Presentation on theme: "Auditing Section Doctoral Consortium January 2006"— Presentation transcript:
1 Auditing Section Doctoral Consortium January 2006 Jere R. Francis Curators’ ProfessorKPMG Research ProfessorUniversity of Missouri, USA
2 Data Innovation in Empirical Audit Research Do what you enjoy, and find the right data for the RQInnovation through new dataUse new data to answer “old” questions better or to answer “new” questions that could not previously be investigatedpublic data – new U.S. audit fee data or internal control reportsbut risky because of competitionprivate data avoids competitionbut can be risky because it’s costly and the outcome is unknownNovel use of existing public dataCreatively use existing data in new wayslink financial statement properties (e.g., abnormal accruals) with auditor characteristicsBecker et al. (CAR 1998) & Francis et al. (AJPT 1999)office-level analysis of Big 4 accounting firmsReynolds &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 RQEconomics, agency & signaling theory, psychologyResearch design – many choicesModeling, experimental, & archivalInherent limits of RQs answerable by a single approach/methodValue of triangulation/complementarity
4 Examples of Practice-Driven Empirical Audit Research 1970s – Congressional investigationsAllegations of large-firm cartel pricing & predatory pricingMotivated first studies of audit pricing1980s – effects of deregulationAllegations of low-balling and poor audit qualityMotivated studies of initial engagement pricing1990s – legal liability and audit litigation crisis (S&L, PSLRA)Motivated risk-screening studies, & effects of PSLRA1990s – growth of industry specialization and non-audit servicesMotivated study of industry expertise and non-audit services2000s – New regulations/institutionsThe effects of PCAOB and SOX on audit practice/quality
5 Triangulation - Low Balling Theory -modeling pricing incentives & consequences on auditor independenceDeAngelo JAE 1981; Dye JAE 1991Experimental evidenceEconomics – induce LB in the lab & effects on audit qualitySchatzburg (TAR 1990); Schatzburg & Sevcik (CAR 1994); Dopuch & King (JAAF 1996)Psychology – effects of “fee pressure” on the quality of auditor judgmentsHouston (AJPT 1999)Empirical evidenceInitial engagement discountsSimon & Francis (TAR 1988); Craswell & Francis (TAR 1999)Consequences of LB on audit hours/audit qualityDeis 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 proceduresAuditor judgments about testing & evidenceAuditors apply/interpret testing proceduresAs individuals (individual judgments)In teams (group judgments)Accounting firmsAuditors work in firmsObservable “audit firm” outcomes are audit reports & audited financial statements (and who audits whom)Audit industry and audit marketsAudit firms operate & compete in audit marketsRegulatory institutions and public policyAuditors, firms and markets are regulated
7 Audit Testing Procedures (requires accounting firms) PurposeUnderstanding, evaluating and improving the quality of audit testing and evidence-gathering proceduresHistorical examplesAre accounts receivable confirmations effective/reliable?Caster (AJPT 1990)Is classical sampling efficient/effective in auditing?Lead to development of dollar-unit samplingCurrent examplesArchival - 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 PurposeTo understand how auditors implement tests, interpret evidenceUltimate goal – to improve audit judgments in the fieldHistorical examplesDescriptive 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 examplesDo 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 riskDoes the “business risk” model improve auditor judgments?
9 Accounting Firms (proprietary & largely a black box) PurposeUnderstanding the organization and administrative structures of accounting firmsField studies – e.g., Dirsmith & Covaleski (AOS 1985)Examples of RQHow centralized/decentralized are firms?How much autonomy do local offices/partners have?A central issue in Andersen’s Enron auditHow do partners share profits? What are incentive effects?Large vs. small profit-sharing pools, and awarding of partnership unitsBurrows & 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 reportsAre reports informative? GC and New I/C reportsIndirectFinancial statement/earnings qualityJointly produced by companies/auditorsWork to date is limited mainly to “accruals”Secondary effects of differential audit qualityDebt marketsMansi et al. (JAR 2004)Equity marketsKhurana 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 expertiseLocale/unit of analysis (global, country, office, partner)How do engagement-specific characteristics affect audit outcomes?Proxies for independenceFees (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 StructureWhy 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 StructureAre 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 AAERHilary and Lennox (JAE 2006) – POB Peer ReviewsHow do legal liability regimes affect audits?Analytical/ExperimentalDye (JPE 1993; JAE 1997); Dopuch et al. (JAE 1997)EmpiricalFrancis & Krishnan (APJAE 2003); Lee & Mande (AJPT 2003);Current topicsHow 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 provenfailures are infrequent.But this does not necessarily mean auditsare always of high quality.What do we know about audit qualityfrom 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 reportsStandard 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 observationsOverall Error Rate – 9.5%Type 1 Errors (false negatives) – 9% (over-qualifying or auditor conservatism)No bankruptcy within one year, but 9% had GC reports5,467 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 assessAudit reports issued concurrently with financialsMost GC reports are “repeat offenders”Evidence that “surprise” first-time GC reports reduce share pricesDodd 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 valueGreater information uncertainty/asymmetryWeber and Willenborg (JAR 2003)Microcap IPO’s < $10 million23% have GC reports preceding IPOPre-IPO audit reports predict delistings and future stock returnsBut 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 observedExcept for “proven” audit failures (ex post) which are rareInstead – differential audit quality is inferredComparing audit outcomes between “classes” of auditorsAll firms are assumed to meet minimum professional & legal requirementsBut many different types of firms existSuggests supply of differential auditingImplies differential demand (clienteles)
22 Audit Firm Size: Is Bigger Better? The big firm/small firm dichotomyBig 8 (now Big 4) firms have brand name reputation and incentives to protect their reputationSimunic 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 dependenceDoesn’t mean Big 4 audits are always betterIt just means that on average they are betterIndividual audit failures can and do occur
23 Evidence of Big 4 Audit Quality Differentiation Audit pricingBig 4 audit fee premia of 20-50%US, Australia, Hong Kong, UKImplies more quantity and/or better quality auditingHigher fees imply voluntary demand for higher quality audits by some clientsDemand for qualityDemand for Big 4 audits is increasing in agency costsFrancis & Wilson (TAR 1988), DeFond (AJPT 1992)IPOs with larger auditors have less IPO underpricingBeatty (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 regulatorsFeroz et al. (JAR 1991)Alternative explanation is that big firms are more powerful and have resources to fightBut evidence on audit “outcomes” is more consistent with higher qualityLet’s turn to that evidence
25 Evidence from Audit Outcomes Audit Reports of Large (Big 4) AuditorsMore 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 AuditorsSmaller abnormal accruals -- less managerial discretionBecker et al. (CAR 1998), Francis et al. (AJPT 1999)Accruals/earnings surprises valued higher in the stock marketTeoh & Wong (TAR 1993), Krishnan (AJPT 2003)
26 Conclusions on Auditor Size Evidence is supportive of higher Big 4 audit qualityBut an alternative explanation is endogeneityi.e., “good” companies choose good (Big 4) auditors, in which case selection may explain outcomes, not audit qualityHeckman 2-stage approach is trendyBut most studies using it support prior findings on audit qualityWeber & Willenborg (JAR 2003), Hogan (TAR 1997), Ireland & Lennox (JAAF 2002)Chaney et al. (TAR 2004) is an exceptionCan we identify good “instruments” in accounting research?Larcker & Rusticus (SSRN WP) are skepticalIf there’s reason to think selection exists, an alternative is to control through research design choicese.g., matched pairs, or samples limited to smaller clients
27 Moving Beyond the Big-Small Dichotomy Differentiation withinthe dominant Big 4 group
28 Within-Big 4 Differentiation In past, Big 4 viewed as homogenous groupB4 (90%) & NB4 (10%) U.S. market sharesLow power due to small variance in auditor typeMay be more variation within Big 4 firmsSome plausible within-Big 4 variations:Industry expertiseGeographical variationOffices (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 judgmentsSolomon et al. (JAR 1999); Low (TAR 2004)Auditor clienteles proxy for industry expertiseMore clients create more opportunities to acquire deep industry knowledge/expertiseIndustry shares are not evenly distributedUsing 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 industriesAA (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 auditsFinancial statement outcomes evidence higher quality audits by Big 4 industry leadersSmaller abnormal accruals (less discretion)Balsam et al. (APJT 2003), Krishnan (AH 2003)Higher valuation of earnings surprisesBalsam et al. (AJPT 2003)Less fraudulent reporting (AAERs)Carcello & Nagy (2004 Managerial Auditing Journal)Less IPO underpricing and smaller accrualsElder and Zhou (2003 WP)
31 What is an Accounting Firm? What’s the relevant unit ofanalysis?Individual offices, nationalpractices, or internationaloperations?
32 Arguments for an Office-Level Analysis Accounting firms are decentralized networks of quasi-independent practice officesEngagement partners in local offices contract and administer audits to clients in the same localeIssue audit reports on office letterheadFrancis et al. (ABACUS 1999); Reynolds & Francis (JAE 2000); Ferguson et al. (TAR 2003)Client influence/fee dependence is stronger at the office levelEnron < 2% of Andersen fees nationallyOver 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 officesThey issue more GC audit reportsClients have smaller abnormal accrualsClient size measured “relative” to office clientelesClient size is not significant using national clienteles to measure relative client sizeConclusionOffice-level data provides better understandingNo 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 argumentsDeep expertise is client-specific and cannot be fully captured by firms and distributed across officesGilson & Mnookin (SLR 1985), law firmsFirm-wide argumentsStandardized 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 leader18% of US sampleEngagements where auditor is a national industry leader (alone)10% of US sampleEngagements where auditor is a city-specific industry leaders (alone)23% of US sampleNonleaders (neither city/national leaders)49% of US sample
36 Evidence Joint national-city #1 has +28% premium City-alone #1 has +10% premiumNational-alone #1 has no fee premium relative to nonleaders (default group is nonleaders)Implication - audit quality is office-specificIndustry premia only when a city leaderEither alone or joint national-city leaderNational market share is driven by city leadershipNational #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 leadersWhat do we find?Clients of city industry leaders have smaller abnormal accruals, and smaller income-increasing accrualsMagnitude is 6-12% of pre-tax earningsClients 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 incentivesTwo research approachesA regime change within a single country (over time)The Private Securities Litigation Reform Act of 1995Lee and Mande (AJPT 2003), Francis & Krishnan (APJAE 2003)Cross-country studies of different legal regimesSeetharaman, Gul and Lyn (JAE 2002)higher audit fees of UK firms cross-listed in USimplies higher fees due to increased litigation risk exposureKhurana 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 ScenariosBig 4 are uniform around the worldIncentives to maintain brand name (standardization)U.S. is an outlier due to extreme liability exposureMore lawsuits in US than rest of world combinedBig 4 conservatism is increasing in country-level investor protection and auditor litigation risk
40 Big 4 Auditor Conservatism Uniform WorldwideU.S. OutlierHighConservatismLowLowHigh (U.S.)Legal Liability/InvestorProtection
41 Preliminary Results Indicate that Legal Regime Matters Big 4 conservatism isIncreasing in investor protection/litigation riskHolds both with/without U.S. observationsImplies less discretion to manage earningsMagnitudeAbnormal accruals are smaller by around 5% of earnings in common law countries with stronger investor protectionNon-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 tenureNon-audit services (NAS)Audit committees/corporategovernanceAccounting 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 biasThe evidence to date:Audit quality is lower in first 3 yearsJohnson et al. (CAR 2002)But longer tenure (5+ years) increases audit qualityMeyer et al. (TAR 2003)Studies of partner tenure in Australia and TaiwanOffice level analysis
44 Nonaudit Services (NAS) Do NAS impair auditor independence?More fee dependenceInherent conflict of interestSEC attempted to ban NAS in 2000Profession’s defenseIncreases auditor’s knowledgeClients demand and value NASIncentives exist to protect reputations for independence
45 Evidence Frankel, Johnson & Nelson (TAR 2002) Compelling set of results against NASFirms with higher NAS are associated with more earnings management:Larger abnormal accruals (more discretion)More likely to meet analysts’ earnings targetsBut also counter-evidenceAshbaugh et al. (TAR 2003), Chung & Kallapur (TAR 2003), Reynolds et al. (AJPT 2004), DeFond et al. (JAR 2003), Larcker & Richardson (JAR 2004)
46 Broader ImplicationsAccounting journals generally don’t publish replications and no-result studiesBut replications show fragility and sensitivity to design choicese.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 reportsCarcello and Neal (TAR 2000)Less likely to be replaced following GC reportCarcello and Neal (TAR 2003)Auditors are more likely to detect fraudDechow 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 servicesAbbot et al. (SSRN 2001), Abbott et al. (AJPT 2003)
48 Accounting Firm Alumni and Auditor Independence Outplacement to clients impairs audit qualityClients know the auditor’s methods too wellAuditor is cozy with former colleaguesLennox (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 MakingWhat’s the role ofacademic auditing researchon audit quality?
50 The U.S. ExperienceAcademic research has little influence on regulation and policy-makingTwo recent examples that ignored researchSEC’s proposed ban on NAS in 2000Arthur Levitt was convinced a ban was neededQuick adoption of Sarbanes-Oxley (SOX) in 2002Political 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 importanceWe may not appear to be neutralThere’s often an explicit anti-regulatory postureAnd we may (rightly) be viewed as apologists for the accounting professionPartly policy-makers’ faultNo tradition of basing policy on researchPolicy-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 lowIs ‘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 countriesThe risk of “audit firm failure” is real in the U.S. but nearly impossible in rest of worldDoes “extreme” legal risk create the best incentive?It didn’t prevent the Arthur Andersen collapse or frauds such as Worldcom, Adelphia, and HealthSouthAnother U.S. audit firm failure could end private-sector auditing around the world (global Big 4)All Big 4 firms have serious legal problemsIs a “Big n <= 3” viable for private-sector auditing
54 Follow-up ReadingsJ. 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.
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