The effect of external audits of internal control over financial reporting on financial reporting for clients of Big 4, Second-tier,and small audit firms

The external audit of internal control over financial reporting (ICFR) is a very expensive and contentious aspect of the Sarbanes–Oxley Act (SOX). Larger public firms were first required to file a management report on and have an external audit of ICFR in 2004. Smaller public firms were first required to file a management report on ICFR in 2007 but are exempt from the audit requirement. Whereas most related prior research investigates the combined effect of management and auditor reports on financial reporting, this study examines the distinct effect of auditor reports on reporting quality. For companies audited by small auditors, we find evidence that financial reporting quality improves with an auditor report on ICFR. We find no evidence that auditor ICFR reports improve reporting quality for clients of Big 4 or Second-tier audit firms. Our study adds to the debate on the applicability of SOX Section 404 to smaller firms.     

审计师更换时机对年报及时性和审计质量的影响

上市公司出于不同的动机,选择在不同的时间进行审计师更换,因而对年报的及时性和审计质量产生了不同影响。本研究发现,较晚更换审计师的上市公司,相对于较早更换审计师的上市公司,不仅其财务报告的及时性显著较差,而且审计质量也明显较低。     

Determinants and consequences of voluntary switches to Chinese auditors in Hong Kong

Hong Kong market regulators have permitted 12 large Chinese accounting firms to audit the financial statements of Chinese firms that cross list in Hong Kong (i.e., H-share firms) since 2010. This paper examines the characteristics of H-share firms that voluntarily replaced their Hong Kong (HK) auditors with Chinese auditors, and the market reaction to auditor switches following this policy. We find that 38 out of 147 H-share firms voluntarily switched to Chinese auditors during 2011–2013. Switching firms are larger in size and are less likely to use Big4; they also have less need for external financing, a longer cross listing history, and a lower percentage of foreign revenue. We also find that investors negatively react to the auditor switches from HK non-Big4 to China non-Big4, but do not react to the auditor switches from HK Big4 to China Big4. This suggests that investors perceived lower audit quality for China non-Big4.     

Government quality,auditor choice and adoption of IFRS: A cross country analysis

We examine the association between country-level government quality and firms' choice of external auditors. Using a cross-sectional sample of 142,193 firm-year observations from 46 countries over 1998–2007, we show that the government quality of a country has a significant positive effect on the likelihood of choosing Big 4 auditors by firms in that country. We also show that firms in countries with strong governments that have adopted IFRS are more likely to choose Big 4 than non-Big 4 auditors. To our knowledge, this is the first study of its kind to provide direct evidence on the role of government quality in firms' choice of external auditors. Choice of a Big 4 auditor may be regarded as a proxy for the demand for high quality financial reporting, and thus the results provide insights for policy makers on the importance of government quality toward improving financial reporting quality in a country.     

Effects of audit committee chair characteristics on auditor choice,audit fee and audit quality

We investigate whether the characteristics of audit committee (AC) chairs are associated with decisions about auditor choice, audit fees and audit quality. Using hand-collected Australian data, firms with AC chairs who have longer tenure and multiple AC memberships across several boards are found to be more likely to choose Big 4 and/or industry specialist auditors, pay higher audit fees and have lower discretionary accruals. Those AC chairs with higher business qualifications are more likely to hire a Big 4 auditor, pay higher audit fees and have lower discretionary accruals, while AC chairs with professional qualifications are more likely to hire a Big 4 and/or industry specialist auditor. In contrast, firms with AC chairs who are executive directors are less likely to hire a Big 4 auditor and have higher discretionary accruals. Our findings contribute to the literature by documenting that various characteristics of AC chairs are important for enhancement of auditor selection and audit quality.     

Does sharing the same network auditor in group affiliated firms affect audit quality?

We contribute to the literature on audit quality by examining whether sharing the same network auditor among group affiliated firms is related to lower or higher audit quality in China. We find that choosing the same network audit firm among group affiliated firms is associated with more sanctions by regulators regarding fraudulent financial reporting, higher abnormal accruals, larger standard deviation of abnormal accruals, higher likelihood of a downward restatement in earnings, and lower likelihood of receiving a going concern modified opinion. We further identify contexts that moderate audit quality. Higher audit quality is associated with the use of a specialist auditor and firms that operate in more homogeneous industries. Lower audit quality is associated with longer auditor tenure (more than five years), greater geographic distance between a parent company and its subsidiaries, and greater control by a parent company over its subsidiaries.     

Audit quality,accruals quality and the cost of equity in an emerging market: Evidence from Vietnam

This study explores the relationship between audit quality, accruals quality, and the cost of equity in the context of Vietnam. Particularly, we examine the impact of auditor size and accruals quality on the industry-adjusted earnings – price ratio. Using a sample of Vietnamese listed companies, the study shows that firms audited by a Big Four auditor are associated with a lower cost of equity than firms with a non-Big Four auditor. The results indicate that the auditors' information role is more relevant than the insurance role in a civil law context with a relatively low auditor litigation risk. In addition, the findings show that companies with better accruals quality are associated with a lower cost of equity. The study has implications for managers and regulators. The findings highlight the importance of ensuring sound auditing practices and maintaining high-quality financial reporting for corporations.     

Do the Big 4 and the Second-tier firms provide audits of similar quality?

In this paper, we examine audit quality for Big 4 and Second-tier auditors during 2003–2006. We utilize the auditor’s propensity to issue a going concern audit report for distressed clients as a measure of audit quality. In addition, since the purpose of an audit is to improve financial reporting quality, we utilize abnormal accruals as an observable proxy for audit quality. Further, we utilize the client- and year-specific ex ante equity risk premium as a proxy for audit quality as perceived by investors. We control for auditor self-selection bias using the matched-pairs sample approach discussed by Francis and Lennox (2008). We find weak evidence that the Big 4 have a higher propensity to issue going concern audit opinions for distressed companies. However, the level of performance-adjusted abnormal accruals for Big 4 and Second-tier audit firm clients appears to be similar. With respect to investor perceptions, we find the client-specific ex ante equity risk premium to be lower for Big 4 clients than for Second-tier audit firm clients. Overall, our findings suggest little difference in actual audit quality but a more pronounced difference in perceived audit quality. Collectively, the evidence we provide informs the current discourse on audit quality, auditor choice, and the viability of Second-tier auditors as an alternative to the Big 4.     

The Emergence of Second‐Tier Auditors in the US: Evidence from Investor Perceptions of Financial Reporting Credibility

We examine changes in the association between auditor type (Big 4, Second‐Tier, and Other non‐Big 4) and perceived financial reporting credibility in the wake of events (e.g., Andersen's failure, the implementation of SOX, creation of the PCAOB, etc.) which led to significant growth in Second‐Tier client portfolios and increased scrutiny of Second‐Tier audit practices. Our results reveal that financial reporting credibility of Second‐Tier clients was lower than that of Big 4 clients and was indistinguishable from that of Other non‐Big 4 clients pre‐Andersen. However, post‐Andersen, we find that financial reporting credibility of Second‐Tier clients is higher than that of Other non‐Big 4 clients and is indistinguishable from that of Big 4 clients. We expect that our results will be of interest to regulators, both in the United States and in the European Union, who have expressed concerns about the current state of competition in the audit market, management and boards of directors that are contemplating switching to a Second‐Tier audit firm, and academics investigating quality differences among audit firm types.     

Being private,Big 4 auditors,and debt raising

This study investigates the role of auditor choice (Big 4/Non-Big 4) in debt financing for private and public firms. We find private firms have less access to debt than public firms, and Big 4 auditors support debt raising in both private and public firms. Consistent with private firms facing greater information asymmetry, Big 4 auditors are more important for debt raising in private firms than in public firms. The benefit of appointing Big 4 auditors for private firms' debt raising is greater in the opaque information environment of the global financial crisis. It is also greater when firms are smaller, younger, or have poorer financial reporting quality. We also find evidence consistent with Big 4 auditors mitigating agency conflicts and enhancing debt raising when ownership concentration is higher in private firms.     

Auditor Choice in Politically Connected Firms

We extend recent research on the links between political connections and financial reporting by examining the role of auditor choice. Our evidence that public firms with political connections are more likely to appoint a Big 4 auditor supports the intuition that insiders in these firms are eager to improve accounting transparency to convince outside investors that they refrain from exploiting their connections to divert corporate resources. In evidence consistent with another prediction, we find that this link is stronger for connected firms with ownership structures conducive to insiders seizing private benefits at the expense of minority investors. We also find that the relation between political connections and auditor choice is stronger for firms operating in countries with relatively poor institutional infrastructure, implying that tough external monitoring by Big 4 auditors becomes more valuable for preventing diversion in these situations. Finally, we report that connected firms with Big 4 auditors exhibit less earnings management and enjoy greater transparency, higher valuations, and cheaper equity financing.     

How individual auditor characteristics impact the likelihood of audit failure: Evidence from China

Audit failure imposes a severe loss on investors and damages market participants' confidence in financial reporting quality. This study investigates the impacts of individual auditor characteristics on the likelihood of audit failure. Chinese regulators mandate listed firms to disclose the engagement auditors' identity. Furthermore, the information regarding individual auditor characteristics in China is also publicly available. Utilizing this unique setting, we examine the relationship between individual auditor characteristics and the likelihood of audit failure in China during the period from 2000 to 2009. We document that individual auditors with more auditing experience are less likely associated with audit failure. We also find a weaker negative relationship between auditor education level and audit failure. Our study has important implications for both auditors and regulators by shedding lights on the determinants of audit failure and by providing guidance to the human resource management in audit firms.     

Top executive gender diversity and financial reporting quality

We examine whether gender diversity of chief executive and chief financial officers (CEOs and CFOs) is associated with financial reporting quality. The CEOs and CFOs of publicly traded companies are both required to certify the appropriateness of their financial statements and annual disclosures. We argue that gender diverse dyads (groups) of executives can bring different perspectives and professional skepticism to financial reporting. Using a sample of different CEO/CFO gender dyads during 2006–2019, we postulate and find evidence of higher accruals quality among firms led by gender-diverse dyads compared to accruals quality reported by firms led by all-male CEO/CFO pairs. Additional analyses reveal that the auditors of firms with gender-diverse executive dyads issue audit reports later, charge higher audit fees, and are more likely to be one of the Big 4 firms. These findings support the view that top executive gender diversity enhances financial reporting quality, which has important implications for corporate governance mechanisms.     

Auditor specialization, perceived audit quality, and audit fees in the local government audit market

Prior governmental research implies a positive relation between auditor specialization and audit quality, but the effect of specialization on audit fees is mixed. However, no single governmental study investigates the effect of auditor specialization on both audit quality and audit fees. Also, prior studies focus on either large- or small audit firms and often employ indirect proxies for audit quality. We study the effects of auditor specialization on perceived audit quality and audit fees. Our data represent both Big 5 and smaller audit firms and include three market-based measures of specialization. We survey 241 Florida local government finance directors and find that specialization is positively associated with perceived audit quality but not with audit fees. We also find that Big 5 auditors, often used as a proxy for higher audit quality in prior research, are not uniformly associated with increased perceived audit quality but consistently charge higher audit fees. Our results confirm a relation between measures of audit firm specialization and audit quality and raise questions regarding audit firm size and audit quality in the municipal sector. Our findings suggest that engaging specialized auditors may be good policy for many local governments.     

Audit committee quality indices,reporting quality and firm value

We investigate the relation between audit committee (AC) quality indices, financial reporting, internal control quality and firm value using a US dataset for the period 2002–12. The indices are developed by linking firm value with principal component analysis (PCA) factors based on a broad set of 82 AC variables, some of which influence the quality of the AC, but are not addressed in prior literature. Significant AC factors include ‘overlapping directors’, ‘busyness’ and ‘foreign director’, and we use these factors to develop ‘high’ and ‘low’ AC quality indices. We show that low AC quality firms are more likely to manage earnings, be external auditor dependent with respect to non‐audit tax services, and switch to a lower quality auditor. Low AC quality firms are also more likely to have internal control concerns disclosed by predecessor auditors, including accounting issues, financial restatements, audit opinion concerns and deficiencies that undermine internal control effectiveness. Further, they are more likely to receive an audit report containing additional explanatory notes. Conversely, high AC quality firms are significantly less likely to have these concerns. Our findings highlight the value of using AC quality indices in delivering greater oversight of the financial reporting process.     

Conservative Reporting and the Incremental Effect of Mandatory Audit Firm Rotation Policy: A Comparative Analysis of Audit Partner Rotation vs Audit Firm Rotation in South Korea

In this paper, we take advantage of Korea's unique experiment with mandatory audit firm rotation (MAFR) and mandatory audit partner rotation (MAPR) to ascertain their influence on audit quality, proxied by conditional conservatism. Overall, we find that the implementation of MAFR did not have the desired effect. Firms that adopted MAFR demonstrate higher levels of conservatism in previous periods under MAPR (or compared to voluntary adopters). Furthermore, we find that audit tenure increases conservatism levels consistent with the auditor expertise hypothesis. However, whilst evidence suggests MAFR decreases audit quality on the whole, we find that firms that switch from non‐Big 4 to Big 4 auditors demonstrate higher conservatism because Big 4 auditors are more likely to demand conservative accounting practices, consistent with Big 4 audit firm knowledge superiority. Overall, the results suggest that MAFR's negative effect on audit quality can be mitigated by Big 4 auditor supervision.     

Auditor Independence: A Nonparametric Test of Differences Across the Big‐5 Public Accounting Firms

This small sample study provides additional evidence on the unsettled question of auditor independence: Does the provision of non‐audit services by an auditor compromise independence resulting in a poor quality audit? We also examine whether these findings vary across the “Big‐5” public accounting firms. Most prior studies addressing this question, using parametric approaches and various measures of audit quality, have reported conflicting results. Contrary to these studies, we use a non‐parametric approach and the probability of GAAP violation as a new measure of audit quality to address this question. Using data from a sample of Fortune 500 companies for the year 2000, we find that firms whose auditors provide substantial non‐audit services tend to have a higher propensity to violate GAAP. At the firm‐level analysis, we find that these results are more likely driven by few of the Big‐5 public accounting firms. For the remaining firms, the association between non‐audit services and quality of audit could not be established, primarily because of small sample size and lack of power in the test. Our main finding is consistent with other recent studies that provide evidence that the rendering of significant non‐audit services by auditors creates conflict of interest resulting in poor quality audits. Furthermore, our result of differences in these levels of association among the Big‐5 accounting firms represents a new finding, and suggests that there is a need for controlling them separately in research studies examining auditor independence.     

Empirical Evidence on the Implicit Determinants of Compensation in Big 4 Audit Partnerships

This study investigates the implicit financial incentives of individual Big 4 audit partners by examining the association between a partner's compensation and characteristics of the audit firm, audit partner, and individual partner clientele for Big 4 firms in Sweden. Using tax and financial data for individual audit partners and clients, our empirical findings indicate that there is significant variation in the implicit determinants that are associated with compensation across the Big 4. We find that audit partners’ compensation is positively associated with the size of their clientele or the number of publicly traded clients, both of which represent revenue‐generating opportunities. Similarly, compensation and developing an industry specialization are positively related. In three firms, gaining clients is clearly related to an increase in compensation, while losing a client is associated with a reduction in partner income in only one firm. We find that audit partner income is more sensitive to performance‐related incentives, such as attracting new clients, as partners progress in their career. Finally, we find evidence that audit failures, proxied by reporting errors related to issuing a going concern opinion, are associated with lower compensation. These results should be of interest to the auditing profession, audit firms, and regulators when they consider the effects of implicit incentives of partner compensation on audit quality.     

Management letter comments: Their determinants and their association with financial reporting quality in local government

The issuance of management letters (MLs) as part of financial statement audits is a long-standing practice; however, previous studies of MLs are few and no previous research has tested the utility of MLs empirically. This paper reports a study of MLs issued by independent CPA firms pursuant to audits of Florida general purpose local governments. We investigate the determinants of ML comments, finding that such comments are influenced by auditee characteristics and auditor tenure but not by auditor specialization, a proxy for audit quality. Further, we explore the relationship between MLs and financial reporting quality. We observe a negative relationship between first-year ML comments and assessed financial reporting quality. When lagged one year, first-year ML comments bear a positive relationship with financial reporting quality. The absence of ML comments is positively associated with financial reporting quality. Our results suggest that MLs are beneficial to auditees. As such, our study should be interesting to policymakers, users of financial reports, auditees, and auditors.     

New Auditors’ Decisions for Released Firms from the Mandatory Auditor Designation Rule: Evidence From South Korea

This study examines the effect of the mandatory designation rule on audit fees charged and audit hours rendered by auditors for firms released from the mandatory auditor designation rule in the Korean audit market. Under the mandatory auditor designation rule, which took effect in 1991, problematic firms are assigned new auditors by the Financial Supervisory Service. Previous studies suggest that this regulation positively affects the quality of audits by promoting auditor independence. Thus, this study hypothesises that firms that have been subjected to mandatory auditor designation improve the quality of their financial reporting, and that auditors hired after the mandatory designation period account for reduced audit risks when determining audit fees and audit hours. This study shows that audit fees and audit hours of firms released from the mandatory auditor designation rule are lower than those of other initial audit engagements. Taken together, this study's findings reinforce the notion that auditors’ perceptions of changes in audit risk yield corresponding changes in the audit fees they charge and audit hours they render.