Transcript What do we know about audit quality?

Auditing Section
Doctoral Consortium
January 2006
Jere R. Francis
Curators’ Professor
KPMG Research Professor
University of Missouri, USA
[email protected]
1
Data Innovation in
Empirical Audit Research
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Do what you enjoy, and find the right data for the RQ
Innovation through new data
 Use new data to answer “old” questions better or to answer “new”
questions that could not previously be investigated
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public data – new U.S. audit fee data or internal control reports
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private data avoids competition
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but risky because of competition
but can be risky because it’s costly and the outcome is unknown
Novel use of existing public data
 Creatively use existing data in new ways
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link financial statement properties (e.g., abnormal accruals) with
auditor characteristics
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Becker et al. (CAR 1998) & Francis et al. (AJPT 1999)
office-level analysis of Big 4 accounting firms
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Reynolds &Francis (JAE 2000)
2
Audit Research:
Intersection of practice, theory &
research design choices
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Practice drives research questions (RQ)
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Theory informs/frames RQ
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Economics, agency & signaling theory, psychology
Research design – many choices
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Some examples (next slides)
Modeling, experimental, & archival
Inherent limits of RQs answerable by a
single approach/method
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Value of triangulation/complementarity
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Examples of
Practice-Driven Empirical
Audit Research
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1970s – Congressional investigations
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1980s – effects of deregulation
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Motivated risk-screening studies, & effects of PSLRA
1990s – growth of industry specialization and non-audit services
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Allegations of low-balling and poor audit quality
Motivated studies of initial engagement pricing
1990s – legal liability and audit litigation crisis (S&L, PSLRA)
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Allegations of large-firm cartel pricing & predatory pricing
Motivated first studies of audit pricing
Motivated study of industry expertise and non-audit services
2000s – New regulations/institutions
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The effects of PCAOB and SOX on audit practice/quality
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Triangulation - Low Balling
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Theory -modeling pricing incentives & consequences on
auditor independence
 DeAngelo JAE 1981; Dye JAE 1991
Experimental evidence
 Economics – induce LB in the lab & effects on audit quality
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Psychology – effects of “fee pressure” on the quality of
auditor judgments
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Schatzburg (TAR 1990); Schatzburg & Sevcik (CAR 1994);
Dopuch & King (JAAF 1996)
Houston (AJPT 1999)
Empirical evidence
 Initial engagement discounts
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Simon & Francis (TAR 1988); Craswell & Francis (TAR 1999)
Consequences of LB on audit hours/audit quality
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Deis and Giroux (JAPP 1996), sample of school district audits
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Units of Analysis in Audit Research
(“red” denotes prime empirical areas)
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Audit testing & evidence-gathering procedures
Auditor judgments about testing & evidence
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Accounting firms
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Auditors work in firms
 Observable “audit firm” outcomes are audit reports &
audited financial statements (and who audits whom)
Audit industry and audit markets
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Auditors apply/interpret testing procedures
 As individuals (individual judgments)
 In teams (group judgments)
Audit firms operate & compete in audit markets
Regulatory institutions and public policy
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Auditors, firms and markets are regulated
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Audit Testing Procedures
(requires accounting firms)
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Purpose
 Understanding, evaluating and improving the quality of audit
testing and evidence-gathering procedures
Historical examples
 Are accounts receivable confirmations effective/reliable?
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Is classical sampling efficient/effective in auditing?
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Caster (AJPT 1990)
Lead to development of dollar-unit sampling
Current examples
 Archival - Do control risk assessments affect other audit tests?
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Mock and Wright (AJPT 1999), test of the “audit risk model”
Experimental - Is the new “business risk” audit approach
effective?
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O’Donnell & Schultz (TAR 2005)
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Auditor Judgment Research
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Purpose
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To understand how auditors implement tests, interpret evidence
Ultimate goal – to improve audit judgments in the field
Historical examples
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Descriptive models (1970s)
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Heuristics and biases (1980s)
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Are auditors different than other decision-makers?
Memory and cognition (1990s)
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What information cues affect auditor decision-making?
What do auditors know and why?
Some current examples
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Do different “interventions” affect auditor-client negotiation outcomes?
Do alternative forms of “review” affect auditor performance?
Do “groups” outperform individuals?
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Audit teams required to “brainstorm” for fraud risk
Does the “business risk” model improve auditor judgments?
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Accounting Firms
(proprietary & largely a black box)
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Purpose
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Understanding the organization and administrative structures of
accounting firms
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Field studies – e.g., Dirsmith & Covaleski (AOS 1985)
Examples of RQ
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How centralized/decentralized are firms?
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How much autonomy do local offices/partners have?
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How do partners share profits? What are incentive effects?
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Large vs. small profit-sharing pools, and awarding of partnership units
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A central issue in Andersen’s Enron audit
Burrows & Black (AOS 1998); Trompeter (AJPT 1994); Liu & Simunic (TAR
2005)
Do firm reputations (audit quality) vary?
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Across offices? Across countries? If so, why?
Begs the question of what is an accounting firm? More on this later
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Observable Audit Outcomes
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Direct (who audits whom?)
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Auditor resignations/client disagreements (8-Ks)
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Audit reports
 Are reports informative? GC and New I/C reports
Indirect
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Financial statement/earnings quality
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Krishnan & Krishnan (TAR 1997); Shu (JAE 2000)
Jointly produced by companies/auditors
Work to date is limited mainly to “accruals”
Secondary effects of differential audit quality
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Debt markets
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Mansi et al. (JAR 2004)
Equity markets
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Khurana et al. (TAR 2004); Teoh & Wong (TAR 1993)
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Examples of audit-outcome
research questions
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How do auditor characteristics affect audit outcomes?
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Firm size, brand name, industry expertise
Locale/unit of analysis (global, country, office, partner)
How do engagement-specific characteristics affect audit
outcomes?
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Proxies for independence
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How do client characteristics affect audit outcomes?
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Fees (client influence), engagement tenure, auditor alumni,
Corporate governance (e.g., audit committees)
How do institutions affect audit outcomes?
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Regulatory agencies, litigation & investor protection
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Audit Industry & Markets
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Industry Structure
 Why is the industry dominated by large firms?
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Scale economies?
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Positive spillovers in joint production of audit/other services?
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Economies of scope?
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Yes – Banker et al. (JAE 2003)
No – Zind & Zeghal (CAR 1991)
Simunic (JAR 1984); Whisenant et al. (JAR 2003)
Audit Market Structure
 Are audit markets competitive, or monopolistic?
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Is there demand for (supply of) differential audit quality?
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Oligopoly/monopolistic competition?
If so, why? How is it priced? How is audit quality affected?
How have mergers/consolidations affected audit markets?
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Regulatory Institutions
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How do professional bodies & regulatory institutions
affect audits and accounting firms?
Examples of RQ:
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How do sanctions affect audits/firms?
 Wilson & Grimlund (APJT 1990) – SEC’s AAER
 Hilary and Lennox (JAE 2006) – POB Peer Reviews
How do legal liability regimes affect audits?
 Analytical/Experimental
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Empirical
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Dye (JPE 1993; JAE 1997); Dopuch et al. (JAE 1997)
Francis & Krishnan (APJAE 2003); Lee & Mande (AJPT 2003);
Current topics
 How do current regulations (PCAOB/SOX) affect audits?
 Should nonaudit services (including taxes) be banned?
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Empirical Research
on Audit Quality
Audits are relatively cheap, and proven
failures are infrequent.
 But this does not necessarily mean audits
are always of high quality.
 What do we know about audit quality
from empirical research?
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Research on
Audit Outcomes
What do know about audit quality
from audit report research?
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Inferring Audit Quality
from Audit Reports
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After 1989, only two primary audit reports
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Standard clean opinion (90%)
Modified opinion for going concern (GC) (10%)
How do users respond to “modified” reports?
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Are modified reports perceived to convey
“negative” news?
If so, then audit reports are informative and
auditing has value to users
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Type 1 & 2 Error Rates
(1995-2003 Compustat Population)
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Clean opinions (90%), GC (10%), n= 62,094
firm-year observations
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Type 1 Errors (false negatives) – 9% (overqualifying or auditor conservatism)
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Overall Error Rate – 9.5%
No bankruptcy within one year, but 9% had GC reports
 5,467 GC reports for 785 bankruptcies (7 GC per
bankruptcy)
Type 2 Errors (false positives) – 55% (underqualifying)
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Bankruptcy within one year (785) but no GC 55% of
time, i.e., 432 cases over an 8-year period
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Do Modified
Audit Reports Matter
(given type 1/2 errors?)
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Informational value is difficult to assess
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Audit reports issued concurrently with financials
Most GC reports are “repeat offenders”
Evidence that “surprise” first-time GC reports
reduce share prices
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Dodd et al. (JAE 1984), Loudder et al. (AJPT 1992)
Predictive ability of modified audit reports for
material loss contingences (lawsuits)
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Raghundan (CAR 1993)
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Audit Reports and
the IPO Setting
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Audit report has potentially more value
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Greater information uncertainty/asymmetry
Weber and Willenborg (JAR 2003)
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Microcap IPO’s < $10 million
23% have GC reports preceding IPO
Pre-IPO audit reports predict delistings and future
stock returns
But more so for large (Big 4 & national)
auditors
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Who Audits Whom?
What do we know about auditor
differences and audit quality?
20
Differential
Audit Quality Research
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Audit quality cannot be directly observed
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Instead – differential audit quality is inferred
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Except for “proven” audit failures (ex post) which are rare
Comparing audit outcomes between “classes” of auditors
All firms are assumed to meet minimum professional
& legal requirements
But many different types of firms exist
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Suggests supply of differential auditing
Implies differential demand (clienteles)
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Audit Firm Size:
Is Bigger Better?
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The big firm/small firm dichotomy
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Auditor size proxies for quality due to less fee
dependence (DeAngelo, JAE 1981)
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Big 8 (now Big 4) firms have brand name reputation and
incentives to protect their reputation
 Simunic and Stein (1987 CGA Monograph)
Client dependence = 1/n (where n=number of clients)
Now we can use actual fee dependence
Doesn’t mean Big 4 audits are always better
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It just means that on average they are better
Individual audit failures can and do occur
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Evidence of Big 4
Audit Quality Differentiation
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Audit pricing
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Big 4 audit fee premia of 20-50%
US, Australia, Hong Kong, UK
Implies more quantity and/or better quality auditing
 Higher fees imply voluntary demand for higher quality
audits by some clients
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Demand for quality
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Demand for Big 4 audits is increasing in agency costs
 Francis & Wilson (TAR 1988), DeFond (AJPT 1992)
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IPOs with larger auditors have less IPO underpricing
 Beatty (TAR 1989), Willenborg (JAR 1999)
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Other Evidence
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Big accounting firms are sued less often
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Big firms sanctioned less often by regulators
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Litigation as quality proxy (Palmose, TAR, 1987)
Feroz et al. (JAR 1991)
Alternative explanation is that big firms are
more powerful and have resources to fight
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But evidence on audit “outcomes” is more
consistent with higher quality
Let’s turn to that evidence
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Evidence from Audit Outcomes
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Audit Reports of Large (Big 4) Auditors
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More conservative reports (more modifications)
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Francis & Krishnan (CAR 1999), (APJAE 2003)
More informative reports (predictive power)
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IPO setting, Weber & Willenborg (JAR 2003)
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More accurate reports in UK, Lennox (ABR 1999)
Financial Statements Audited by Big 4 Auditors
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Smaller abnormal accruals -- less managerial discretion
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Becker et al. (CAR 1998), Francis et al. (AJPT 1999)
Accruals/earnings surprises valued higher in the stock market
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Teoh & Wong (TAR 1993), Krishnan (AJPT 2003)
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Conclusions on Auditor Size
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Evidence is supportive of higher Big 4 audit quality
But an alternative explanation is endogeneity
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i.e., “good” companies choose good (Big 4) auditors, in which
case selection may explain outcomes, not audit quality
Heckman 2-stage approach is trendy
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But most studies using it support prior findings on audit quality
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Can we identify good “instruments” in accounting research?
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Weber & Willenborg (JAR 2003), Hogan (TAR 1997), Ireland &
Lennox (JAAF 2002)
Chaney et al. (TAR 2004) is an exception
Larcker & Rusticus (SSRN WP) are skeptical
If there’s reason to think selection exists, an alternative is to
control through research design choices
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e.g., matched pairs, or samples limited to smaller clients
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Moving Beyond the
Big-Small Dichotomy
Differentiation within
the dominant Big 4 group
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Within-Big 4 Differentiation
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In past, Big 4 viewed as homogenous group
B4 (90%) & NB4 (10%) U.S. market shares
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Low power due to small variance in auditor type
May be more variation within Big 4 firms
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Some plausible within-Big 4 variations:
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Industry expertise
Geographical variation
Offices (cross-city differences)
Countries (cross-country differences)
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Industry Expertise
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Firms actively promote their industry expertise
Industry experts have more experience and appear
to make better audit judgments
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Auditor clienteles proxy for industry expertise
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Solomon et al. (JAR 1999); Low (TAR 2004)
More clients create more opportunities to acquire deep
industry knowledge/expertise
Industry shares are not evenly distributed
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Using 2000-2001 U.S. fee data & 2-digit SIC codes
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#1 firm has 50% of industry fees, #2 firm only 22%
Leadership among Big 5 firms for 63 industries
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AA (14), DT (5), EY (16), KPMG (9), PWC (19)
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Evidence from Audit Fees
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Big 4 industry leaders have higher fees (10-30%)
and higher fees imply higher quality audits
Financial statement outcomes evidence higher
quality audits by Big 4 industry leaders
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Smaller abnormal accruals (less discretion)
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Higher valuation of earnings surprises
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Balsam et al. (AJPT 2003)
Less fraudulent reporting (AAERs)
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Balsam et al. (APJT 2003), Krishnan (AH 2003)
Carcello & Nagy (2004 Managerial Auditing Journal)
Less IPO underpricing and smaller accruals
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Elder and Zhou (2003 WP)
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What is an Accounting
Firm?
What’s the relevant unit of
analysis?
 Individual offices, national
practices, or international
operations?
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31
Arguments for
an Office-Level Analysis
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Accounting firms are decentralized networks of
quasi-independent practice offices
Engagement partners in local offices contract and
administer audits to clients in the same locale
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Issue audit reports on office letterhead
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Francis et al. (ABACUS 1999); Reynolds & Francis (JAE
2000); Ferguson et al. (TAR 2003)
Client influence/fee dependence is stronger at the
office level
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Enron < 2% of Andersen fees nationally
Over 30% of Houston office fees
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First Office-Level Study
Reynolds & Francis (JAE 2000)
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Auditors are more conservative for larger clients in
U.S. practice offices
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They issue more GC audit reports
Clients have smaller abnormal accruals
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Client size measured “relative” to office clienteles
Client size is not significant using national clienteles
to measure relative client size
Conclusion
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Office-level data provides better understanding
 No results using aggregate data; but evidence of auditor
conservatism using office-level data
33
Office-Level Reputation
for Industry Expertise
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Is industry expertise firm-wide (national),
office-specific (city), or combination of both?
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Office-specific arguments
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Deep expertise is client-specific and cannot be fully
captured by firms and distributed across offices
Gilson & Mnookin (SLR 1985), law firms
Firm-wide arguments
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Standardized training/audit practices and knowledge
sharing is possible across offices
34
How is National Versus City
Industry Leadership Priced?
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4 possibilities (Francis et al., TAR 2005)
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Engagements where auditor is both the national
and the city-specific industry leader
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Engagements where auditor is a national industry
leader (alone)
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10% of US sample
Engagements where auditor is a city-specific
industry leaders (alone)
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18% of US sample
23% of US sample
Nonleaders (neither city/national leaders)
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49% of US sample
35
Evidence
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Joint national-city #1 has +28% premium
City-alone #1 has +10% premium
National-alone #1 has no fee premium relative to
nonleaders (default group is nonleaders)
Implication - audit quality is office-specific
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Industry premia only when a city leader
 Either alone or joint national-city leader
National market share is driven by city leadership
 National #1, 86% of fees where city leader
36
RQ - Does City Leadership
Affect Earnings Quality?

Follow-up WP to Francis et al. (TAR 2005)
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Uses same B5 sample from 2000-01 first-time cycle of fee
disclosures to measure industry leaders
What do we find?
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Clients of city industry leaders have smaller abnormal
accruals, and smaller income-increasing accruals
 Magnitude is 6-12% of pre-tax earnings
Clients of joint national-city leaders are less likely to meet or
beat by +1 cent analysts’ forecasts (40%  29%)
City-only leaders are also less likely to do so (40% 
33%)
In both tests results for national leaders (alone) are n.s.
37
Legal Systems
and Differential Auditing
(over time/countries)
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Institutions & legal regimes affect auditor incentives
Two research approaches
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A regime change within a single country (over time)
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The Private Securities Litigation Reform Act of 1995
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Lee and Mande (AJPT 2003), Francis & Krishnan (APJAE 2003)
Cross-country studies of different legal regimes
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Seetharaman, Gul and Lyn (JAE 2002)
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higher audit fees of UK firms cross-listed in US
implies higher fees due to increased litigation risk exposure
Khurana et al. (TAR 2004)

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B4 clients have lower COC in US (but not Australia, UK, Canada)
Implies US litigation risk drives B4 behavior (not reputations)
38
RQ – Do B4 incentives vary
across legal regimes?

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Do B4 audits vary across jurisdictions?
Three Scenarios
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Big 4 are uniform around the world

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U.S. is an outlier due to extreme liability exposure

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Incentives to maintain brand name (standardization)
More lawsuits in US than rest of world combined
Big 4 conservatism is increasing in country-level
investor protection and auditor litigation risk
39
Big 4 Auditor Conservatism
Uniform Worldwide
Conservatism
High
Low
U.S. Outlier
Low
High (U.S.)
Legal Liability/Investor
Protection
40
Preliminary Results Indicate
that Legal Regime Matters
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Big 4 conservatism is

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Magnitude
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Increasing in investor protection/litigation risk
Holds both with/without U.S. observations
Implies less discretion to manage earnings
Abnormal accruals are smaller by around 5% of earnings
in common law countries with stronger investor protection
Non-Big 4 firms are uniform across countries (and
less conservative than Big 4)

Less incentive for reputation protection/litigation
avoidance behavior (same as within US)
41
Other Examples of
Research
on Audit Quality
Auditor tenure
 Non-audit services (NAS)
 Audit committees/corporate
governance
 Accounting firm alumni

42
Auditor Tenure

Tenure and mandatory auditor rotation

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Long tenure is good because auditors know more
about the client (deeper knowledge)
Long tenure is bad because of entrenchment and
self-serving bias
The evidence to date:

Audit quality is lower in first 3 years


But longer tenure (5+ years) increases audit quality

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Johnson et al. (CAR 2002)
Meyer et al. (TAR 2003)
Studies of partner tenure in Australia and Taiwan

Office level analysis
43
Nonaudit Services (NAS)

Do NAS impair auditor independence?


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More fee dependence
Inherent conflict of interest
SEC attempted to ban NAS in 2000
Profession’s defense


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Increases auditor’s knowledge
Clients demand and value NAS
Incentives exist to protect reputations for
independence
44
Evidence

Frankel, Johnson & Nelson (TAR 2002)



Compelling set of results against NAS
Firms with higher NAS are associated with more earnings
management:
 Larger abnormal accruals (more discretion)
 More likely to meet analysts’ earnings targets
But also counter-evidence

Ashbaugh et al. (TAR 2003), Chung & Kallapur (TAR
2003), Reynolds et al. (AJPT 2004), DeFond et al. (JAR
2003), Larcker & Richardson (JAR 2004)
45
Broader Implications


Accounting journals generally don’t publish
replications and no-result studies
But replications show fragility and sensitivity
to design choices

e.g., Frankel et al. (TAR 2002) & Ashbaugh et al.
(TAR 2003) get different results on main tests, but
with slightly different samples/models
46
Audit Quality and
Corporate Boards/Governance

Audit quality is better when strong boards and audit
committees exist (independence/outside directors)

Auditors are more likely to issue GC reports


Less likely to be replaced following GC report


Dechow et al. (CAR 1995)
Accruals are smaller (less earnings management)


Carcello and Neal (TAR 2003)
Auditors are more likely to detect fraud


Carcello and Neal (TAR 2000)
Klein (JAE 2002), Bedard et al. (AJPT 2004)
Auditors have higher audit fees and are less likely to
perform non-audit services

Abbot et al. (SSRN 2001), Abbott et al. (AJPT 2003)
47
Accounting Firm Alumni
and Auditor Independence

Outplacement to clients impairs audit quality



Lennox (JAE 2005)

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Clients know the auditor’s methods too well
Auditor is cozy with former colleagues
Outplacement is less than perceived (10%)
But GC reports are less frequent than predicted
(suggests client leniency)
Menon & Williams (TAR 2004)

Firms with alumni have larger abnormal accruals
48
Policy Making
What’s the role of
academic auditing research
on audit quality?
49
The U.S. Experience


Academic research has little influence on
regulation and policy-making
Two recent examples that ignored research

SEC’s proposed ban on NAS in 2000


Arthur Levitt was convinced a ban was needed
Quick adoption of Sarbanes-Oxley (SOX) in 2002

Political cover following Enron/Worldcom scandals
50
Why so little impact?

Partly our fault


We rarely frame our research around normative regulatory
issues or ‘sell’ its policy importance
We may not appear to be neutral



There’s often an explicit anti-regulatory posture
And we may (rightly) be viewed as apologists for the
accounting profession
Partly policy-makers’ fault



No tradition of basing policy on research
Policy-making is inherently political (not scientific)
Overtures by the PCAOB are encouraging
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Some Important
Unanswered Questions


Does the U.S. evidence generalize to countries with
different legal and regulatory institutions?
How much auditing is optimal?



Is differential audit quality a good thing?



Audits are not very costly and proven failure rate is low
Is ‘more’ auditing desirable, or cost-effective, e.g., SOX?
If Big 4 or industry leaders are better, should they be
mandated?
Or should there be choice?
Is government regulation (SEC/PCAOB) better than
self-regulation with government oversight?
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And Finally

What level of “legal risk” achieves optimal audit
quality?



Does “extreme” legal risk create the best incentive?


U.S. is an outlier in legal-liability risk, although we observe B4
conservatism in other common law countries
The risk of “audit firm failure” is real in the U.S. but nearly
impossible in rest of world
It didn’t prevent the Arthur Andersen collapse or frauds such
as Worldcom, Adelphia, and HealthSouth
Another U.S. audit firm failure could end privatesector auditing around the world (global Big 4)


All Big 4 firms have serious legal problems
Is a “Big n <= 3” viable for private-sector auditing
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Follow-up Readings

J. Francis, “What Do We Know About Audit
Quality?” The British Accounting Review
(December 2004), Vo. 34, No. 4: 345-36

DeFond, M., and J. Francis, “Audit Research
after Sarbanes-Oxley?” Auditing: A Journal of
Practice and Theory (2005, Supplement):
forthcoming.
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