Costs Associated With Going-Concern-Modified Audit Opinions: An Analysis of the Australian Audit Market

This article examines the potential costs to Australian auditors and their clients from the issuance of first-time going-concern-modified audit opinions. We examine the population of Australian companies receiving a first-time going-concern-modified audit opinion during the period 1994–97 and a matched sample of financially distressed firms receiving a clean audit opinion. Results indicate that auditor switching is positively associated with receipt of a going-concern-modified opinion. However, we find no empirical evidence that there is a self-fulfilling prophecy of increased probability of company failure following the issuance of a going-concern-modified opinion for the Australian companies in our study. Our analyses of lost audit fees indicate that auditors issuing first-time going-concern-modified audit opinions lost proportionately more fees by losing clients (through switching or company failure) than firms not issuing a going-concern-modified opinion to financially stressed clients.     

FRC intervention,financial reporting quality and due diligence

This study provides evidence of the relationship between government intervention, financial reporting quality and due diligence. Specifically, the authors examine the consequences of the disclosure of inspection reports by the Financial Reporting Council (FRC) for individual audit firms inspected in the UK. Using a difference-in-differences design, it is found that clients are more likely to receive qualified audit opinions during the post-disclosure period. This significant impact on reporting decisions is more concentrated among clients of small audit firms. Moreover, despite general efficiency during the sample period, clients affected by an FRC intervention experience longer delays in receiving their audit reports. Overall, this study contributes to literature on corporate governance and audit regulation, and has implications for policy making. FRC inspections are of greater concern to small audit firms than large firms, as the latter have already built a strong reputation. In general, the transparent inspection process may be beneficial in enhancing auditor oversight.     

Comparing self-regulation and statutory regulation: Evidence from the accounting profession

The accounting profession in the United States recently shifted from self-regulation by peer review to statutory regulation by the Public Company Accounting Oversight Board (PCAOB). Using this shift, I compare outcomes from self-regulation and statutory regulation for the same group of firms. I find that firms choosing their own reviewers, and firms choosing reviewers likely to be connected through prior relationships, tend to receive peer review opinions more favourable than their subsequent PCAOB reports, suggesting that some firms obtained ‘friendly’ reviews in the peer review era. On the other hand, reviewers with relevant industry knowledge are less likely to give such favourable reviews. Further, reviewers from the same geographic area are likely to give peer reviews that are more negative than the subsequent PCAOB reports. Additional analysis suggests that peer reviewers from similar industry or geographic areas bring greater firm-specific expertise to the reviewing process. In the PCAOB regime, I find that firms inspected later tend to receive PCAOB reports more favourable than their peer reviews, suggesting some trends over time in PCAOB reporting. Overall, the findings help in understanding the influences on each approach to regulation, and suggest a nuanced understanding of both approaches as having strengths as well as weaknesses.     

Address forms in Chinese audit opinions

Although forms of address are widely used in textual and other types of disclosure,empirical evidence of their effects is rare.China provides a unique setting in which to test the economic consequences of the forms of address used in audit reports.From 2003 to 2011,about 60%of auditors surveyed addressed their clients by their real names in audit opinions,while the others used honorifics.Based on a sample of Chinese audit opinions,I report the following findings.First,the announcement of an audit opinion that uses the client’s real name elicits a greater market response than the announcement of an opinion featuring an honorific form of address.Second,the effects of real-name forms of address are stronger in firms with weak board governance.Third,the association between audit fees and audit risk factors,such as loss-making,is stronger in firms that are addressed by their real names in audit reports.I conclude from these findings that the forms of address used in audit opinions may reveal private information on audit quality.The results of this study are consistent with the power-solidarity effect described by sociolinguists.     

The dark side of audit market competition

This paper examines the relation between audit market competition and audit quality. We use the staggered introduction of bullet trains in different Chinese cities as shocks to travel time between audit clients and prospective audit firms, which increases the threat of competition for incumbent audit firms. The inception of bullet train connectivity leads to a 4.5 percentage point (pp) increase in the probability of GAAP violations and a 1.7 pp decrease in the probability of modified audit opinions for clients headquartered in connected cities. Bullet train connectivity is also followed by a 1.6 pp decrease in income-decreasing audit adjustments but no change in income-increasing audit adjustments. The negative relation between bullet train connectivity and audit quality is 1) stronger when bullet trains put greater competitive pressure on incumbent auditors and 2) weaker when clients demand high audit quality. Our paper provides plausibly causal evidence that competition lowers audit quality.     

Opening Up the “Black Box” of Audit Firms: The Effects of Audit Partner Ownership on Audit Adjustments

Audit firms need to provide high-quality audits but they also need to please their clients. We argue that these conflicting incentives become manifest when comparing the incentive effects of equity ownership on engagement quality (EQ) reviewers and audit engagement partners. We predict that EQ reviewers monitor audit quality more closely when they hold greater ownership. In contrast, we expect that equity ownership has conflicting effects on the incentives of engagement partners because they need to please their clients as well as provide high-quality audits. Consistent with these predictions, we find that the associations between audit adjustments and partner equity ownership are (1) significantly positive for EQ reviewers, (2) significantly negative or insignificant for audit engagement partners, and (3) significantly more positive for EQ reviewers than engagement partners. Our findings suggest that larger ownership stakes motivate EQ reviewers to monitor audit quality more closely, whereas larger ownership stakes do not motivate engagement partners to deliver higher quality audits.     

Audit Reporting of Big 4 Versus Non-Big 4 Auditors: The Case of Ex-Andersen Clients

This paper examines audit reporting of Big 4 auditors versus non-Big 4 auditors for ex-Andersen clients and other clients. It suggests that ex-Andersen clients are more risky than other clients and are able to exert more influence than other clients on non-Big 4 auditors because they are larger in size than other non-Big 4 auditees. In addition, Big 4 auditors are more risk-averse and able to withstand clients' pressure than non-Big 4 auditors. The results show that Big 4 auditors are more likely than non-Big 4 auditors to issue going-concern opinions to ex-Andersen clients or restrict the level of discretionary accruals of those clients compared with other clients. Further, ex-Andersen clients of Big 4 auditors would have had a lower likelihood of receiving going-concern opinions or higher levels of discretionary accruals had reporting practices for other clients been applied. Ex-Andersen clients of non-Big 4 auditors would have had a higher likelihood of going-concern opinions or lower levels of discretionary accruals. Hence, the suggestion to reduce the Big 4 concentration in the audit market by allowing non-Big 4 firms a larger market share should be viewed prudently. Overall, these results are consistent with the suggestion that litigation risk and client pressure are important factors in audit reporting.     

Do modified audit opinions have economic consequences? Empirical evidence based on financial constraints

We present a framework and empirical evidence to explain why, on average, 11% of listed firms in China received modified audit opinions (MAOs) between 1992 and 2009. We argue that there are two reasons for this phenomenon: strong earnings management incentives lower firms’ financial reporting quality and soft budget constraints weaken the information and governance roles of audit opinions. We find that firms’ financial constraints eased after receiving MAOs, which suggests that MAOs have limited economic consequences. Further analysis shows that this phenomenon predominantly exists in government-controlled firms and firms that receive MAOs for the first time. We also find that MAOs have not influenced financial constraints after 2006. Finally, we find that MAOs did not affect borrowing cash flows from banks until 2005, suggesting that MAOs did not start affecting bank financing until that year. We also find that firms receive more related-party financing after receiving MAOs. Our results indicate that a limited effect on bank financing and increased related-party financing reduce the effect of MAOs on financial constraints.     

审计报告对预测银行授信失败有用性之实证研究

本研究的主要目的是探讨审计报告是否能帮助债权人评估借款人的违约风险(即借款人在借款之后发生逾期、催收和呆账等情况);亦即,当注册会计师对公司(借款人)的财务报告出具非无保留意见(包括保留意见、否定意见、及无法表示意见)时,该公司后续年度发生违约的机率是否较高﹖本研究结果有助我们了解,对债权人的授信决策及债权监控而言,注册会计师的审计报告是否为具有信息内涵的重要参考信息。实证结果支持本研究的实证假设:受查公司财务报告被注册会计师签具非无保留意见者,该公司后续年度发生违约(即催收、逾期、或呆账)的可能性较高。     

Information sharing between mutual funds and auditors

This paper examines whether there is information sharing between mutual funds and their auditors about the auditors’ other listed firm clients. Using data from the Chinese market, we find that mutual funds earn higher profits from trading in firms that share the same auditors. The effects are more pronounced when firms have a more opaque information environment and when the audit partners for the fund and the partners for the listed firm share school ties. The evidence is consistent with information flowing from auditors to mutual funds, providing mutual funds with an information advantage in firms that share the same auditors. Our findings are robust to the use of audit-firm mergers and acquisitions (M&As) as exogenous shocks and several other robustness checks. We further find that auditors benefit by charging higher audit fees for mutual fund clients and by improving their audit quality for listed firm clients. Our study provides evidence of bi-directional information sharing between two important market intermediaries.     

The effect of SOX on small auditor exits and audit quality

We find that over six hundred auditors with fewer than 100 SEC clients exit the market following SOX. Compared to the non-exiting auditors, the exiting auditors are lower quality, where quality is gauged by: (1) avoidance of AICPA peer reviews and failure to comply with PCAOB rules, and (2) severity of the peer review and inspection reports. In addition, clients of exiting auditors receive higher quality auditing from successor auditors, as captured by a greater likelihood of receiving going concern opinions. Our results suggest that the PCAOB inspections improve audit quality by incentivizing low quality auditors to exit the market.     

Do Expert Informational Intermediaries Add Value? Evidence from Auditors in Microcap Initial Public Offerings

Do expert informational intermediaries add value? We address this question by examining the informativeness of the audit report contained in the prospectus associated with a firm's initial public offering (IPO). At the time of the IPO, there is a relative lack of information to facilitate the establishment of equity values, suggesting that the information provided by outside “experts” (e.g., auditors, underwriters) is particularly important. In this article we study small, non‐venture‐backed IPOs, a segment of the market with the poorest long‐run performance and where the prestigious audit firm is often the sole (if any) expert present. We find that the pre‐IPO opinions of larger auditors are more predictive of post‐IPO negative stock delistings. Of particular note, the opinions of the national‐tiered firms are comparably predictive to those of the Big 6, though this finding emerges only after we consider the selectivity‐based differences in the clients that hire these national firms. Our findings also indicate that, for larger auditors the presence of a pre‐IPO going‐concern opinion is more strongly associated with first‐year stock returns and that larger auditors are more likely to give such opinions to their distressed clients. Overall, we address a deficiency in the literature relating to “the paucity of evidence on the value of auditor opinions to investors” (Healy and Palepu [ 2001 p. 415]).     

To switch or not to switch? The effect of audit firms’ economies of scale on audit firm switches after audit price deregulation in China

We exploit the unique setting of China’s 2014 audit price deregulation policy to examine whether audit firms use their economies of scale (EOS) to compete for clients. We find a significant increase in client firms switching from a non-EOS auditor to an EOS auditor after the audit price deregulation policy was implemented. The additional analyses show that EOS audit firms are more likely to offer audit fee discounts than non-EOS audit firms while retaining audit quality. We also find that the auditors’ EOS effect is more pronounced for highly homogeneous industries and firms paying high abnormal audit fees, firms in financial distress, and firms receiving less capital market attention than for less homogeneous industries and firms paying low abnormal audit fees, financially stable firms, and firms receiving more capital market attention. Finally, we find that the presence of state-owned enterprises and political connections both separately and jointly moderate the effect of audit firm–client realignments from a non-EOS auditor to an EOS auditor after the audit price deregulation. Overall, our study provides important insights for policymakers and regulators reviewing and developing new policies on audit services.     

The Impact of Disclosures of Internal Control Weaknesses and Remediations on Investors' Perceptions of Earnings Quality

We hypothesize and find that firms making SOX‐mandated disclosures of material weaknesses in internal control over financial reporting (ICOFR) exhibit lower investor‐perceived earnings quality (IPEQ) than nondisclosers. We measure IPEQ using e‐loading, a market‐returns–based representation of earnings quality developed by Ecker, Francis, Kim, Olsson, and Schipper (2006). Firms do not exhibit decreases in IPEQ after initially disclosing material weaknesses. This is consistent with investors having anticipated ICOFR strength based on observable firm characteristics. However, firms exhibit increases in IPEQ after receiving their first clean audit reports that confirm the remediation of previously disclosed weaknesses. This indicates that, although investors do not find initial weakness disclosures to be incrementally informative, SOX motivates firms to remediate weak controls and provides a venue for credible remediation disclosures, thus enhancing investors' perception of financial reporting reliability. These findings are consistent with the existence of regulatory benefits associated with SOX's internal control disclosure and audit requirements.     

Non-audit services and financial reporting quality: evidence from 1978 to 1980

We provide evidence on the long-standing concern about the potential conflicts of interest of auditors that provide clients with non-audit services using rarely explored non-audit services fee data from 1978 to 1980. In this setting, we find evidence of improved earnings quality when auditors provide non-audit services, especially those related to information services. This is consistent with better audit quality resulting from knowledge spillovers in the joint offering of audit and consulting services. Events related to the 1982 repeal of mandatory non-audit services disclosures are associated with a small positive stock price reaction, suggesting that the disclosure repeal has no adverse economic consequences. Furthermore, following the repeal we find no change in the earnings quality of client firms. In sum, our data suggest that non-audit services offered by audit firms can be associated with improved audit and reporting quality in client firms via auditors’ reputational incentives, synergies, and knowledge transfers.     

The vanishing searches and audit fees: Evidence from Google's withdrawal from China

I investigate the impact of the disruption of free information access via search engines on audit fees using a quasi-natural experiment provided by Google's withdrawal from China. Employing a difference-in-differences design, I document an increase in audit fees for firms with overseas business relative to firms without overseas business after Google's withdrawal. The results are robust to matched samples, placebo tests, alternative specifications, excluding alternative explanations and different event windows. This trend in audit fees suggests that Google's withdrawal hampers firms' foreign information streams and increases audit risk and audit effort. Consistent with this argument, after Google's withdrawal, firms with overseas business conduct more earnings management, pay more abnormal audit fees and experience longer audit report lags. Furthermore, the increase in audit fees is greater for firms with poor information environments, more retail investors or non-Big 4 auditors. My findings suggest a potential auditing cost of restricting the free flow of public foreign information about firms.     

Audit market concentration,audit fees,and audit quality: A cross-country analysis of complex audit clients

Regulators around the world are concerned about the potentially harmful effects of high audit market concentration on audit pricing and quality. However, results in the overall literature have failed to reach consensus on this issue. We contribute to this debate by arguing that the audit market is segmented and that concentration in the Big 4 segment of the market leads to higher audit pricing. Accordingly, our analyses use international data and focus on concentration within the Big 4 group of firms across countries. We find that audit fees are increasing in our concentration measure for clients where the barriers to entry by competing auditors are higher, as proxied by client size, international operations, and IFRS use. Finally, we find evidence that audit quality is decreasing in Big 4 market concentration for these types of engagements. This indicates a wealth transfer from shareholders to audit firms when auditor concentration is high because these complex clients are charged more, but receive audits that are of lower quality.     

Risk-preparedness mechanism and audit quality: Evidence from mandatory increase of professional indemnity insurance and professional risk fund

We examine the risk-preparing benefits of Chinese audit firms’ professional indemnity insurance (PII) and professional risk fund (PRF) by using the Notice on Adjusting the Application Requirement of Audit Firms for Securities Qualifications as an exogenous shock. This policy requires audit firms to raise the sum of the cumulative compensation limit of their PII and PRF from 6 million to 80 million yuan. It is found, first, that the capital market regards this policy revision as a signal to strengthen investor protection and responds positively; client firms with high audit risks have a stronger response. Second, auditors’ governance of financial information has strengthened, resulting in the significant improvement of their clients’ financial reporting quality, with a stronger effect on firms with higher earnings management risk. There is no evidence that audit firms pass the costs on to their clients. Finally, the mismatch between auditors and new client firms is alleviated. We show that in an emerging market with weak investor protection, establishing a sound risk-preparedness mechanism for audit firms and strengthening the capacity for civil compensation ex post greatly improve the adaptive degree between international auditing standards and the legal environment of China, thereby enhancing the overall service quality of the audit market.     

The effect of small audit firms’ failure to remediate the PCAOB’s quality control criticisms on audit market segmentation

This paper examines the role of the Public Company Accounting Oversight Board (PCAOB) quality control inspection program on market segmentation of small firms’ audit services. Specifically, we investigate how non-remediation of quality control criticisms (QCCs) affects the supply and demand of low-quality audits. We find that remediation of QCCs improves audit quality for small accounting firms. However, some small accounting firms do not remediate QCCs (NR firms) and continue to provide low audit quality. We investigate how NR clients react to the disclosure of non-remediation of QCCs. We find that NR clients with low agency costs are more likely to retain NR firms after the disclosure of non-remediation. This finding is consistent with our expectation that voluntary QCC remediation creates a low-quality audit market segment for NR firms. Our findings suggest that the public disclosure of QCCs is not sufficient to remove low-quality auditors. Instead, NR clients use the disclosure of non-remediation of QCCs as a signal to sort themselves into segments based on their demand for audit quality. We are the first to study and find that PCAOB inspections, and specifically the voluntary nature of remediation and public disclosure of lack of remediation, create market segmentation.     

Does the mandatory disclosure of audit information affect analysts' information acquisition?

This paper explores the effect of public information on analysts' information acquisition. By introducing the implementation of the Key Audit Matters (KAM) Disclosure Standards for China's firms cross-listed in Hong Kong in 2017, we present evidence that KAM disclosure reduces analysts' firm visits, which is an important channel of information acquisition. The effect is particularly pronounced for firms with audit partner rotation and low institutional ownership. KAM disclosure by industrial leaders has a spillover effect on analyst visits for peer firms. Disclosure also improves the frequency and quality of analysts' forecasts and firms' information environments, indicating that KAMs are informative and audit information is an important determinant of analysts' information acquisition. Our study reveals the real effect of KAM disclosure on analyst decisions, which may be of interest to regulators concerned with the mandatory disclosure of audit information and capital market efficiency.