, along with a change in the component auditor, further underlines the importance of robust risk analysis for the upcoming engagement.

How Do Lead Auditor Instructions Influence Component Auditors’ Evidence Collection Decisions? The Joint Influence of Construal Interpretations and Responsibility

How Do Lead Auditor Instructions Influence Component Auditors’ Evidence Collection Decisions? The Joint Influence of Construal Interpretations and Responsibility

Inexperienced Component Auditors and the Internal Information Asymmetry of Multinational Corporations

With the global expansion of business operations, many U.S. corporations now operate internationally. While these multinational corporations (MNCs) rely on information about their operations to allocate resources, this information is likely dispersed within the firm, leading to internal information asymmetry between top executives and divisional managers. Meanwhile, audits of these geographically dispersed MNCs are challenging, and parts of these audits are sometimes outsourced to local foreign auditors who have no experience serving as opinion-issuing auditors for U.S. issuers (“inexperienced component auditors”). In this article, we examine whether involving such inexperienced component auditors is associated with MNCs’ internal information environment. We find that, relative to a matched control sample, Securities and Exchange Commission (SEC) issuers with the participation of inexperienced component auditors have higher internal information asymmetry and lower internal capital allocation efficiency. Our results suggest that audit quality matters not only to a firm’s external financial statement users but also to its internal users.

Involvement of Component Auditors in Multinational Group Audits: Determinants, Audit Quality, and Audit Fees

ABSTRACTWe study what determines the involvement of component auditors in multinational enterprise (MNE) group audits and the association with audit quality and audit fees. Using unique Australian disclosures of group audit fees paid to the principal and component auditors, we first document that MNE complexity, MNE internationalization, and auditor characteristics are associated with component auditor involvement, and extent and type of component auditor involvement. Next, we find that involvement of component auditors benefits audit quality as long as the principal auditor conducts a substantial amount of work. Once the involvement of component auditors exceeds a certain level, audit quality decreases. We also document that audit fees are higher in the presence of a component auditor and increase with the extent of involvement, irrespective of component auditor type. Our results contribute to the emerging literature on group audits and provide empirical evidence on regulatory concerns about group audit quality.

Do U.S. Investors Value Foreign Component Auditors?

ABSTRACTWe examine whether investors consider foreign component auditors when assessing the value of U.S. multinational corporations (MNCs) using two sets of Public Company Accounting Oversight Board (PCAOB) international regulatory events. We find investors react negatively when the PCAOB is denied access to inspect foreign component auditors in jurisdictions where a U.S. MNC has significant operations and positively when those countries later allow inspection. For foreign component auditors that are inspected, we find investors react positively when they receive clean inspection reports and negatively when they fail to remediate quality control deficiencies. Consistent with PCAOB international oversight providing additional assurance about foreign component auditor quality, our collective results indicate investors consider foreign component auditors when valuing U.S. MNCs.

The effects of self‐esteem and perspective‐taking on group auditor's review actions

We examine the effects of self‐esteem and perspective‐taking—both separately and jointly—on group auditors' selection of the next steps after reviewing the findings of a component auditor on a warranty provision. These individual and situational determinants of professional scepticism are important factors for enhancing audit quality in multinational group audits given the concerns about group audit quality raised by regulators. We hypothesize that group auditors who have high self‐esteem and are prompted to take the regulator's perspective plan more effective next steps after reviewing the work of component auditors. In an experiment with 103 audit partners and managers, we measured self‐esteem and manipulated a perspective‐taking prompt. As hypothesized, we find that group auditors who have high self‐esteem or who are prompted to take the regulator's perspective plan more effective next steps than those with low self‐esteem or who are unprompted. We find no support for an interaction between self‐esteem and perspective‐taking in the context of our study. Audit firms can use the insights from our study in selecting group auditors based on self‐esteem and developing firm policies to consider the regulator's perspective when reviewing the findings of component auditors to enhance audit quality in multinational group audits.

Do Foreign Component Auditors Harm Financial Reporting Quality? A Subsidiary‐Level Analysis of Foreign Component Auditor Use*

ABSTRACTWe hypothesize and find that financial reporting quality at the foreign subsidiaries of US multinational companies (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 the 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 US MNC group audits is an avenue through which US 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.

Do Investors Care Who Did the Audit? Evidence from Form AP

ABSTRACTIn early 2017, the Public Company Accounting Oversight Board (PCAOB) mandated the disclosure of audit participants, including the lead audit partner and other audit firms participating in the audit (“component auditors”). In this study, we examine whether investors use these disclosures in a way that influences their investment decisions, a primary goal of the PCAOB. Using trading volume, absolute abnormal returns, and bid–ask spreads, we find little evidence of a significant investor response following the disclosure of partner identity or component auditor participation in the first three years of the requirement. We also examine instances where these disclosures are most likely to be informative (e.g., partners associated with restatements or component auditors with PCAOB deficiencies) and find no significant investor response. Taken together, we find little evidence that capital markets respond to partner and component auditor identity in the United States.

Comments of the AFAANZ Auditing and Assurance Standards Committee on Proposed International Standard on Auditing 600 (ED 600)

AbstractThe International Auditing and Assurance Standards Board (IAASB) issued for public comment Proposed International Standard on Auditing 600 (Revised) ‘Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors) (ED 600). The Australian Auditing and Assurance Standards Board (AUASB) and New Zealand Auditing and Assurance Standards Board (NZAuASB) also called for comments. The Auditing and Assurance Standards Committee of AFAANZ prepared a submission, based on the findings reported in extant research, responding to a number of the questions asked by the IAASB (and AUASB/NZAuASB). This commentary presents the formal submission made to the IAASB (and AUASB/NZAuASB).

Challenging Global Group Audits: The Perspective of US Group Audit Leads*

ABSTRACTRegulators are concerned about the quality of group audits because of poor inspection results, recent enforcement actions against component auditors, and the significance of these audits to the global economy. Yet research in this area is nascent. In response, we survey and interview US‐based global group audit leads to better understand the group audit process and their perceptions of challenges that arise on such engagements. Our findings indicate that group auditors organize their audits consistent with the client's structure, which drives component auditor selection, scoping, and fees. Group auditors routinely find fault with component auditors, perceiving that work performed and/or documentation provided is not sufficient, not appropriate and/or not communicated timely, to comply with US standards and reporting deadlines. In some cases, they perceive that the component auditor is unable and/or unwilling to comply and in others, that the component auditor misunderstands group instructions due to language proficiency or differing interpretation of the standards. Notably this perspective is ethnocentric, as group auditors almost exclusively attribute issues to component auditors. While ethnocentric tendencies appear myopic, they provide insight into unrecognized or overlooked aspects of the global firm model of cooperative arrangements. This study highlights the significance of the global firm's network structure to global group audits. Thus, we encourage intercommunity research, among (quantitative and qualitative) scholars and standard setters, to consider group audits in the broader context of firm networks.

The Use and Characteristics of Foreign Component Auditors in U.S. Multinational Audits: Insights from Form AP Disclosures*

ABSTRACTThis paper investigates the common, yet previously opaque, practice of using foreign audit firms (component auditors) to conduct portions of audit work for U.S. public companies. U.S. regulators have expressed concern for the transparency and quality of audits using component auditors. Employing data disclosed in the newly mandated PCAOB Form AP, we find that component auditor use is largely structural, determined by the size and complexity of clients' multinational operations. We do not find that the mere use of component auditors is detrimental to audit outcomes, but rather the amount of work conducted by component auditors is associated with lower audit quality (i.e., higher likelihood of misstatement), higher likelihood of nontimely reporting, and higher audit fees, which collectively suggest that component auditor engagements are associated with adverse outcomes. Furthermore, we find that only the work performed by less competent component auditors and those facing geographic and cultural/language barriers, including significant geographic and cultural distance, weak rule of law, and low English language proficiency, is associated with adverse audit outcomes. Overall, these findings provide initial archival evidence that the use of certain component auditors on U.S. multinational audits is associated with audit coordination issues, which suggests that PCAOB Form AP disclosures provide relevant information.

To Outsource or Not? Evidence from Changes in Component Auditor Use after the Disclosure of An Internal Control Material Weaknesses

This paper investigates how increases in client audit risk influence the use of component auditors. Auditors respond to increases in audit risk by making adjustments to the audit engagement such as increasing fees and/or increasing effort. As more audit resources are demanded by clients with increased audit risk, one way for the lead auditor to free up resources is to allocate more work to component auditors. Using a difference-in-difference research design, with the revelation of an internal control material weakness (ICMW) as an event for increased audit risk, we find that component auditor use increases after the revelation of an ICMW, and increases even more when the ICMW is severe. We also find that the increase in component auditor use after an ICMW is positively associated with the likelihood of ICMW remediation. Thus, we identify a situation where component auditor use enhances audit quality and provides a benefit to the company (i.e., increased likelihood of ICMW remediation). Our study should be of interest to regulators, given the criticism by the PCAOB regarding firms’ use of component auditors and the evidence in prior literature on how component auditor use influences audit quality.

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

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.

Do Lenders Care Who Did the Audit?

While non-U.S. auditors audit a significant proportion of U.S.-based clients, until recently, lenders were largely unaware of the involvement of component auditors since the U.S.-based lead auditor was not required to disclose information about participating auditors. Using the disclosure under Form AP mandated by the PCAOB, we find that the increase in cost of debt ranges from 15 basis points to 22 basis points when component auditors are used relative to engagements that do not involve component auditors. We also find that cost of debt is greater when the component auditor has GAAP-related audit deficiencies and fewer CPAs, face PCAOB disciplinary orders or more frequent inspection, and when the lead auditor and the component auditors are not from the same Big 4 audit networks. These findings are consistent with the notion that lenders associate lower audit quality and higher information risk with certain attributes of component auditors. Further, the component auditor’s superior local knowledge mitigates cost of debt for firms with high foreign operations. We also conduct an event study and find an adverse bond market reaction around the first-time disclosure of Form AP.