Non-audit fees, institutional monitoring, and audit quality

We posit that the effect of non-audit fees on audit quality is conditional on the extent of institutional monitoring. We suggest that institutional investors have incentives and the ability to monitor financial reporting quality. Because of the reputation concerns and potential litigation exposure, auditors are likely to provide high audit quality, when they also provide non-audit services to clients, particularly when clients are subject to high institutional monitoring. We find evidence that, as non-audit fees increase, audit quality (measured by performance-adjusted discretionary current accruals and earnings-response coefficients) reduces only for clients with low institutional ownership but not for clients with high institutional ownership. Our results are robust after controlling for auditor industry specialization, firms’ operating volatility, size effect, and potential endogeneity between institutional ownership and audit quality.     

Institutional Ownership and the Selection of Industry Specialist Auditors

This study provides evidence linking corporate governance mechanisms to the choice of auditor, namely industry specialists. Given that institutional investors are likely to prefer higher quality financial reports to lower quality reports, we theorize that institutional investors will influence managers of companies in which they invest to improve reporting quality by using higher quality, industry specialist auditors. Our findings indicate that firms having relatively greater levels of institutional ownership tend to employ industry specialist audit firms. The results of this study contribute to an understanding of an important facet of corporate governance, the selection of a high quality audit firm.     

事务所规模、审计行业专长与知情交易概率

外部审计的作用在于提高公司的信息披露透明度,减少信息不对称,以保护投资者利益。本文从知情交易概率视角出发,研究了外部审计在减少信息不对称方面所发挥的作用。研究结果发现,国内"十大"审计的公司,以及由具有审计行业专长的事务所审计的公司,知情交易概率更低,而且行业专长的国内十大(非十大)审计的公司的知情交易概率也低于不具有行业专长的国内十大(非十大)。进一步检验还表明,在机构投资者持股的公司中,事务所规模和审计行业专长能够更有效减少知情交易概率。     

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.     

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.     

Audit Firm Tenure,Non‐Audit Services,and Internal Assessments of Audit Quality

We use data from internal assessments of audit quality in a Big 4 firm to investigate the impact of audit firm tenure and auditor‐provided non‐audit services (NAS) on audit quality. We find that first‐year audits receive lower assessments of audit quality and that quality improves shortly thereafter and then declines as tenure becomes very long. Partitioning our sample between SEC registrants and private clients, we find that the decline in audit quality in the long tenure range is attributable to audits of private clients. For audits of SEC registrants, the probability of a high quality audit reaches its maximum with very long tenure. We also find that audit fees are discounted for first‐year audits but auditor effort is higher than in subsequent years. We find no association, on average, between total NAS fees and audit quality in the full sample but observe that total NAS fees are positively associated with quality for SEC registrants and negatively associated with quality for privately held clients. Our findings are important for regulatory policies related to audit firm tenure and auditor‐provided NAS.     

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.     

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.     

Consequences of adopting an expanded auditor’s report in the United Kingdom

The United Kingdom has recently required an expanded auditor’s report for large public companies. We investigate whether this requirement is associated with an increase in the decision usefulness of the auditor’s report and whether it has indirect consequences on audit fees and quality. Our analyses cover four years surrounding the changes, including companies that transitioned to the new regime and companies that continued issuing the previous report’s format. We do not find evidence that the regulatory change significantly affected investors’ reaction to the release of auditors’ reports, audit fees, or audit quality. Furthermore, we do not find that variation in the expanded reports’ content has affected these outcomes. Although companies with long reports pay comparatively higher fees, the mere increase in disclosure does not affect audit fees or quality. Collectively, our evidence is consistent with the expanded auditor’s report providing little incremental information to investors.     

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.     

How does the executive pay gap influence audit fees? The roles of R&D investment and institutional ownership

Using a sample of US firms from 2003–2014, this study examines how the executive pay gap affects audit fees for firms with different levels of R&D investment and institutional ownership. Consistent with managerial power theory, we find that the executive pay gap is positively associated with audit fees, and that the positive association is attenuated by intense R&D investment and higher institutional ownership. We also find that the executive pay gap more strongly affects audit fees after the passage of the 2010 Dodd–Frank Act and the PCAOB's 2012 call to identify the audit risk related to executive incentive compensation. Additional analyses show that the moderating effects of R&D investment and institutional ownership on the pay gap–audit fees association are not conditional on auditor tenure, but the moderating effect of institutional ownership is stronger for firms hiring specialist auditors. Collectively, our findings suggest that auditors consider the business context, such as innovation initiative and external monitoring, when assessing audit risk related to the executive pay gap.     

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.     

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.     

Do Analysts and Auditors Use Information in Accruals?

Existing research indicates that firms with high accruals are more likely to experience future earnings problems, but that investors' expectations, as reflected in stock prices, do not appear to anticipate these problems. In this paper, we directly examine the published opinions of two types of professional investor intermediaries to see if they provide investors with information concerning the future earnings problems experienced by firms with high accruals. First, we examine the earnings forecasts of sell-side analysts. We show that analysts' earnings forecasts do not incorporate the predictable future earnings declines associated with high accruals. Second, we examine the behavior of independent auditors. We find no evidence that auditors signal the future earnings problems associated with high accruals through either their audit opinions or through auditor changes. Overall, our evidence indicates that analysts and auditors do not alert investors to the future earnings problems associated with high accruals, thus corroborating previous findings that investors do not appear to anticipate these problems.     

Auditor rotation and the appearance of independence: Evidence from non-professional investors

We examine the impact of audit firm versus partner rotation on non-professional investors’ independence-related perceptions, extending prior research on auditor rotation and independence in fact. Arguments for mandatory audit firm rotation continue to be made by regulators and investor groups based, in part, on the idea that firm rotation will incrementally strengthen independence in appearance relative to audit partner rotation. We report the results of two experiments. The first examines 5-year audit firm versus partner rotation under relatively weak or strong audit committees. We find no statistically significant difference in beliefs about how much of an income reducing audit difference management will record, or in beliefs about auditor independence, between the two auditor rotation conditions. On the other hand, we find that non-professional investors do believe more of the audit difference will be recorded, and the auditors will be more independent, under a strong audit committee than a relatively weak audit committee. The second experiment provides further evidence on audit firm versus partner rotation by examining a setting involving a 26-year audit firm–client relationship. Again, no statistically significant differences between the two auditor rotation conditions were found. These findings suggest that compared to audit partner rotation, audit firm rotation does not strengthen independence in appearance among non-professional investors and that non-professional investors recognize the value of strong audit committees.     

The undesirable effect of audit quality: Evidence from firm innovation

This study examines whether and how audit quality affects a firm's technological innovation. Using a sample of 7,482 U.S. firms between 2000 and 2009, we demonstrate that high audit quality is associated with lower innovation output, measured by patent counts and patent citations. The effect remains valid after a series of tests for endogeneity issues, alternative measures of audit quality, and different subsamples. We also find that firms with high audit quality attract more non-dedicated institutional investors and financial analysts, who often exert excessive pressure on managers for short-term performance. These pressures, in turn, exacerbate managerial myopia and lead them to forgo investments in innovation. Our findings provide new insights into audit quality by showing its undesirable, most likely unintended, consequences.     

Do seasoned industry specialists provide higher audit quality? A re-examination

The purpose of this paper is to re-examine the recent findings in Gaver and Utke (2019) (GU) who find that seasoned industry specialist auditors provide higher audit quality. We first illustrate how the magnitude of residuals from the accruals model can vary significantly by industry, thus highlighting the importance of including industry fixed effects when the dependent variable is discretionary accruals. We next replicate GU’s findings. We first attempt to replicate prior literature after including industry fixed effects in the audit quality (discretionary accruals) models. This is an important control, as the relevant benchmark for a firm with an industry specialist auditor is a peer firm in the same industry with a non-specialist auditor. We find that after including industry fixed effects, there is no association between seasoned industry specialist auditors and discretionary accruals. We also find that the association between industry specialization and discretionary accruals is very sensitive to the way in which the researcher calculates specialization. Our findings are informative for shareholders of public companies who vote on auditor ratification.     

Corporate governance and incidences of listing suspension by the JSE Securities Exchange of South Africa: An empirical analysis

We examine the association between corporate governance structures and incidences of listing suspension from the JSE Securities Exchange of South Africa. Using a matched-pairs research design, we compare 81 firms suspended between 1999 and 2005 to an equal number of control firms matched in terms of time, size and industry. Employing a conditional logistic model, we find that the likelihood of suspension is higher in firms with a smaller proportion of non-executive directors, without an audit committee, and with greater block-share ownership and higher gearing (i.e. leverage). Further analysis splitting block-share ownership into institutional and non-institutional investors provides mixed results. While we find a positive association between suspension and non-institutional investors, we observe no association with institutional investors. No association is detected for board size, role duality, directors' share ownership, auditor quality and return on assets. Given the paucity of studies examining listing suspension from stock exchanges and corporate governance mechanisms, these findings contribute to the literature. Additionally, the dearth of research on corporate governance in developing countries suggests that our findings have important implications for policy makers in these countries as they endeavor to improve corporate governance.     

The Impact of Consulting Services on Audit Quality: An Experimental Approach

We use experimental markets to examine whether providing consulting services to a non‐audit client impacts audit quality. Our paper directly addresses concerns raised by the Public Company Accounting Oversight Board that the largest public accounting firms’ growth in their consulting practices threatens audit quality. We conduct an experiment proposed using a registration‐based editorial process. We compare a baseline where the auditor does not provide consulting services to conditions where auditors provide consulting to audit clients or where auditors only provide consulting services to non‐audit clients. Our unique design provides evidence on whether providing consulting to non‐audit clients strengthens the salience of a client‐cooperative social norm that reduces audit quality. We do not find differences in audit quality by condition in our planned analysis, however we find greater variation in audit quality in the conditions where auditors provide consulting services compared to the baseline. In unplanned analyses, our results suggest providing consulting services increases auditor cooperation with managers, increasing audit quality when managers prefer high audit quality and decreasing audit quality when managers prefer low audit quality.     

The impact of corporate governance on auditor choice: Evidence from China

As the largest and fastest growing emerging market, China is becoming more and more important to investors throughout the world. The purpose of this paper is to investigate the determinants of firms’ auditor choice in China in respect of their corporate governance mechanism. Normally firms have to take a trade-off in their auditor choice decisions, i.e., to hire high-quality auditors to signal effective audit monitoring and good corporate governance to lower their capital raising costs, or to select low-quality auditors with less effective audit monitoring in order to reap private benefits derived from weak corporate governance and less-transparent disclosure (the opaqueness gains). We develop a logit regression model to test the impact of firms’ internal corporate governance mechanism on auditor choice decisions made by IPO firms getting listed during a bear market period of 2001–2004 in China. Three variables are used to proxy for firms’ internal corporate governance mechanism, i.e., the ownership concentration, the size of the supervisory board (SB), and the duality of CEO and chairman of board of directors (BoDs). We classify all auditors in China into large auditors (Top 10) and others (non-Top 10), assuming the large auditors can provide higher quality audit services. The empirical results show that firms with larger controlling shareholders, with smaller size of SB, or in which CEO and BoDs chairman are the same person, are less likely to hire a Top 10 (high-quality) auditor. This suggests that when benefits from lowering capital raising costs are trivial, firms with weaker internal corporate governance mechanism are inclined to choose a low-quality auditor so as to capture and sustain their opaqueness gains. On the other hand, with improvement of corporate governance, firms should be more likely to appoint high-quality auditors.