Lower Audit Quality Research Articles

The Impact of Group Audit Arrangements on Audit Quality and Pricing

Regulators have raised concerns about the quality of group audits, particularly where other component auditors are involved. These other component auditors may be affiliated (i.e. part of the principal auditor’s network) or unaffiliated with the principal auditor. Using Australian disclosures, we examine these arrangements and their impact on audit quality and fees. Although international auditing standards require the signing auditor to accept responsibility for the entire engagement, we find lower audit quality for group audits involving the principal auditor’s network compared to other arrangements, suggesting potential over reliance on the work of network members. Further, we find that fees are relatively higher when other auditors are involved, particularly network auditors. Collectively, our evidence supports the need for closer monitoring of group audits by audit firms and regulators when other auditors, especially network auditors, are involved.

Understanding Audit Quality: Insights from Audit Partners and Investors

Projects seeking to define, measure, and evaluate audit quality are on the agendas of auditing standards setters as well as audit firms. The PCAOB currently provides information regarding audit quality through the release of inspection reports, and the Board intends to establish and report audit quality indicators. To provide additional perspective on audit quality, we obtain auditors’ and investors’ views, definitions, and indicators of audit quality. We find that investors’ definitions of audit quality focus more on inputs to the audit process than do auditors’, and that the two groups have differing views on the relation between PCAOB inspections and audit firm quality. We find a consensus that auditor characteristics may be the most important determinants of audit quality, and that restatements may be the most readily available signal of low audit quality. We relate responses to a generally accepted audit quality framework, provide support for archival audit research, and identify additional disclosures that participants suggest could signal audit quality. Taken together, we provide evidence regarding the construct of audit quality in the post-SOX environment, add substance to theoretical frameworks, evaluate many of the audit quality indicators proposed by the PCAOB, and suggest avenues for future research.

Japanese Stock Market Reaction to the Announcements of News Affecting Auditorss Reputation: The Case of Olympus Fraud

The revelation of accounting fraud by the Olympus Corporation gave rise to shareholder allegations of audit failure against Olympus’ auditors — Ernst & Young ShinNihon LLC and KPMG AZSA LLC — in 2011. In this study, we investigate whether the auditors’ affiliation with Olympus contributes to divergent perceptions of audit quality in the event of news announcements affecting the reputation of Olympus’ auditors. First, we use a nonparametric generalized rank event study methodology on 918 sample firms from the First Section of the Tokyo Stock Exchange (TSE) to observe Japanese investors’ perceptions of auditor reputation as proxied by abnormal returns. Second, we perform a multivariate linear regression on firms’ abnormal returns after controlling for firm-specific variables. We find that Japanese investors do not respond to negative or neutral reputational information arising from news announcements concerning Olympus’ auditors for firms affiliated and not affiliated with those auditors. In the absence of legal penalties imposed on Olympus’ auditors, we argue that Japanese investors consider the Olympus fraud case as an expected occurrence of audit failure due to a lack of evidence suggesting systematic audit failure on the part of Olympus’ auditors and an expectation of lower audit quality in the Japanese capital market. As a result, Japanese investors do not consider news announcements affecting the Olympus auditors’ reputation as sufficient evidence to change their prior expectation regarding the reputations of the audit firms affiliated with the Olympus fraud case.

Is There a Relation between Audit Fee Cuts During the Global Financial Crisis and Banks’ Financial Reporting Quality?

As a result of the global financial crisis (GFC), several audit clients were able to negotiate lower audit fees for the years 2008 and 2009. However, the PCAOB has expressed concern that lower audit fees might lead to lower audit effort and lower audit quality and financial reporting quality. This study examines the relation between audit fee cuts and banks’ financial reporting quality. Specifically, we focus on earnings management via loan loss provisions (LLP), the relation between current period LLP and future loan charge-offs, i.e., LLP validity, and the timely recognition of loan losses. For banks audited by Big 4 auditors, we find that income-increasing abnormal LLP are decreasing in audit fee cuts and LLP validity is increasing in audit fee cuts. For banks audited by non-Big 4 auditors, LLP validity is higher for banks that received a fee cut of more than 25 percent relative to other banks audited by non-Big 4 auditors. We do not observe an association between timely loan loss recognition and cuts in audit fees except for banks audited by non-Big 4 auditors and exempt from internal control audits where a fee cut of more than 25 percent is associated with less timely loan loss recognition. Overall, the findings suggest that Big 4 auditors constrained earnings management via LLP in banks that received cuts in audit fees. Our findings have important implications for regulators, investors, and others.

Firms that Fail to Address PCAOB Quality Control Criticisms Satisfactorily: New Insights on Audit Quality and Going Concern Reports

Part II of the Public Company Accounting Oversight Board (PCAOB) inspection report is released one year after the initial inspection report (Part I) only for firms that fail to remediate quality control criticisms (QCC firms). We provide evidence that the release of Part II discloses new relevant information about a firm’s disregard for maintaining an effective quality control system. More specifically, we find that QCC firms have lower audit quality in terms of restatements after the PCAOB provides their inspection findings than those firms that address their criticisms (Remediate firms). This suggests that the release of Part II indicates a disregard or an inability to address the identified weaknesses, which results in continued audit quality issues. We also find that the release of Part II foreshadows a change in auditors, either due to dismissal or resignation. Finally, we find that a majority of restatements for clients of QCC firms are discovered by a successor auditor of higher quality (non-QCC firm) after the client has changed auditors. We conclude that for triennial firms, Part II signals audit quality and the two-part reporting process leads to improved financial statement reliability.

Is Corporate Governance A Determinant of Auditor Choice -Evidence From Turkey

External independent audit is an important component of strong corporate governance. The choice of independent external auditor is determined by several different factors. Besides all firmspecific factors, corporate governance might be a determinant of external auditor choice. The relation between auditor choice and corporate governance varies in accordance with the “substitution or complementary effect”. Firms may prefer to demand less effective and low quality audit and substitute the quality of audit services by a strong corporate governance structure. Alternatively, firms may demand a high quality audit in order to complement and support firms’ corporate governance structure. Therefore it is important to understand how a strong corporate governance structure is associated with auditor choice to reveal the effect of each corporate governance mechanisms on Big-4 and industry-specialist auditor choice. The main aim of this study is to investigate the association between corporate governance and auditor choice by using a sample of 805 firm-year observations from Istanbul Stock Exchange (ISE) between the years 2005-2009. Overall findings show that, firms’ auditor choice in terms of Big-4 and audit firm industry specialization is affected by the firm-level corporate governance mechanisms of firms, particularly, board of directors’ composition and ownership structure

Are 'Contaminated' Offices Quarantined? An Examination of the Economic Consequences of Low Quality Audits

Are 'Contaminated' Offices Quarantined? An Examination of the Economic Consequences of Low Quality Audits

PCAOB inspection reports and audit quality

With the creation of the Public Company Accounting Oversight Board (PCAOB), audit firm oversight shifted away from self-regulation to independent regulation. The inspections program is the central feature of the PCAOB. We examine whether PCAOB inspections are able to distinguish actual audit quality (as opposed to perceived) during the period inspected to better understand this important regulatory tool. We use three measures that proxy for actual audit quality: abnormal accruals, restatements, and the propensity to issue a going concern opinion. For triennially inspected auditors, we find that PCAOB inspections are associated with lower audit quality when the reports are seriously deficient (weaker results for deficient reports). More specifically, we find clients of triennially inspected auditors that receive a deficient or seriously deficient report are associated with significantly higher abnormal current accruals and clients of auditors that receive a seriously deficient report are associated with a greater propensity to restate. Our evidence is subject to the caveat that PCAOB reports for triennially inspected auditors do not capture the going concern aspect of audit quality. For annually inspected auditors, the results are conflicting and suggest PCAOB inspection reports do not distinguish audit quality during the period inspected for annually inspected auditors.

Importing Accounting Quality: The Case of Foreign Reverse Mergers

The recent influx of foreign companies to the U.S. capital markets via reverse mergers, transactions that bypass the scrutiny given to IPOs, has raised concerns about the quality of financial reporting by the resulting firms. Using an array of proxies for reporting quality, we find that the reporting quality of these reverse merger (RM) firms, regardless of country of origin, is lower than that of their domestic industry peers and foreign cross-listed companies. However, the evidence is less conclusive regarding the alleged inferior quality of foreign RM firms relative to that of RM firms originating in the U.S. We also find that important determinants of the inferior reporting quality of RM firms are their lower audit quality and weaker external monitoring by the investing public. With few exceptions, investors appear to recognize this quality differential by tempering their reaction to accounting information reported by RM firms, and discounting these firms’ equity values relative to their non-RM industry peers. The findings have implications for investors, market regulators and auditors. They are also relevant for the discussion on the costs and benefits of harmonizing accounting standards and for the debate on the desirability of capital market stimuli in the form of relaxed reporting and disclosure rules.

The Effect of Workload Compression on Audit Quality

SUMMARYThis study investigates whether workload pressures, as proxied by the audit busy season (i.e., December fiscal year-end date) and auditor workload compression (i.e., relative concentration of companies with the same fiscal year-end date in an auditor's client portfolio), affect audit quality. Using a sample of 8,384 firm-year observations during the period 2006–2009, we find that busy season companies exhibit greater magnitudes of abnormal accruals and are more likely to meet or beat certain earnings benchmarks. Additional tests show that these associations are enhanced by the degree of auditor workload compression. Prior experimental and survey research indicates that workload pressures lead to dysfunctional behaviors and lower audit quality among individual auditors. Our archival findings suggest that these pressures can transcend the quality control mechanisms of a firm, affecting quality at the audit engagement level.

The Contagion Effect of Low-Quality Audits

We investigate if the existence of low-quality audits in an audit office indicates the presence of a contagion effect on the quality of other (concurrent) audits conducted by the office. A low-quality audit is defined as the presence of one or more clients with overstated earnings that were subsequently corrected by a downward restatement. We document that the quality of audited earnings (abnormal accruals) is lower for clients in these office-years (when the misreporting occurred) compared to a control sample of office-years with no restatements. This effect lasts for up to five subsequent years, indicating that audit firms do not immediately rectify the problems that caused contagion. We also find that an office-year with client misreporting is likely to have subsequent (new) client restatements over the next five fiscal years. Overall, the evidence suggests that certain audit offices have systematic audit quality problems and that these problems persist over time.

The Contagion Effect of Low-Quality Audits

ABSTRACTWe investigate if the existence of low-quality audits in an auditor office indicates the presence of a “contagion effect” on the quality of other (concurrent) audits conducted by the office. A low-quality audit is defined as the presence of one or more clients with overstated earnings that were subsequently corrected by a downward restatement. We document that the quality of audited earnings (abnormal accruals) is lower for clients in these office-years (when the misreporting occurred) compared to a control sample of office-years with no restatements. This effect lasts for up to five subsequent years, indicating that audit firms do not immediately rectify the problems that caused contagion. We also find that an office-year with client misreporting is likely to have subsequent (new) client restatements over the next five fiscal years. Overall, the evidence suggests that certain auditor offices have systematic audit-quality problems and that these problems persist over time.Data Availability: All data are publicly available.

The consequences of protecting audit partners’ personal assets from the threat of liability

This study investigates the audit firm’s decision to protect its partners’ personal assets by becoming a limited liability partnership (LLP). We find that the likelihood of an audit firm switching from unlimited to limited liability is increasing in its size and exposure to litigation risk. We find no evidence that audit firms supply lower audit quality, lose market share, or charge lower audit fees after they become LLPs. However, the mix of public and private clients in audit firms’ portfolios exhibits a significant shift toward riskier publicly traded companies after the switch to limited liability.

Auditing Fair Values: Effects of Procedure Frame, Procedure Verifiability, and Pressure for Audit Efficiency

Auditors must ensure that their audit plans budget sufficient time to key audit procedures. Research has shown that insufficient audit time budgets can be detrimental to audit quality. We examine whether framing audit procedures negatively (e.g., assess whether management’s assumptions are not appropriate) increases time budgets, particularly for procedures for which the auditor perceives that performance quality is less verifiable and thus most at risk of being performed with low quality. We report the results of an experiment in which 50 experienced audit managers budget time for an audit program to test a Level-3 fair value estimate, which prior research and PCAOB inspections indicate is a challenging audit area vulnerable to allegations of low audit quality. The results support our predictions. We also find that auditors are not aware of the extent to which framing affects their planning decisions. These results suggest that re-framing audit procedures negatively would increase audit time budgets, particularly for less-verifiable procedures.

Earnings Management and Auditor Quality

This paper analyzes the relationship between a firm’s demand for different quality auditors and opportunities for earnings management.In our model, the firm simultaneously chooses the bias it introduces into its pre-audited earnings and the quality of its auditor. We show that firms that choose a highlevel of bias also choose a low-quality auditor, even though the market-maker makes a correction for the level of residual bias in audited reports. Firms that choose a low level of bias choose a high-quality auditor.We also study the effect of changes in the regulatory environment on the market equilibrium.Our analysis shows that stricter regulation leads to more firms choosing low-quality auditors, thus it is not in the interest of high quality auditors to support such measures.

Ownership Concentration, Family Control, and Auditor Choice: Evidence from an Emerging Market

This empirical study extends the existing, yet limited, literature on the influence of ownership concentration and family control on auditor choice. Following prior studies, a firm is considered using a higher-quality audit when its external auditor is one of Big 4 audit firms. The sample consists of 787 firm-year observations of public firms listed on the Indonesia Stock Exchange (IDX) in the financial years 2005-2007. Empirical evidence obtained reveals that firms with larger ownership concentration are more likely to hire a Big 4 auditor. Hence, in such firms, high-quality audits are employed to mitigate agency issues. However, when the controlling shareholder is a family, the association between ownership concentration and demands for high-quality auditors turns negative, implying that family-controlled firms tend to sustain opaqueness gains by hiring lower-quality auditors.

Restoring Trust Among Investors after Shredded CPA Reputation: Evidence from China

Our study examines whether CPA firms take measures to improve their audit quality and restore trust among investors when their reputations are in danger subsequent to disciplinary actions by the government regulatory agencies in China. Compared with a control group of the CPA firms without a reputation crisis, we find that the CPA firms with shredded reputation have lower audit quality, experience more CPA turnover, and earn lower audit fees prior to the publicized accounting scandals and relevant disciplinary actions. We also find that, subsequent to the disciplinary actions, these CPA firms significantly increase their audit quality when they operate under strong legal environments and when affiliated with Big 4, have no difference in audit quality from the control group, and are less likely to be dismissed and more likely to charge higher audit fees after taking remedial action. These results should be of interest to the accounting profession in general and those in emerging markets in particular.

Office Size of Big 4 Auditors and Client Restatements

Francis and Yu (2009) and Choi, Kim, Kim, and Zang (2010) report evidence that Big 4 audits are of higher quality when the engagement office is of larger size: specifically, client earnings quality is higher and auditors in larger offices are more likely to issue going concern audit reports. We extend this line of research to test if larger Big 4 offices have fewer client restatements. A client restatement provides more direct evidence of a low-quality audit than earnings quality metrics or going concern reports, because a restatement indicates the client’s auditor did not effectively enforce the correct application of GAAP at the time the original financial statements were issued. We analyze 2,557 firm-year restatements in a sample of 23,190 financial statements originally issued by U.S. firms in 2003-2008. We find that Big 4 office size is associated with fewer client restatements after controlling for innate client characteristics that may affect restatements (client size, financial performance, industry membership, non-financial measures, off-balance sheet activities, and market-related measures), and a set of controls for other auditor factors such as fees and industry expertise. The study raises important questions about the ability of smaller offices to deliver high-quality audits for SEC registrants.

Are All Industry Specialist Auditors the Same?

SUMMARYWe expand upon the traditional market share-based measure of industry specialization by auditors to address the following question: Are industry specialist auditors who obtain their market share by auditing varying proportions of clients in an industry similar in terms of product (audit) quality and price (audit fees)? Our analyses suggest that the audit market is characterized by a type of segmentation in which some specialists pursue product differentiation strategies, focusing more extensively on the acquisition of requisite expertise, while others pursue cost minimization strategies, producing lower cost, lower quality audits. We find that audit fees and quality are higher (lower) when the specialist gains significant market share by auditing a low (high) proportion of clients in that industry. Our evidence suggests that specialists pursue different strategies in different settings. In some cases, specialist auditors may actually be low-end producers, raising a question of whether the “specialist” label is even appropriate.

Effects of Audit Quality on Earnings Management and Cost of Equity Capital: Evidence from China*

We examine the effects of audit quality on earnings management and cost of equity capital for two groups of Chinese firms: state-owned enterprises (SOEs) and non-state-owned enterprises (NSOEs). The differences in the nature of the ownership, agency relations and bankruptcy risks lead SOEs to have weaker incentives than NSOEs to engage in earnings management. As a result, the effect of audit quality in reducing earnings management will be greater for NSOEs than for SOEs. In addition, investors’ pricing of information risk as reflected in the cost of equity capital will be more pronounced for NSOEs than for SOEs with high and low audit quality. We find empirical evidence consistent with these hypotheses. Our findings indicate that (1) while high-quality auditors play a governance role in China, that role is limited to a subset of firms, and (2) even under the same legal jurisdiction, the effects of audit quality (in the form of lower earnings management and cost of equity capital) vary across firms with different ownership structures. Our study extends prior research by focusing on the economic consequences of SOEs’ and NSOEs’ auditor choices and underscores the importance of controlling for ownership type when conducting audit research.