1. Auditing Section Doctoral Consortium January 2006
Jere R. Francis Curators’ Professor
KPMG Research Professor
University of Missouri, USA

2. Data Innovation in Empirical Audit Research
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
public data – new U.S. audit fee data or internal control reports
but risky because of competition
private data avoids 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
link financial statement properties (e.g., abnormal accruals) with auditor characteristics
Becker et al. (CAR 1998) & Francis et al. (AJPT 1999)
office-level analysis of Big 4 accounting firms
Reynolds &Francis (JAE 2000)

3. Audit Research: Intersection of practice, theory & research design choices
Practice drives research questions (RQ)
Some examples (next slides)
Theory informs/frames RQ
Economics, agency & signaling theory, psychology
Research design – many choices
Modeling, experimental, & archival
Inherent limits of RQs answerable by a single approach/method
Value of triangulation/complementarity

4. Examples of Practice-Driven Empirical Audit Research
1970s – Congressional investigations
Allegations of large-firm cartel pricing & predatory pricing
Motivated first studies of audit pricing
1980s – effects of deregulation
Allegations of low-balling and poor audit quality
Motivated studies of initial engagement pricing
1990s – legal liability and audit litigation crisis (S&L, PSLRA)
Motivated risk-screening studies, & effects of PSLRA
1990s – growth of industry specialization and non-audit services
Motivated study of industry expertise and non-audit services
2000s – New regulations/institutions
The effects of PCAOB and SOX on audit practice/quality

5. Triangulation - Low Balling
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
Schatzburg (TAR 1990); Schatzburg & Sevcik (CAR 1994); Dopuch & King (JAAF 1996)
Psychology – effects of “fee pressure” on the quality of auditor judgments
Houston (AJPT 1999)
Empirical evidence
Initial engagement discounts
Simon & Francis (TAR 1988); Craswell & Francis (TAR 1999)
Consequences of LB on audit hours/audit quality
Deis and Giroux (JAPP 1996), sample of school district audits

6. Units of Analysis in Audit Research (“red” denotes prime empirical areas)
Audit testing & evidence-gathering procedures
Auditor judgments about testing & evidence
Auditors apply/interpret testing procedures
As individuals (individual judgments)
In teams (group judgments)
Accounting firms
Auditors work in firms
Observable “audit firm” outcomes are audit reports & audited financial statements (and who audits whom)
Audit industry and audit markets
Audit firms operate & compete in audit markets
Regulatory institutions and public policy
Auditors, firms and markets are regulated

7. Audit Testing Procedures (requires accounting firms)
Purpose
Understanding, evaluating and improving the quality of audit testing and evidence-gathering procedures
Historical examples
Are accounts receivable confirmations effective/reliable?
Caster (AJPT 1990)
Is classical sampling efficient/effective in auditing?
Lead to development of dollar-unit sampling
Current examples
Archival - Do control risk assessments affect other audit tests?
Mock and Wright (AJPT 1999), test of the “audit risk model”
Experimental - Is the new “business risk” audit approach effective?
O’Donnell & Schultz (TAR 2005)

8. Auditor Judgment Research
Purpose
To understand how auditors implement tests, interpret evidence
Ultimate goal – to improve audit judgments in the field
Historical examples
Descriptive models (1970s)
What information cues affect auditor decision-making?
Heuristics and biases (1980s)
Are auditors different than other decision-makers?
Memory and cognition (1990s)
What do auditors know and why?
Some current examples
Do different “interventions” affect auditor-client negotiation outcomes?
Do alternative forms of “review” affect auditor performance?
Do “groups” outperform individuals?
Audit teams required to “brainstorm” for fraud risk
Does the “business risk” model improve auditor judgments?

9. Accounting Firms (proprietary & largely a black box)
Purpose
Understanding the organization and administrative structures of accounting firms
Field studies – e.g., Dirsmith & Covaleski (AOS 1985)
Examples of RQ
How centralized/decentralized are firms?
How much autonomy do local offices/partners have?
A central issue in Andersen’s Enron audit
How do partners share profits? What are incentive effects?
Large vs. small profit-sharing pools, and awarding of partnership units
Burrows & Black (AOS 1998); Trompeter (AJPT 1994); Liu & Simunic (TAR 2005)
Do firm reputations (audit quality) vary?
Across offices? Across countries? If so, why?
Begs the question of what is an accounting firm? More on this later

10. Observable Audit Outcomes
Direct (who audits whom?)
Auditor resignations/client disagreements (8-Ks)
Krishnan & Krishnan (TAR 1997); Shu (JAE 2000)
Audit reports
Are reports informative? GC and New I/C reports
Indirect
Financial statement/earnings quality
Jointly produced by companies/auditors
Work to date is limited mainly to “accruals”
Secondary effects of differential audit quality
Debt markets
Mansi et al. (JAR 2004)
Equity markets
Khurana et al. (TAR 2004); Teoh & Wong (TAR 1993)

11. Examples of audit-outcome research questions
How do auditor characteristics affect audit outcomes?
Firm size, brand name, industry expertise
Locale/unit of analysis (global, country, office, partner)
How do engagement-specific characteristics affect audit outcomes?
Proxies for independence
Fees (client influence), engagement tenure, auditor alumni,
How do client characteristics affect audit outcomes?
Corporate governance (e.g., audit committees)
How do institutions affect audit outcomes?
Regulatory agencies, litigation & investor protection

12. Audit Industry & Markets
Industry Structure
Why is the industry dominated by large firms?
Scale economies?
Yes – Banker et al. (JAE 2003)
No – Zind & Zeghal (CAR 1991)
Positive spillovers in joint production of audit/other services?
Economies of scope?
Simunic (JAR 1984); Whisenant et al. (JAR 2003)
Audit Market Structure
Are audit markets competitive, or monopolistic?
Oligopoly/monopolistic competition?
Is there demand for (supply of) differential audit quality?
If so, why? How is it priced? How is audit quality affected?
How have mergers/consolidations affected audit markets?

13. Regulatory Institutions
How do professional bodies & regulatory institutions affect audits and accounting firms?
Examples of RQ:
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
Dye (JPE 1993; JAE 1997); Dopuch et al. (JAE 1997)
Empirical
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?

14. 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?

15. Research on Audit Outcomes
What do know about audit quality from audit report research?

16. Inferring Audit Quality from Audit Reports
After 1989, only two primary audit reports
Standard clean opinion (90%)
Modified opinion for going concern (GC) (10%)
How do users respond to “modified” reports?
Are modified reports perceived to convey “negative” news?
If so, then audit reports are informative and auditing has value to users

17. Type 1 & 2 Error Rates (1995-2003 Compustat Population)
Clean opinions (90%), GC (10%), n= 62,094 firm-year observations
Overall Error Rate – 9.5%
Type 1 Errors (false negatives) – 9% (over-qualifying or auditor conservatism)
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% (under-qualifying)
Bankruptcy within one year (785) but no GC 55% of time, i.e., 432 cases over an 8-year period

18. Do Modified Audit Reports Matter (given type 1/2 errors?)
Informational value is difficult to assess
Audit reports issued concurrently with financials
Most GC reports are “repeat offenders”
Evidence that “surprise” first-time GC reports reduce share prices
Dodd et al. (JAE 1984), Loudder et al. (AJPT 1992)
Predictive ability of modified audit reports for material loss contingences (lawsuits)
Raghundan (CAR 1993)

19. Audit Reports and the IPO Setting
Audit report has potentially more value
Greater information uncertainty/asymmetry
Weber and Willenborg (JAR 2003)
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

20. What do we know about auditor differences and audit quality?
Who Audits Whom?
What do we know about auditor differences and audit quality?

21. Differential Audit Quality Research
Audit quality cannot be directly observed
Except for “proven” audit failures (ex post) which are rare
Instead – differential audit quality is inferred
Comparing audit outcomes between “classes” of auditors
All firms are assumed to meet minimum professional & legal requirements
But many different types of firms exist
Suggests supply of differential auditing
Implies differential demand (clienteles)

22. Audit Firm Size: Is Bigger Better?
The big firm/small firm dichotomy
Big 8 (now Big 4) firms have brand name reputation and incentives to protect their reputation
Simunic and Stein (1987 CGA Monograph)
Auditor size proxies for quality due to less fee dependence (DeAngelo, JAE 1981)
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
It just means that on average they are better
Individual audit failures can and do occur

23. Evidence of Big 4 Audit Quality Differentiation
Audit pricing
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
Demand for quality
Demand for Big 4 audits is increasing in agency costs
Francis & Wilson (TAR 1988), DeFond (AJPT 1992)
IPOs with larger auditors have less IPO underpricing
Beatty (TAR 1989), Willenborg (JAR 1999)

24. Other Evidence Big accounting firms are sued less often
Litigation as quality proxy (Palmose, TAR, 1987)
Big firms sanctioned less often by regulators
Feroz et al. (JAR 1991)
Alternative explanation is that big firms are more powerful and have resources to fight
But evidence on audit “outcomes” is more consistent with higher quality
Let’s turn to that evidence

25. Evidence from Audit Outcomes
Audit Reports of Large (Big 4) Auditors
More conservative reports (more modifications)
Francis & Krishnan (CAR 1999), (APJAE 2003)
More informative reports (predictive power)
IPO setting, Weber & Willenborg (JAR 2003)
More accurate reports in UK, Lennox (ABR 1999)
Financial Statements Audited by Big 4 Auditors
Smaller abnormal accruals -- less managerial discretion
Becker et al. (CAR 1998), Francis et al. (AJPT 1999)
Accruals/earnings surprises valued higher in the stock market
Teoh & Wong (TAR 1993), Krishnan (AJPT 2003)

26. Conclusions on Auditor Size
Evidence is supportive of higher Big 4 audit quality
But an alternative explanation is endogeneity
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
But most studies using it support prior findings on audit quality
Weber & Willenborg (JAR 2003), Hogan (TAR 1997), Ireland & Lennox (JAAF 2002)
Chaney et al. (TAR 2004) is an exception
Can we identify good “instruments” in accounting research?
Larcker & Rusticus (SSRN WP) are skeptical
If there’s reason to think selection exists, an alternative is to control through research design choices
e.g., matched pairs, or samples limited to smaller clients

27. Moving Beyond the Big-Small Dichotomy
Differentiation within
the dominant Big 4 group

28. Within-Big 4 Differentiation
In past, Big 4 viewed as homogenous group
B4 (90%) & NB4 (10%) U.S. market shares
Low power due to small variance in auditor type
May be more variation within Big 4 firms
Some plausible within-Big 4 variations:
Industry expertise
Geographical variation
Offices (cross-city differences)
Countries (cross-country differences)

29. Industry Expertise Firms actively promote their industry expertise
Industry experts have more experience and appear to make better audit judgments
Solomon et al. (JAR 1999); Low (TAR 2004)
Auditor clienteles proxy for industry expertise
More clients create more opportunities to acquire deep industry knowledge/expertise
Industry shares are not evenly distributed
Using U.S. fee data & 2-digit SIC codes
#1 firm has 50% of industry fees, #2 firm only 22%
Leadership among Big 5 firms for 63 industries
AA (14), DT (5), EY (16), KPMG (9), PWC (19)

30. Evidence from Audit Fees
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
Smaller abnormal accruals (less discretion)
Balsam et al. (APJT 2003), Krishnan (AH 2003)
Higher valuation of earnings surprises
Balsam et al. (AJPT 2003)
Less fraudulent reporting (AAERs)
Carcello & Nagy (2004 Managerial Auditing Journal)
Less IPO underpricing and smaller accruals
Elder and Zhou (2003 WP)

31. What is an Accounting Firm?
What’s the relevant unit of
analysis?
Individual offices, national
practices, or international
operations?

32. Arguments for an Office-Level Analysis
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
Issue audit reports on office letterhead
Francis et al. (ABACUS 1999); Reynolds & Francis (JAE 2000); Ferguson et al. (TAR 2003)
Client influence/fee dependence is stronger at the office level
Enron < 2% of Andersen fees nationally
Over 30% of Houston office fees

33. First Office-Level Study Reynolds & Francis (JAE 2000)
Auditors are more conservative for larger clients in U.S. practice offices
They issue more GC audit reports
Clients have smaller abnormal accruals
Client size measured “relative” to office clienteles
Client size is not significant using national clienteles to measure relative client size
Conclusion
Office-level data provides better understanding
No results using aggregate data; but evidence of auditor conservatism using office-level data

34. Office-Level Reputation for Industry Expertise
Is industry expertise firm-wide (national), office-specific (city), or combination of both?
Office-specific arguments
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
Standardized training/audit practices and knowledge sharing is possible across offices

35. How is National Versus City Industry Leadership Priced?
4 possibilities (Francis et al., TAR 2005)
Engagements where auditor is both the national and the city-specific industry leader
18% of US sample
Engagements where auditor is a national industry leader (alone)
10% of US sample
Engagements where auditor is a city-specific industry leaders (alone)
23% of US sample
Nonleaders (neither city/national leaders)
49% of US sample

36. Evidence 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
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

37. RQ - Does City Leadership Affect Earnings Quality?
Follow-up WP to Francis et al. (TAR 2005)
Uses same B5 sample from first-time cycle of fee disclosures to measure industry leaders
What do we find?
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.

38. Legal Systems and Differential Auditing (over time/countries)
Institutions & legal regimes affect auditor incentives
Two research approaches
A regime change within a single country (over time)
The Private Securities Litigation Reform Act of 1995
Lee and Mande (AJPT 2003), Francis & Krishnan (APJAE 2003)
Cross-country studies of different legal regimes
Seetharaman, Gul and Lyn (JAE 2002)
higher audit fees of UK firms cross-listed in US
implies higher fees due to increased litigation risk exposure
Khurana et al. (TAR 2004)
B4 clients have lower COC in US (but not Australia, UK, Canada)
Implies US litigation risk drives B4 behavior (not reputations)

39. RQ – Do B4 incentives vary across legal regimes?
Do B4 audits vary across jurisdictions?
Three Scenarios
Big 4 are uniform around the world
Incentives to maintain brand name (standardization)
U.S. is an outlier due to extreme liability exposure
More lawsuits in US than rest of world combined
Big 4 conservatism is increasing in country-level investor protection and auditor litigation risk

40. Big 4 Auditor Conservatism
Uniform Worldwide
U.S. Outlier
High
Conservatism
Low
Low
High (U.S.)
Legal Liability/Investor
Protection

41. Preliminary Results Indicate that Legal Regime Matters
Big 4 conservatism is
Increasing in investor protection/litigation risk
Holds both with/without U.S. observations
Implies less discretion to manage earnings
Magnitude
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)

42. Other Examples of Research on Audit Quality
Auditor tenure
Non-audit services (NAS)
Audit committees/corporate
governance
Accounting firm alumni

43. Auditor Tenure Tenure and mandatory auditor rotation
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
Johnson et al. (CAR 2002)
But longer tenure (5+ years) increases audit quality
Meyer et al. (TAR 2003)
Studies of partner tenure in Australia and Taiwan
Office level analysis

44. Nonaudit Services (NAS)
Do NAS impair auditor independence?
More fee dependence
Inherent conflict of interest
SEC attempted to ban NAS in 2000
Profession’s defense
Increases auditor’s knowledge
Clients demand and value NAS
Incentives exist to protect reputations for independence

45. 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)

46. 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

47. 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
Carcello and Neal (TAR 2000)
Less likely to be replaced following GC report
Carcello and Neal (TAR 2003)
Auditors are more likely to detect fraud
Dechow et al. (CAR 1995)
Accruals are smaller (less earnings management)
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)

48. Accounting Firm Alumni and Auditor Independence
Outplacement to clients impairs audit quality
Clients know the auditor’s methods too well
Auditor is cozy with former colleagues
Lennox (JAE 2005)
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

49. What’s the role of academic auditing research on audit quality?
Policy Making
What’s the role of
academic auditing research
on audit quality?

50. 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

51. Why so little impact? Partly our fault Partly policy-makers’ 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

52. Some Important Unanswered Questions
Does the U.S. evidence generalize to countries with different legal and regulatory institutions?
How much auditing is optimal?
Audits are not very costly and proven failure rate is low
Is ‘more’ auditing desirable, or cost-effective, e.g., SOX?
Is differential audit quality a good thing?
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?

53. And Finally What level of “legal risk” achieves optimal audit quality?
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
Does “extreme” legal risk create the best incentive?
It didn’t prevent the Arthur Andersen collapse or frauds such as Worldcom, Adelphia, and HealthSouth
Another U.S. audit firm failure could end private-sector 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

54. Follow-up Readings
J. Francis, “What Do We Know About Audit Quality?” The British Accounting Review (December 2004), Vo. 34, No. 4:
DeFond, M., and J. Francis, “Audit Research after Sarbanes-Oxley?” Auditing: A Journal of Practice and Theory (2005, Supplement): forthcoming.