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.     

The impact of voluntary audit and governance characteristics on accounting errors in private companies

This paper examines the extent to which the audit and corporate governance characteristics of UK private companies are associated with defective accounting information. Despite the economic importance of private firms, relatively little is known about their financial reporting and governance characteristics. Using a large sample of UK private companies, we examine the effects of voluntary audit, board gender balance and financial expertise on the likelihood of errors occurring in published annual accounts. Our results indicate that audited accounts are approximately half as likely as unaudited accounts to contain errors. In addition to contributing to recent academic research in this field, our findings are likely to be of interest to policy makers, who are considering exempting more firms from mandatory audit. We also find that gender diversity among board members is positively associated with the accuracy of accounting information, though our primary measure of directors’ financial expertise has no significant effect.     

How Do Various Forms of Auditor Rotation Affect Audit Quality? Evidence from China

The Enron/Arthur Andersen scandal has raised concerns internationally about auditor independence, audit quality, and the need for regulatory action such as mandatory auditor rotation. China's unique institutional features provide a setting in which we can compare comprehensively the various forms of auditor rotation at different levels (partner vs. firm) and in different settings (voluntary vs. mandatory). In addition, institutional conditions vary dramatically across China, which provides us with an opportunity to test whether the development of market and legal institutions affects the impact of rotation on audit quality. We expect that auditors are less (more) constrained by market forces and less (more) self-disciplined to maintain audit quality in regions with less (more) developed market and legal institutions. Therefore, mandatory rotation may play a more (less) important role in less (more) developed regions. Using auditors' propensity to issue a modified audit opinion (MAO) as a proxy for audit quality, we find that firms with mandatory audit partner rotations are associated with a significantly higher likelihood of an MAO than are no-rotation firms. However, this effect is restricted to firms located in less developed regions. We find similar evidence for voluntary audit firm rotation although the significance level is much weaker than for mandatory partner rotation. Other forms of auditor rotations (i.e., mandatory audit firm rotation and voluntary audit partner rotation), have no effect on MAOs.     

Audit Firm Tenure and Audit Quality in a Constrained Market

We examine the relation between audit quality and audit firm tenure in the Iranian audit market, which is constrained by government policies that create intense competition for clients among many small audit firms. We develop arguments that these circumstances create cost pressures that entrench low audit quality and render auditors' plans more predictable to managers wishing to misstate their accounts. Using publicly available data for the audits of listed companies in Iran prior to mandatory audit firm rotation and the incidence of misstated financial reports identified by the Iranian Association of Certified Public Accountants Inspection Office, we find that the likelihood of a misstatement is lowest in the first two years of audit firm tenure. We also find that the likelihood of misstatement is not associated with the year preceding a mandatory audit firm rotation, suggesting outgoing auditor effort is not sensitive to the prospect of subsequent revelations of deficiencies. Although our results from a pre-mandatory rotation period show that frequent rotations appear to improve the financial reporting quality in our sample, we are wary of interpreting these results as support for the mandatory audit firm rotation policy in Iran. Rather, we suggest this is a peculiar consequence of deficiencies in audit quality inherent in the Iranian market.     

Does auditor designation by the regulatory authority improve audit quality? Evidence from Korea

In Korea, the regulatory authority designates external auditors for firms that are deemed to have strong incentives and/or great potential for opportunistic earnings management, and mandates these firms to replace their incumbent auditors with new designated auditors and to retain them for a certain period, typically one to three years. We call this regulatory regime ‘auditor designation’. This paper investigates whether the auditor designation rule in Korea is effective in deterring managers from making income-increasing earnings management. Consistent with our hypothesis, we find that the level of discretionary accruals is significantly lower for firms with designated auditors than firms with a free selection of auditors. We also find that firms with mandatory auditor changes (i.e., auditor designation) report significantly lower discretionary accruals compared to firms with voluntary auditor changes. The above findings are robust to a battery of robustness checks. Overall, our results are consistent with the notion that the auditor designation enhances audit quality and thus the credibility of financial reporting.     

Reporting accountant appointments and accounting restatements: Evidence from UK private companies

In recent years, regulators have exempted an increasing number of companies from the requirement to appoint auditors, yet little is known about the role of the accounting profession in preparing and validating the financial statements of unaudited companies. In this paper, we examine empirically the factors associated with the appointment of reporting accountants. We then provide novel evidence on whether unaudited UK small private companies are less likely to restate their annual accounts when they have been prepared by an external accountancy firm (i.e., a reporting accountant). Based on a cross sectional analysis of a large sample of small private unaudited UK companies, we find that, in accordance with the ‘confirmation hypothesis’, larger companies that voluntarily disclose more financial information are more likely to appoint a reporting accountant. We also find that the accounts of companies with a reporting accountant are significantly less likely to be restated than those without. This result is more pronounced for companies disclosing more financial information and for those employing a larger accounting firm. Given the dwindling number of private companies opting for audits, our findings contribute to debates on the role of the accounting profession in enhancing private company financial reporting quality.     

Using machine learning to predict auditor switches: How the likelihood of switching affects audit quality among non-switching clients

In this paper, we utilize machine learning techniques to identify the likelihood that a company switches auditors and examine whether increased likelihood of switching is associated with audit quality. Building on research that finds a deterioration in audit quality associated with clients that engage in audit opinion shopping, we predict and find lower audit quality among companies that are more likely to switch auditors but remain with their incumbent auditor. Specifically, we find that companies more likely to switch auditors have a higher likelihood of misstatement and larger abnormal accruals. These results are consistent with auditors sacrificing audit quality to retain clients that might otherwise switch. Our findings are especially concerning because there is no public signal of this behavior, such as an auditor switch. Our methodology is designed such that it could be implemented by investors, audit firms and regulators to identify companies with a higher probability of switching auditors and preemptively address the deterioration in audit quality.     

Audit firm tenure and financial restatements: An analysis of industry specialization and fee effects

This study investigates the relation between audit firm tenure and clients’ financial restatements. Specifically, we extend the audit tenure literature by assessing restatement-based reporting failures using dimensions of auditor expertise and independence previously assumed to underlie short and long audit tenure problems. Short tenure expertise and independence effects are hypothesized using audit firm industry specialization and audit fees as proxies. Long tenure independence effects are hypothesized using nonaudit fees as a proxy. Using matched-sample logistic regression and 382 companies with and without financial restatements during 2000–2004, the results support prior findings by indicating a negative relation between the length of the auditor–client relationship and the likelihood of restatement. For short tenure engagements, we find that auditor industry specialization and audit fees are negatively related to the likelihood of restatement. This result is consistent with concerns about reduced audit quality due to a lack of client-specific knowledge and low audit fees on new audit engagements. Alternatively, the long tenure results indicate an insignificant relation between nonaudit fees and the likelihood of restatement. This finding contradicts independence concerns about nonaudit fees paid to entrenched auditors.     

Internal governance structures and earnings management

This paper investigates the role of a firm's internal governance structure in constraining earnings management. It is hypothesized that the practice of earnings management is systematically related to the strength of internal corporate governance mechanisms, including the board of directors, the audit committee, the internal audit function and the choice of external auditor. Based on a broad cross‐sectional sample of 434 listed Australian firms, for the financial year ending in 2000, a majority of non‐executive directors on the board and on the audit committee are found to be significantly associated with a lower likelihood of earnings management, as measured by the absolute level of discretionary accruals. The voluntary establishment of an internal audit function and the choice of auditor are not significantly related to a reduction in the level of discretionary accruals. Our additional analysis, using small increases in earnings as a measure of earnings management, also found a negative association between this measure and the existence of an audit committee.     

The Effect of Corporate Status on External Audit Fees: Evidence From the UK

Abstract:  This paper simultaneously examines, for the first time, the determinants of external audit fees of UK companies drawn from the quoted sector (Main Market, the Alternative Investment Market and Ofex), and the unquoted sector (public and private limited companies). The paper also provides new evidence on the effects of corporate failure and the persistence of the big four and mid-tier auditor premiums across the public and private corporate sectors. After controlling for firm size, audit risk and complexity, we find that quoted and unquoted public limited companies have significantly higher audit fees than their private limited counterparts. Our estimates imply that relative premiums for market/corporate form are as follows: Main Market over AIM, 6.8%; AIM over Ofex, 19.5%; Ofex over unquoted plc, 15.5%; and unquoted plc over private, 16.7%. However, despite indications in prior US research to the contrary, we find no evidence that insolvent firms that failed were charged higher audit fees in the year preceding failure. A positive relationship is also found between audit and consultancy fees – a result that persists using an instrumental variables approach to control for endogeneity.     

Investor perceptions of the earnings quality consequences of hiring an affiliated auditor

The Sarbanes–Oxley Act (SOX) requires that firms wait 1 year before hiring an individual employed as a member of the external audit team. SOX’s intent is to reduce the perceived loss of auditor independence due to affiliated hiring. SOX also requires fully independent audit committees and disclosure of directors with financial expertise. Using a sample of financial executive hires during the pre-SOX period, we find that earnings response coefficients (ERCs) decline following hires of individuals recently employed by the firm’s external auditor, but ERCs do not decline following hires not recently employed by the external auditor. We also find smaller ERC declines following affiliated hires for firms with audit committee compositions consistent with subsequently imposed SOX requirements. Further investigation using measures of earnings quality suggests that differences in ERC changes are attributable to perceived, rather than real, changes in earnings quality following affiliated hires.     

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.     

The impact of audit committee expertise on audit quality: Evidence from UK audit fees

Governance regulators currently place great emphasis on ensuring the presence of financial expertise on audit committees (Sarbanes-Oxley, 2002; UK Corporate Governance Code 2010–2016). Underlying this is a belief that greater expertise enhances the effectiveness of audit committees and, by extension, the quality of the external audit. This study investigates the impact of audit committee expertise on one measure of audit quality - audit fees paid by FTSE350 companies. Our analysis finds that audit committees possessing greater levels of financial expertise are associated with higher audit fees. When we segregate financial expertise between accounting and non-accounting, we find that the positive impact identified is driven by non-accounting expertise. Furthermore, when we separate FTSE100 and FTSE250 firms we find the impact of financial expertise is confined to FTSE250 firms. Our findings are important as they highlight the usefulness of segregating financial expertise between specialists and non-specialists, something which regulators in the UK and in the USA currently do not do. Our findings also highlight the potential value of audit committee expertise in smaller as opposed to larger listed firms, suggesting that the value of expertise to audit quality depends on the specific financial reporting challenges firms face.     

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.     

公司特征、外部审计与内部控制信息的自愿披露——基于沪市上市公司2003—2005年年报的经验研究

本文利用沪市非金融业上市公司2003—2005年年度报告中自愿披露的内部控制信息相关数据,立足于公司特征和外部审计角度,针对上市公司自愿披露内部控制信息的决定因素进行了经验研究。研究发现:我国上市公司自愿披露内部控制信息的总体水平较差,但在2003—2005年间有逐年增加的趋势;上市公司是否自愿披露内部控制信息与是否在海外交叉上市、是否聘请"四大"进行外部审计、资产总规模、资产净利率、独立董事人数占董事总人数的百分比显著正相关,与外部审计意见类型显著负相关,与监事会规模、是否设立审计委员会以及样本年度正相关;在影响上市公司内部控制信息自愿披露的因素中,是否海外交叉上市、独立董事占董事总人数百分比和资产净利率是比较一致的显著因素,相对而言,外部审计尚未起到显著的促进作用。     

Perceived auditor independence and audit firm fees

Regulations requiring the disclosure of fees paid to an auditor for audit and non-audit services (NAS) respond to concerns that such payments are potentially detrimental to auditors' actual or perceived independence. Although empirical studies have failed to produce unequivocal evidence of detrimental effects on auditor independence, the actions of regulators, audit firms and companies are consistent with the belief that economic bonding generated by fees can impair perceived levels of auditor independence.

Using a sample of UK companies over a six year period to March 2006, we study perceived impairment of auditor independence by examining the relationship between levels of total relative fees (combined audit and NAS fees payable by a company to its auditor as a proportion of the audit firm's UK income) and market value. This paper's methodological innovation is its use of a valuation framework in this setting. A further contribution lies in dropping the assumption of linearity found in most prior empirical studies. We provide evidence that shareholders perceive a threat to auditor independence only at high total relative fee levels. At lower levels, total relative fees are positively related to company value. These results suggest that disclosure of NAS and audit fees are of relevance to investors, as is information about auditor income. Our results support the view that regulation by reference to the threshold at which total relative fees are perceived negatively is more consistent with investor preferences than prohibition of the supply of NAS by auditors to their audit clients.     

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.     

Audit committee financial expertise,corporate governance,and the voluntary switch from auditor-provided to non-auditor-provided tax services

A prime objective of the SOX is to safeguard auditor independence. We investigate the relation between audit committee quality, corporate governance, and audit committees' decision to switch from permissible auditor-provided tax services. We find that firms with more independent boards, audit committees with greater accounting financial expertise, higher stock ownership by directors and institutions, that separate the CEO and Chairman of the board positions, and with higher tax to audit fee ratios are more likely to switch to a non-auditor provider. Further, we document that firms are more likely to switch prior to issuing equity. We find no evidence that broad financial expertise on audit committees is related to the switch decision, suggesting that the SEC's initial narrow definition of expertise is more consistent with the objective of the SOX. Overall, our results suggest that accounting financial expertise and strong corporate governance contribute to enhanced audit committee monitoring of auditor independence.     

Auditor Concentration: A Replication and Extension for the UK Audit Market 1991–1995

This paper examines the issue of auditor concentration in the UK during the period from 1991 to 1995. It shows that in 1995 the Big Six held 75% of the total number of audits and collectively earned 92% of the total audit fees. There was only a small increase in auditor concentration during the five year period, resulting from companies switching from small audit firms to Big Six and newly listed companies choosing a Big Six firm. The paper also examines auditor concentration within industries. Finally, the study assesses the measurement methods most commonly used in auditor concentration studies.     

The Impact of Managing Director Changes and Financial Distress on Audit Qualification and Auditor Switching

Abstract:   This study examines the interactive effects of change in managing director/chief executive officer (MD) and financial distress together with five control variables (type of audit firm; audit fees; gearing; time; and company size) on first, audit opinion and secondly on auditor switching. Based on a sample of 297 UK listed companies between 1987 and 2001, we find that companies that are financially distressed and change their MD are most likely to receive a qualified audit report, ceteris paribus . In addition, we find evidence of both familiarity and intimidation threats and that the probability of a switch increases with the severity of qualification.