Legal systems and auditor independence

This paper examines whether an appropriate legal system, which is a combination of a legal regime and a damage apportionment rule, effectively enhances auditor independence. Economic and psychological hypotheses derived from a one-period game model in which the auditor may commit either a technical audit failure (resulting from the auditor’s inability to detect true output given a lack of audit effort) or an independence audit failure (resulting from the auditor’s intentional misreporting on false output) are tested. Three major findings are documented. First, auditor independence affects firm investment, which in turn affects audit effort. Under this strategic dependence, no single legal system can provoke audit effort, improve auditor independence, and encourage firm investment simultaneously. To enhance auditor independence and motivate investment, a legal system consisting of both a strict regime and a proportionate rule is preferred. Second, the strict regime induces more auditor independence than the negligence regime, while the proportionate rule induces higher audit effort than the joint-and-several rule. Finally, auditors’ moral reasoning and penalty for misreporting are both positively associated with their independence. In addition, the effect of moral reasoning on auditor independence diminishes as the level of penalty increases. These two results hold only when the legal systems that auditors face are considered.     

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.     

Audit quality, auditor compensation and initial public offering underpricing

We jointly study the impact of audit quality on auditor compensation and initial public offering (IPO) underpricing using a sample of Australian firms going public over the period 1996–2003. We find that quality (Big Four) audit firms earn significantly higher fees than non-Big Four auditors, and audit quality is positively associated with IPO underpricing. The positive relation between audit quality and underpricing is more pronounced for small issues, IPOs underwritten by non-prestigious underwriters, and those that are not backed by venture capitalists. Taken together, our results suggest that quality auditors serve as a signalling device that enhances post-issue market value of equity.     

Information uncertainty and auditor reputation

This paper explores the relationship between information uncertainty and auditor reputation revealed by the failure of Arthur Andersen (AA). AA’s reputation deteriorated considerably when it announced on January 10, 2002, that it had shredded documents related to its audit of Enron. AA’s demise was sealed on March 14, 2002, with its indictment for obstruction of justice. We find that on these dates the clients of AA and other Big Five auditors that are characterized by higher information uncertainty experience relatively larger share price declines compared to clients with lower information uncertainty. The findings suggest that the market relies more heavily on auditor reputation for higher information uncertainty firms, which implies that the value of an audit is greater when a firm is harder to value. Our results highlight the importance of information uncertainty in financial markets: where there is a shock to auditor reputation, firms with greater information uncertainty suffer the largest losses.     

A test of the auditor reliability framework using lenders’ judgments

Taylor et al. (2003) challenged the longstanding notion that independence is the capstone of the audit profession by proposing a conceptual framework that emphasizes reliability, rather than independence, as the professional endgame for auditors. Although the reliability framework has attracted attention from policymakers, it has not been tested empirically in an audit context to assess its validity from a user’s perspective. The objective of this study is to test the auditor reliability framework and its formative ethical constructs (i.e., integrity, expertise, independence, objectivity, and reliability) with a sample of 168 commercial lenders. We also extend the reliability framework to examine the extent that perceived auditor reliability affects lenders’ judgments of financial reporting reliability and default risk in a hypothetical lending scenario. Finally, we evaluate the extent that lenders’ judgments are affected by auditor provision of nonaudit bookkeeping and payroll services to a prospective borrower in violation of current independence rules. The results provide strong empirical support for the relations predicted in the reliability framework. Structural equation model results indicate that auditor integrity is the foundation of the framework, directly affecting lenders’ assessments of auditor expertise, independence, objectivity, and reliability. Further, although integrity and objectivity directly affect perceived auditor reliability, independence and expertise only affects reliability indirectly through its impact on objectivity. Finally, we find that lenders perceive no decrease in auditor objectivity or reliability when existing independence rules are violated by combining audit services with nonaudit services for prospective borrowers.     

Consulting revenue sharing,auditor effort and independence,and the regulation of auditor compensation

The joint provision of audit and non-audit services by audit firms to their audit clients has posed a threat to auditor independence. To mitigate the independence problem, the US Securities and Exchange Commission (SEC) issued a regulation (SEC, 2003) that prohibits audit partners from receiving compensation for the sale of non-audit services to their audit clients. This study examines the effects of this regulatory change on the effort and reporting decisions of audit partners. We show that partners in an audit firm strategically change the firm’s liability-sharing rule. As a consequence, the regulation restores truthful reporting but has an undesirable negative effect on audit effort. The effect of the regulation on the welfare of the economy (defined as the total payoff to both audit firms and their clients) hinges on the tradeoff between the benefit of the regulation, which is derived from the inducement of truthful reporting, and the cost of the regulation, which results from less diligent audit work. We show that the regulation is more likely to increase the welfare in a strong legal regime (where the legal liability cost of auditor litigation is high) than in a weak legal regime.     

Audit Effort and Stock Price Crash Risk

We examine how stock price crash risk is affected by audit effort, as measured by audit hours. Using a unique dataset of audit hours in China, we find that audit effort is negatively related to crash risk. The negative impact of audit effort on crash risk is more pronounced for listed firms that have higher inherent risks and weaker external monitoring of their information environment. Our findings are robust to various tests, including a two-stage regression analysis, controlling for listed firm-fixed effects and audit firm-fixed effects, and using alternative measures of crash risk. In addition to audit output measures, audit effort has an incremental influence on crash risk. The effects of audit effort on crash risk continue to hold after controlling for auditor industry expertise and auditor tenure.     

Earnings management and auditor specialization in the post-sox era: An examination of the banking industry

This study examines the impact of auditor specialization on bank loan loss provisions for a large cross-section of US banks for the period 2002-2006. We find a positive relationship between earning (before provision) and loan loss provision, suggesting that bank managers use LLP to smooth earnings in the post-SOX period. However, this relationship is significantly moderated by audit industry expertise, providing strong evidence that industry specialization constrains income smoothing. In further analysis, we find some evidence that auditor specialization is more effective in reducing potentially incoming-increasing earnings management. Our results hold after controlling for self-selection bias and are robust to alternative measures of industry specialization. Overall, our findings support the conclusion that audit industry expertise plays an effective monitoring role in constraining management’s discretionary accounting choices.     

The effect of mandatory auditor assignment and non-audit service on audit fees: Evidence from Korea

In Korea, regulators could assign auditors to firms. We investigate the relationship among audit fees, mandatory auditor assignment, and the joint provision of non-audit and auditor services in Korea. We find that assigned auditors charge significantly higher audit fees than freely selected auditors. We also find that the joint provision of non-audit and audit services does intensify the relation between auditor assignment and audit fees. Combined with the results of other studies that have shown that firms audited by assigned auditors report smaller amounts of discretionary accruals than firms audited by freely selected auditors, our results suggest the possibility that mandatory auditor assignment may improve auditor independence.     

The relative effectiveness of persuasion tactics in auditor–client negotiations

In this study, we examine the effectiveness of four persuasive arguments that auditors may use to convince clients to accept their desired position in auditor–client negotiations. In addition, we investigate how the style in which the argument is communicated by the auditor impacts its effectiveness. Our results indicate that the type of persuasion tactic used by auditors significantly impacts the amount of concessions made by clients. Specifically, we find that, while threatening to qualify the audit opinion can result in significant client concessions, a tactic of simply informing the client that other companies have handled the accounting issue in a way consistent with the auditor’s preference is as effective, or more effective, than all of the other tactics examined at eliciting significant concessions as well as engendering positive affect toward the auditor. This result is consistent with findings from the persuasion literature relating to the pervasive power of social validation. We also find that clients offer more concessions, evaluate the auditor more positively, and are more satisfied with the negotiation outcome when auditors communicate their arguments using a cooperative, as opposed to a contentious, communication style. The results of this study indicate that auditors may benefit from training in persuasion tactics in order to achieve more desirable negotiation outcomes.     

Client influence and auditor independence revisited: Evidence from auditor resignations

Financial scandals such as the Enron-Andersen debacle provoke concerns that auditors lack independence when faced with influential clients. Unlike previous studies that examine whether client influence affects audit quality on ongoing engagements (providing mixed results), we investigate whether client influence (which engenders “independence risk”) at the audit-office level affects auditor resignations from high engagement-risk clients. We construct summary measures of engagement risk, using client disclosures on Form 8-K filings, potential risk factors (e.g., litigation risk), and auditor action (e.g., issuance of a going concern opinion) on the previous year’s financial statements. Focusing on risky clients, we find that auditors are more likely on average to resign from influential clients, and this positive association holds for auditors that are less likely to have mechanisms in place to mitigate independence risk. Also, importantly, influential clients are prevalent across the spectrum of client size, and the positive association between client influence and auditor resignations holds for both large and small clients.     

Does corporate social responsibility affect auditor-client contracting? Evidence from auditor selection and audit fees

We find that firms with higher CSR performance are more likely to choose Big N auditors and less likely to switch to non-Big N auditors, consistent with socially responsible firms demanding higher audit quality. Furthermore, we provide robust evidence that firms with higher CSR performance pay lower audit fees using both levels and changes models, suggesting that higher CSR performance reduces auditor engagement risk. Our analysis based on the difference-in-differences approach indicates that it is higher CSR performance that leads to lower audit fees, not vice versa. Overall, the results highlight the important role of CSR performance in auditor-client contracting.     

The impact of the Social Security Fund on auditor litigation risk

In this study, we examine the effect of the Social Security Fund on auditor litigation risk. Using audit fees as a proxy for auditor perceptions of litigation risk, we find that the Social Security Fund significantly reduces auditor litigation risk. Furthermore, we show that the Social Security Fund influences auditor litigation risk through reducing both the audit risk and the business risk of public companies. In addition, the impact of the Social Security Fund for reducing auditor litigation risk is more obvious in the group of firms with low levels of internal governance, which indicates that the Social Security Fund plays an important governance role as a high-quality institutional investor. In summary, we verify that the Social Security Fund, when acting as an institutional investor, plays an important role in corporate governance, and that it helps to reduce auditor litigation risk. Our results provide empirical support for expanding the governance role of the Social Security Fund as an institutional investor in China’s A-share market.     

The effect of auditor IT expertise on internal controls

Material weaknesses in internal controls related to information technology (IT) represent unique threats to organizations. Utilizing the external auditor as an example of an externally observable governance mechanism, we investigate if firms with revealed IT internal control deficiencies employ a strategy of disassociation with their current auditor. Our tests show that prior evidence of disassociation strategies hold in both IT and non-IT contexts. Of particular focus to our study, we document a positive association between firms that report IT material weaknesses and subsequent auditor dismissals or switching. We next investigate the potential internal control benefits of switching to auditors with greater expertise in environments that emphasize the importance of IT. We argue that greater audit firm IT expertise promotes improved internal controls for their clients, especially those controls that are dependent on IT. We find that clients that switch to auditors with greater IT expertise, relative to their former auditor, have a greater likelihood of material weakness remediation within one year of reporting control weaknesses. Complementing these findings, we find that audit IT expertise is negatively associated with both non-IT and IT material weaknesses in an ex ante reporting setting. Prior literature takes a longstanding interest in both the incentive for developing auditor expertise and the effects of that expertise. We contribute to this literature stream by providing additional evidence related to a specific type of expertise.     

The influence of jurors' perceptions of auditor tenure on blame

This study investigates whether jurors' judgments of auditor blameworthiness are influenced by the length of an auditor's tenure with a client. We use an experiment to determine whether tenure affects juror perceptions of an auditor's competence and independence. We then examine whether these perceptions influence the attribution of blame. Results, consistent with both sides of the mandatory auditor rotation debate, indicate that tenure has a positive impact on perceptions of competence and a negative impact on perceptions of independence. Further, as juror perceptions of the auditor's competence and independence decrease, attributions of blame increase. These results have implications for auditor tenure research as well as for auditors involved in litigation. By utilizing structural equation analysis, we find that the effects of auditor tenure on perceptions of audit quality are complex. Perceptions of both competence and independence are significantly related to extended tenure; however, these perceptions independently affect the assignment of blame. While longer tenure improves perceptions of competence and lessens blame, it decreases perceptions of independence resulting in greater blame. From a litigation perspective, the auditor's tenure with a client is a double-edged sword that must be addressed strategically in court.     

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.     

The market reaction to auditor resignations

Under UK company law, external auditors who resign must warn shareholders and creditors of any matter that ought to be brought to their attention. Auditor resignations and the subsequent change in auditor are informative corporate events. Resignation from office is likely to be a costly signal for the audit firm, particularly when the client is a quoted company. Our analysis of daily data suggests that there is a negative reaction to the auditor resignation on the date of the resignation letter, even though very few auditors indicate there were problems of which the shareholders and creditors should be made aware. This provides backing for the statutory rules on disclosure of the auditor resignation. We also find that the extent of the market reaction on the day of the resignation is related to the size of the resigning audit firm.     

Pro forma disclosures,audit fees,and auditor resignations

The disclosure of non-GAAP (pro forma) earnings numbers by managers in the post-SOX era continues to attract attention from regulators, media, and researchers. However, there is limited empirical evidence on how auditors view clients that emphasize pro forma earnings over GAAP earnings. We study the extent to which audit fees and auditor resignations are associated with opportunistic non-GAAP disclosures. We find that during the pre-SOX period, optimistic pro forma differences, measured using either IBES actual earnings or hand-collected pro forma earnings, are associated with higher audit fees and a higher likelihood of auditor resignations. Additional results indicate that auditors seem to be more concerned with non-GAAP earnings disclosures in the post-SOX period.     

Audit Labor Usage and Fees under Business Risk Auditing

The adoption of business risk audit (BRA) approaches during the 1990s by several leading audit firms has been the subject of considerable scrutiny and commentary. Under BRA, the auditor responds to the increasing complexity of auditee financial reports by acquiring a deep and comprehensive understanding of the auditee's industry, strategy, business models, and processes—tasks best accomplished by higher-ranked labor—and by employing this understanding to make audit labor allocations. Using proprietary data for 165 audits conducted in 2002, we investigate three propositions about audit labor use under BRA. First, relative to pre-BRA benchmarks for the same auditor, we expect BRA audits to use a greater proportion of higher-ranked labor. Second, we expect engagements with high assessed auditor business risk (ABR), a summary risk assessment that reflects the BRA auditor's rich understanding of the auditee, to be allocated more labor and more higher-ranked labor than pre-BRA benchmarks. Third, at all ranks of labor, we expect a positive association between assessed ABR and levels of labor use. We find empirical evidence consistent with these propositions. We also find that total labor use in our sample is only modestly lower than pre-BRA norms. Analysis of fee data from these engagements suggests that audit fees in 2002 are substantially less than would be expected under pre-BRA benchmarks. After controlling for audit labor use, both total fees and fees per hour increase with assessed ABR for first-year auditees but not for continuing auditees. Overall, our results provide evidence on the impact of the BRA audit regime and speak to the likely impact of BRA on audit effectiveness and efficiency.     

Determinants of auditor changes for non-accelerated filers

Significant accounting scandals and the imminent collapse of Arthur Andersen in 2001 precipitated a period of heightened regulatory response, most notably the enactment of the Sarbanes–Oxley Act of 2002. In the years that followed, the Securities and Exchange Commission created a separate class of non-accelerated filers (companies with public float of up to $75 million) and provided these companies with significant regulatory relief from certain financial reporting disclosure and auditing requirements, including the extension of scaled disclosure to these companies in 2007. Over the period of 2001 through 2007, as non-accelerated clients anticipated and responded to their different and evolving regulatory regime, audit firms were adjusting to the increased concentration in their market, a new monitoring structure, and significant changes to the scope of their work. We examine whether auditor–client misalignment is a significant determinant of auditor change during this period, particularly for non-accelerated filers, as large auditors sought to rebalance their client portfolios. We find evidence that auditor–client misalignment increases the likelihood of auditor change (resignation and dismissal) for non-accelerated, but not accelerated, filers. We also find that auditor–client misalignment increases the likelihood of downward changes to third-tier auditors for non-accelerated, but not accelerated, filers.