Public Company Audit Research Articles

Public Company Audits and City-Specific Labor Characteristics

Prior research emphasizes the centrality of audit offices in understanding auditing practices, and documents significant inter-office variation in audit outcomes based on industry expertise and office size. Our study examines how two city-specific labor characteristics also affect audit offices and local audit markets: the city’s average educational attainment, and the number of accountants in a city, which proxy for a city’s human capital. Our argument draws on the urban economics literature and predicts that the level of human capital in a city is positively associated with an audit office’s ability to conduct high-quality audits. As expected, there is a positive association between audit quality (quality of audited earnings and accuracy of going concern reports) and average education level in the city in which the lead engagement office is located. This association is generally significant for both Big 4 and non-Big 4 offices, but is relatively stronger for non-Big 4 firms that are more tied to local labor markets. A company is also more likely to choose a non-Big 4 auditor in cities with higher educational levels and relatively more accountants, and there is evidence of higher non-Big 4 audit fees as a city’s education level increases. Collectively, these results suggest that local labor characteristics affect audit offices, audit quality, and the ability of non-Big 4 auditors to compete with Big 4 auditors in the audits of public companies.

Securing Big Data Provenance for Auditors: The Big Data Provenance Black Box as Reliable Evidence

ABSTRACTThe purpose of this article is to highlight a main issue regarding reliable audit evidence derived from Big Data—that of secure data provenance. Traditionally, audit evidence external to the client has been regarded as superior to other forms of evidence. However, regarding external “messy” Big Data sources that may be material to aspects of the audit, these sources may lack provenance and verifiability. That is, the origins of the data may be unclear and its log files incomplete. According to the standards, such evidence should be considered as less reliable for audit evidence. External auditors, as outsiders of the client, should be able to reproduce the data lifecycle or transaction path, which may not be possible in an electronic environment with incomplete provenance. Furthermore, this mapping or provenance of the data origins and history should be securely maintained so that it cannot be thwarted. This need for secure data provenance has been largely ignored by the business community in its haste to utilize Big Data, but has been acknowledged by extant systems research as being an area that requires attention. This paper contributes to the discussion of Big Data provenance through the lens of public company auditing, where the provenance and reliability of data sources and audit evidence are of paramount importance. This paper also proposes a system of secure provenance collection, the Big Data Provenance Black Box, which is derived from several streams of extant research.

The Pre-Departure Revolving Door Phenomenon: Investors' Independence Perceptions

This study examines nonprofessional investors’ perceptions of auditor independence when an accounting firm audits a client who has offered a job to a member of the audit team. The study also compares whether the perceived independence of both public and non-public company accounting firms improve as the strength of the revolving door safeguards increase. Empirical research has not proven whether Section 206 of the Sarbanes-Oxley Act improves perceptions of auditor objectivity when issues of auditor employment with the client appear prior to the auditor leaving the firm. Ninety-six nonprofessional investors from a University in the United States respond to an experiment to answer the hypotheses in this study. While the revolving door phenomenon impairs perceptions of public and non-public accounting firms’ independence, public company auditors’ independence is perceived to be more impaired by this threat to independence. The results also indicate that even though perceptions of both firms’ objectivity improve as the strength of the independence safeguards increase, public company auditor are perceived as being more objective than non-public company auditors. This study has implications for accounting regulators and academics. Accounting regulators may first consider how to improve perceptions of firms that audit non-public companies in order to fully realize the benefits of increasing the strength of the standards. Regarding the academic literature, this study is the first post-Sarbanes-Oxley study to empirically establish that the pre-revolving door phenomenon impairs objectivity. This is also the first study to investigate nonprofessional investors’ perceptions of the issue, despite their prominence in the capital markets.

Discussion of “Does the Identity of Engagement Partner Matter? An Analysis of Audit Partner Reporting Decisions”

AbstractThe authors of this provocative study apply commonly used audit quality surrogate measures to a large and unique set of financial and other data on statutory audits of small private companies in Sweden. The paper has received unparalleled attention by the financial press and the PCAOB for its presumed support for regulatory intervention in standards for U.S. public company audits. In this Discussant Comment, I review the paper's content, analyze its predictive validity, and discuss its multiple implications plus, following Conference instructions, I provide constructive suggestions for improvements. Based on predictive validity analysis, I conclude that engagement partner assignment strategy is an important and acknowledged omitted variable that affects the study's internal validity via both the independent variable (partner's prior performance measure) and the dependent variable (borrower's cost of debt capital). The omission also affects construct validities and, if audit firms are applying a plausible assignment strategy, then interpretation of the study's main results would be reversed. Finally, the lack of a standards intervention noted by the authors and the extreme size and other differences between audits of Swedish private companies and U.S. public companies impair external validity and generalization to the U.S. intervention. As to improvements, I suggest that the authors (i) ask Swedish lenders to validate their presumed use of partner performance ratings in determining a borrower's interest rate, and (ii) ask Swedish Big 4 audit firms to provide a few internal partner performance ratings for comparison with the external performance measures used in the study. This two‐pronged, multimethod approach might confirm or deny critical assumptions underlying the present study and may substantively inform standards setters, evidence‐based standards, and fellow researchers about the validity of commonly applied surrogates for audit quality and the study's stated conclusion.

Non-Big 4 Local Market Leadership and its Effect on Competition

ABSTRACTThis study examines local characteristics associated with non-Big 4 local market leadership and the impact of non-Big 4 local market leadership on competition. We identify non-Big 4 local market leaders by collecting accounting firm rankings from business publications for 46 of the largest metropolitan statistical areas from 2005–2010. These rankings are based on the number of local office employees and provide a more holistic measure of office size than measures based on public company audit fees. We find local supply and demand factors are significantly associated with non-Big 4 local market leadership and that non-Big 4 leadership is associated with lower overall audit fees in the local market. We also find that non-Big 4 leaders earn a fee premium over other non-Big 4 auditors. Our results imply that non-Big 4 leaders increase local market competition.Data Availability: All data are publicly available from sources identified in the study.

Discussant Comments on 'Does the Identity of Engagement Partner Matter? An Analysis of Audit Partner Reporting Decisions'

The authors of this provocative study apply commonly used audit quality surrogate measures to a large and unique set of financial and other data on statutory audits of small private companies in Sweden. The paper has received unparalleled attention by the financial press and the PCAOB for its presumed support for regulatory intervention in standards for U.S. public company audits. In this Discussant Comment, I review the paper’s content, analyze its predictive validity, and discuss its multiple implications plus, following Conference instructions, I provide constructive suggestions for improvements. Based on predictive validity analysis, I conclude that engagement partner assignment strategy is an important and acknowledged omitted variable that affects the study’s internal validity via both the independent variable (partner’s prior performance measure) and the dependent variable (borrower’s cost of debt capital). The omission also affects construct validities and, if audit firms are applying a plausible assignment strategy, then interpretation of the study’s main results would be reversed. Finally, the lack of a standards intervention noted by the authors and the extreme size and other differences between audits of Swedish private companies and U.S. public companies impair external validity and generalization to the U.S. intervention. As to improvements, I suggest that the authors (a) ask Swedish lenders to validate their presumed use of partner performance ratings in determining a borrower’s interest rate, and (b) ask Swedish Big four audit firms to provide a few internal partner performance ratings for comparison with the external performance measures used in the study. This two-pronged, multi-method approach might confirm or deny critical assumptions underlying the present study and may substantively inform standards setters, evidence-based standards, and fellow researchers about the validity of commonly applied surrogates for audit quality and the study’s stated conclusion.

Auditors' Perceptions of the PCAOB Inspection Process

This study examines U.S. auditors’ observations of the PCAOB inspection process, and its impact on their work, in order to understand the current U.S. regulatory audit climate. Using 20 interviews with experienced auditors, we consider behavioral factors (e.g., perceived power of and trust in the PCAOB) that can impact the level and form of auditor compliance according to theory from the slippery slope framework on audit regulation (Kirchler et al. 2008; Dowling et al. 2018). Our participants described an audit climate with a powerful regulator. They reported that their desire to receive “clean” inspection reports has had a substantial impact on audit procedures and quality control. However, our participants do not appear to have high trust in the PCAOB, as they questioned aspects of the inspection process and its expectations. Accordingly, we conclude that U.S. public company auditors operate in an antagonistic environment where auditors perceive the PCAOB has high coercive power. In other words, they comply due to fear of enforcement rather than agreement with the PCAOB’s views on audit quality. Some auditors also indicated that they consider both the costs and benefits of compliance. Theoretical intuition implies that any future increases to perceived costs relative to perceived benefits of compliance could ultimately decrease the PCAOB’s coercive power and reduce U.S. auditor compliance. Our findings have implications for regulators and researchers interested in understanding behavioral factors that may influence regulatory compliance.

Audit fee residuals: Costs or rents?

Audit fee residuals (the error term from audit fee models) are widely used in the accounting research literature. Researchers, however, have adopted contrasting views of these fee residuals. One view is that fee residuals are a combination of noise and auditor rents (i.e., abnormal profits), while the other view is that they are a combination of noise and unobserved audit costs (including any risk premium and a normal rate of return on all factors of production). As a result, identical research findings are presently given conflicting policy interpretations. We use differences in fee residual persistence across continuing and new audit engagements to elucidate the extent to which fee residuals consist of unobserved audit costs, auditor rents, and noise elements. In a large sample of U.S. public company audit engagements, we find evidence suggesting that fee residuals largely consist of researcher-unobserved audit production costs common to all auditors. We discuss the implications of this finding for policy setters and for future auditing research.

The Impact of Downward Auditor Changes on Information Risk for Non-Accelerated Filers

In this study, we examine the impact of changes in auditor quality on financial reporting information risk, particularly for smaller public companies (non-accelerated filers). Non-accelerated filers represent a large share of public reporting companies (over 60% in 2009), and given opportunity to grow, can create new jobs, providing incentives for recent efforts to exempt or scale back costly regulations. The regulatory easing has created lower disclosure and audit requirements for smaller public companies (non-accelerated filers) compared to larger public companies (accelerated filers). The demise of Arthur Andersen and increased attestation requirements for larger public companies has caused a dramatic decrease in Big 4 audits of smaller public companies. A downward auditor change (from a Big 4 to lower tier auditor) provides the setting to examine the extent to which auditor quality (proxied by auditor size) attenuates or mitigates non-accelerated filer information risk, as measured by stock return synchronicity. Contrary to our expectations, we find that non-accelerated filers have lower information risk in the period following downward auditor changes from Big 4 auditors compared to a matched sample of non-accelerated filers that continue to retain Big 4 auditors. This result also applies when the comparison group is a sample of accelerated filers that change from Big 4 auditors. The results are particularly salient for downward changes to Tier 2 auditors. Our study adds to the literature on audit quality and should be of interest to investors, researchers, and regulators.

Standardi revizije

The theme of this article is to present the importance of international auditing standards, the provisions of the Lima Declaration, as well as the international organization of state audit (INTOSAI). Regional working groups are spread on all continents promote the objectives of INTOSAI in their regions, thus providing members the opportunity for professional and technical cooperation at the regional level. In order to audit process successfully completed, with the expertise and training of auditors, require use of and adherence to standards audit. Many states have laws on the public sector audit incorporate the provisions of the Lima Declaration, in the sense that it is the responsibility of the budget and performance audits of public companies. For example 24 countries within the European Union's laws on public sector auditing within the jurisdiction of the Supreme Audit Institutions put the audit of public companies.

Do PCAOB Inspection Reports Influence Corporate Executives' Perceptions of Audit Quality and the Likelihood of Switching Auditors?

ABSTRACT The PCAOB conducts inspections of public company auditors to improve audit quality and build investors' confidence in the quality of financial reporting (PCAOB 2010f). While there is some evidence that the inspection reports could be improving actual audit quality (e.g., Gramling et al. 2011; Carcello et al. 2011), their impact on perceptions of audit quality remains largely unexplored. We investigate the effects of inspection reports, which consistently disseminate negative information in the form of audit deficiencies (and in some cases, quality control criticisms) on perceived audit quality and potential auditor switching. We report the results of an experiment in which 90 corporate executives considered one of three response patterns that firms typically offer across multiple inspection reports: consistently provide concessions, consistently provide denials, or provide mixed responses that consist of both concessions and denials. We find that PCAOB inspection reports generally decrease perceived audit quality, regardless of response pattern, which, in turn, is generally associated with an increased likelihood that executives will consider switching auditors. We offer implications for audit policy and research, including the possibility that, while PCAOB inspections could be improving actual audit quality, the reports could be imposing costs by reducing perceived audit quality and, in turn, increasing the likelihood of auditor changes. Data Availability: Contact the first author.

Between a Rock and a Hard Place: A Path Forward for Using Substantive Analytical Procedures in Auditing Large P&L Accounts: Commentary and Analysis

SUMMARYSubstantive analytical procedures can be an important and effective audit tool to gather evidence and highlight areas of potential misstatement, and for decades have been one of the common substantive procedures applied to income statement accounts. Recently, however, there is a growing trend for public company auditors to forego substantive analytical procedures on large income statement accounts, such as revenue, due to criticisms from regulatory inspectors that such procedures are not capable of providing useful substantive evidence. In this commentary, we address the concern that discouraging the application of appropriately rigorous substantive analytical procedures may diminish overall audit quality. We consider whether rigorous substantive analytical procedures can be designed to provide useful evidence at moderate and low levels of assurance for large income statement accounts, such as revenue, even when the significant-difference threshold exceeds overall materiality. Such procedures can provide strong evidence that financial statements are free of massive fraud or unintentional misstatement. Further, the moderate or low assurance obtained by such substantive analytical procedures can be combined with assurance provided by other audit procedures to yield high overall assurance. We illustrate one potential approach that may be useful in designing substantive analytical procedures to achieve moderate or low assurance and we explain how our approach is consistent with auditing theory and auditing standards.

Comments by the Auditing Standards Committee of the Auditing Section of the American Accounting Association on PCAOB Release No. 2013-009,Proposed Rule on Improving the Transparency of Audit: Proposed Amendments to PCAOB Auditing Standards to Provide Disclosure in the Auditor's Report of Certain Participants in the Audit

SUMMARYOn December 4, 2013 the Public Company Accounting Oversight Board (PCAOB) solicited public comments on its reproposed amendments to its standards that would improve the transparency of public company audits. The amendments would require (1) disclosure in the auditor's report of the name of the engagement partner, and (2) disclosure in the auditor's report of the names, locations, and extent of participation of other independent public accounting firms that took part in the audit and the locations and extent of participation of other persons not employed by the auditor that took part in the audit. The comment period initially ended on February 3, 2014, but was subsequently extended to March 17, 2014. This commentary summarizes the contributors' views on these amendments.Data Availability: The exposure drafts of the proposed and reproposed rules and related information are available at: http://pcaobus.org/Rules/Rulemaking/Pages/Docket029.aspx

Reflections on the Establishment of the PCAOB and Its Audit Standard-Setting Role

SYNOPSIS This is an essay on the causes of the establishment of the PCAOB as the U.S. regulator of auditors of the financial statements of public companies, and the key developments in its role as a professional standard setter. From its inception in the U.S., the accounting profession was largely self-regulated. There was a degree of governmental regulation by state licensing laws, and the SEC's regulation of the offering and trading of securities of public companies. The federal securities laws gave the SEC direct authority over accounting standards, and indirect authority over auditing requirements through its ability to specify the form of audit reports. The SEC, however, looked primarily to the accounting profession to set its own standards. Some viewed the ability to set professional standards as an essential hallmark of professionalism. In 2002, that comfortable arrangement changed dramatically, and the regulation of auditors of public companies became the purview of the PCAOB.

What Drives Auditor Selection?

SUMMARY This study provides evidence on the factors that currently impact audit committee members' selection of external auditors. Using a two-stage approach, we survey and interview public company audit committee members (ACMs), and find evidence that management continues to provide input into the decision process even as SOX regulations require audit committees to take responsibility for the auditor selection decision. ACMs view management as an important information source when they assess the proposing audit partner's reputation for accessibility, timeliness, and ability to liaise with the firm's national technical office, as well as the proposing audit firm's technical and industry expertise. Results of this study can help firms be more competitive in the audit bidding process, inform policy makers when considering whether to impose further audit committee regulations, and aid academics in ensuring an up-to-date understanding of the audit committee's role in the auditor selection process.

Measuring Country Differences in Enforcement of Accounting Standards: An Audit and Enforcement Proxy

AbstractIn this paper we present an index designed to capture differences between countries in relation to the institutional setting for financial reporting, specifically the auditing of financial statements and the enforcement of compliance with each country's accounting standards. The use of a common set of standards such as International Financial Reporting Standards (IFRS) aims, in broad terms, to promote the comparability and transparency of financial statements and to improve the quality of financial reporting. However, the effectiveness of IFRS adoption may be hampered by differences, across countries, in the institutional setting in which financial reporting occurs. Studies of outcomes from adopting IFRS use a range of legal system proxies to capture these country differences, but the proxies are deficient in that they seldom focus explicitly on factors that affect how compliance with accounting standards is promoted through external audit and the activities of independent enforcement bodies. To address this deficiency, we calculate measures of the quality of the public company auditors’ working environment (AUDIT) and the degree of accounting enforcement activity (ENFORCE) by independent enforcement bodies. We do this for 51 countries for each of the years 2002, 2005 and 2008, using publicly available data provided by the International Federation of Accountants (IFAC), the World Bank and the national securities regulators. Preliminary tests suggest our indices have additional explanatory power (over more general legal proxies) for country‐level measures of economic and market activity, financial transparency and earnings management. We expect they will prove useful to researchers and other interested parties who require country‐level measures that focus on the degree of enforcement of financial reporting practices.

Between a Rock and a Hard Place: A Path Forward for Using Substantive Analytical Procedures in Auditing Large P&L Accounts: Commentary and Analysis

Substantive analytical procedures can be an important and effective audit tool to gather evidence and highlight areas of potential misstatement, and for decades have been one of the common substantive procedures applied to income statement accounts. Recently, however, there is a growing trend for public company auditors to forego substantive analytical procedures on large income statement accounts, such as revenue, due to criticisms from regulatory inspectors that such procedures are not capable of providing useful substantive evidence. In this commentary, we address the concern that discouraging the application of appropriately rigorous substantive analytical procedures may diminish overall audit quality. We consider whether rigorous substantive analytical procedures can be designed to provide useful evidence at moderate and low levels of assurance for large income statement accounts, such as revenue, even when the significant-difference threshold exceeds overall materiality. Such procedures can provide strong evidence that financial statements are free of massive fraud or unintentional misstatement. Further, the moderate or low assurance obtained by such substantive analytical procedures can be combined with assurance provided by other audit procedures to yield high overall assurance. We illustrate one potential approach that may be useful in designing substantive analytical procedures to achieve moderate or low assurance and we explain how our approach is consistent with auditing theory and auditing standards.

Audit Quality

The importance of fostering more accurate audits has been heightened by a series of high-profile accounting scandals at the beginning of the millennium. These scandals prompted more stringent regulations over corporate governance and financial reporting and the creation of audit oversight bodies as the Public Company Accounting Oversight Board (PCAOB) in the United States and the Public Oversight Board (POB) in the United Kingdom. In parallel, the growing globalization of business has brought forth calls for adherence to a common set of International Financial Reporting Standards (IFRS). Even if a common standard is promulgated, it will not lead to similar results if implementation differs across countries. Therefore, it is important to investigate the auditing regulatory regimes in different nations and the status of cross-border audit inspections. Accordingly, we begin by describing the cross-national institutions (e.g., the International Federation of Accountants [IFAC]) that impact national regulatory choices. Then we survey the audit regulatory practices of public company auditors of a select group of major economic powers and based on this analysis, we discuss the challenges and obstacles to engaging in intra-national audit, cross-national audit/inspections, and the challenges posed by differences in auditing standards used in various linked (e.g., by joint ventures, etc.) nations. We include in this discussion the effects of national culture, investor legal protection, economic development, and differing financial standard sources.

A summary of 10 years of PCAOB research: What have we learned?✩

For the past 10 years, the Public Company Accounting Oversight Board (PCAOB) has operated as an independent overseer of public company audits. Over 70 percent of PCAOB studies have been published since 2010, evidencing the increasing relevance of PCAOB-related research in recent years. Our paper reviews the existing literature on the PCAOB’s four primary functions – registration, standard-setting, inspections, and enforcement. In particular, we examine PCAOB registration trends and evaluate the effects of PCAOB registration requirements on the issuer audit market, as well as discuss the relative costs and benefits (e.g., auditor behavior changes, improvements in audit quality, auditor perceptions) of the 16 auditing standards the PCAOB passed in its first 10 years of operation. Further, we summarize the literature’s findings on the effects of the PCAOB inspection process on various facets of audit quality. Finally, we analyze the research concerning the PCAOB’s enforcement actions to determine how markets have responded to sanctions against auditors and audit firms. We contend that understanding and reviewing the effects of the PCAOB’s activities are important to future audit research because of the PCAOB’s authority over and oversight of the issuer audit profession. We also identify PCAOB-related research areas that have not been fully explored and propose several research questions intended to address these research areas.

Direct and Mediating Effects of Auditor Quality on Auditor Size and Performance

In defining audit quality, DeAngelo (1981) assumes no variation in auditor’s technical competency in discovering a breach. Instead, we relax this assumption and utilize principal components analysis technique to extract auditor quality from human capital factors of an audit firm. With the auditor quality, this study examines the association between auditor size and performance. In terms of market segment, audit firms are divided into public company audit market firms (PCAMFs) and non-public company audit market firms (NCAMFs). Based on path analysis, we find that auditor size has direct effect on performance and indirect effect through auditor quality. Auditor quality associates with both auditor size and performance positively. In further, auditor size has more contribution to performance of PCAMFs than that of NCAMFs. Auditor quality of PCAMFs explains more variation of financial performance than do NCAMFs. The results indicate that PCAMFs earn more financial performance through the upgrade of auditor quality.