01 Auditing (AUD)

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    Inside Audit Firms
    ( 2022) Qian, Wenlan ; Reeb, David M. ; Wang, Shirley Jiexuan ; Zhang, Rongjie
    We develop and test hypotheses about compensation policy and auditor retention in accounting firms. Our analyses use de-identified employment and compensation data to investigate the entire pay distribution within accounting firms. Accounting firms all have low retention rates but exhibit differing pay structures. Big 4 firms give similar raises within each cohort, while non-Big 4 give substantial raises to a few top performers. Auditors often "move up" to Big 4 firms, but relatively few move the other way. Audit fees are consistently related to compensation structure. Overall, our results suggest that compensation policies in professional accounting firms affect auditor behavior.
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    Anti-Corruption Intensity and Auditors’ Propensity for Incorruption
    ( 2022) Ma, Chen ; Cheng, Maoyong ; Zhou, Jian
    We examine whether anti-corruption intensity affects auditors’ propensity for incorruption, i.e., the relationship between audit fees and financial reporting quality. Using hand-collected anti-corruption data and audit-related data for a sample of 16,677 firm-year observations from 2012 to 2018 and controlling for the anti-corruption intensity in the audit clients’ city, we find that anti-corruption intensity in the auditors’ city increases the auditors’ propensity for incorruption. In addition, we find that the effect of anti-corruption intensity on auditors’ propensity for incorruption is mainly related to the review auditor and not the engagement auditor, suggesting that the review auditor is more concerned about corruption risk than the engagement auditor. We find that the fear effect and auditor sanctions are two mechanisms through which anti-corruption intensity affects auditors’ propensity for incorruption. Overall, the results indicate that anti-corruption intensity in auditors’ location can affect auditors’ work, making them more prudent and diligent.
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    Auditor's Response to Accruals Estimates and Audit Quality
    ( 2022) Chen, Jason ; Judd, Scott ; Omer, Thomas
    This study examines (1) the impact of the number of accruals estimates on audit fees and (2) sheds light on auditors’ discretionary response to estimates through its implications on audit quality. We measure the number of estimates using firms’ qualitative discussions in the Notes to the Financial Statements section of their 10-K filing (Chen, Chen, and Li, 2022). Consistent with our expectations, we find that firms with more accruals estimates have higher audit fees and document that the number of estimates is a significant determinant of audit fees. Next, we find that more accruals estimates, in the presence of higher abnormal audit fees, are associated with incrementally lower accruals estimates quality. Additionally, we find that accruals estimates are associated with an increased likelihood of future restatements and lower audit report lag for firms with higher abnormal audit fees. These results suggest that higher abnormal audit fees in this context do not represent additional auditor effort: Auditors receiving unexpectedly higher audit fees do not provide an audit that incrementally improves accruals estimates quality. Instead, they receive such fees to compensate for greater audit risk associated with firms with more accruals estimates.
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    Do auditors react to misreporting allegations of short selling campaigns?
    ( 2022) Li, Dan ; Zhao, Wuyang ; Rajgopal, Shiva ; Srinivasan, Suraj
    We study whether and why auditors fail to detect and report irregularities exposed by short sellers, who usually have access to only public information. Using a sample of 407 short selling campaigns from 2009 to 2020 where short sellers allege reporting or going concern issues, we first confirm that those campaigns are informative in predicting negative consequences such as stock price declines, delisting, class action lawsuits, restatements, and SEC investigations. While there is some evidence of audit turnover after short-selling attacks, most auditors take no observable actions in terms of audit fees, going concern opinions (GCO), or internal control weaknesses (ICW) in the years leading to and after short-selling campaigns. Auditor response is more likely to be observed in more severe cases. Regardless of the severity, auditor response is less likely to be observed (i) for more competent auditors (such as Big Four firms or industry leaders); (ii) for clients that are more important; or (iii) in cases where auditors have a long-term relationship with their clients. Moreover, we find that litigation and reputation costs of auditors’ inaction are minimal, and overt response to a short selling campaign is not rewarded in terms of market share of auditees. We also find a declining and disappearing relation between audit fees and short interest after the 2008 financial crisis, indicating that auditors appear to stop inferring audit risk from short interest in recent years. Overall, our evidence suggests that lack of incentives potentially explains auditors’ reticence in detecting and reporting irregularities exposed by short sellers.
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    The Consequences of a Decrease in the Threat of PCAOB’s Inspections and the HFCAA for Chinese Companies
    ( 2022) Wang, Yini
    Since 2017, the PCAOB is substantially unable to inspect auditors in Chinese jurisdictions. In 2020, amid growing political and regulatory tensions, the U.S. Congress passed the Holding Foreign Companies Accountable Act (HFCAA) that threatens to delist companies that do not comply with the PCAOB’s inspections regime. Presently, there are more than 200 Chinese companies considered non-compliant, representing 18% of all U.S.-listed foreign companies. I investigate the consequences of a decrease in the threat of PCAOB’s inspections and the incremental effects of the HFCAA. I document three broad findings. First, the U.S. market remains appealing for Chinese companies seeking new financing. Second, a decreased threat of inspections is not associated with a detectable deterioration in Chinese companies’ financial reporting quality and audit quality. Third, the HFCAA did not trigger immediate compliance, but resulted in fifteen companies –with aggregate market capitalization of $468 billion– seeking to list in alternative overseas markets.
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    Staggered Audit Partner Rotations and Audit Quality
    ( 2022) Chang, Hsihui ; Fang, Junxiong ; Guo, Yingwen ; Lohwasser, Eric ; Wu, Liansheng
    We examine whether staggered audit partner rotations, where partners overlap their experience on clients, are positively associated with audit quality. We use dual signature audit opinions to compare audits where partners are rotated on a staggered basis to those where both partners are rotated simultaneously. Consistent with knowledge continuity management theory, staggered rotations are associated with more audit adjustments that correct clients’ pre-audited earnings, fewer financial restatements, fewer regulatory misconduct sanctions against auditors, and lower discretionary accruals. These results are present regardless of whether staggered rotations occur voluntarily or due to mandatory partner rotation rules. Our findings support audit firms’ assertion that overlapping partner experience on audits is beneficial and increases financial reporting reliability.
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    Deconstructing the PCAOB: Using organizational economics to assess the state of a regulator
    ( 2022) McKenna, Francine ; Pevzner, Mikhail ; Sheneman, Amy ; Zach, Tzachi
    Using the principles of organizational economics in this study we assess the quality of the organizational architecture of the Public Companies Accounting Oversight Board (PCAOB). In particular, we use the Four Pillar Framework developed in Brickley et al. (2000) to understand why—according to the SEC’s Chairman Gensler and other stakeholders—the PCAOB may not have entirely realized its mission of investor protection. Our analysis is enabled by the transcripts of the 2019 criminal trial U.S. vs. Middendorf and Wada (i.e., PCAOB-KPMG “steal the inspection data” scandal), which for the first time exposed the inner workings of the PCAOB. Our analysis of the transcripts is augmented by other publicly available documents. Our primary conclusion is that the functioning of the PCAOB has been significantly hampered by misalignment of its tasks (in particular in relation to the SEC), sub-optimally designed performance measurement and employee compensation, and weaknesses in the PCAOB’s organizational culture. These misalignments created an environment susceptible to PCAOB employee criminal misconduct which enabled the PCAOB-KPMG “steal the inspection data” scandal and other Board governance and leadership challenges.
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    Communication during the Pandemic: Use of videoconferencing in Audit Committee-Auditor Communication
    ( 2022) Cho, Meeok ; Jo, Jaehee ; Jung, Taejin ; Won Kim, Natalie Kyung
    Using Korean listed firms’ mandatory disclosure on the communication method for meetings between the Audit Committee and auditors from 2019 to 2020, we find that videoconferencing leads to weaker audit quality. We measure the degree of videoconferencing by the proportion of videoconferencing in the total number of meetings between the Audit Committee and auditors. We provide preliminary results on whether changes in communication methods affect audit quality. Our results are robust to change analyses, balanced sample analyses, including auditor fixed effects, and using an alternative measure of audit quality and videoconferencing. We find that Audit Committee independence or expertise does not affect the relationship between videoconferencing and audit quality but holding more formal Audit Committee meetings during the year mitigates the negative impact of videoconferencing on audit quality. Our paper contributes to the literature on information processing of Audit Committees.
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    Matching Audit Partners with Client Firms
    ( 2022) Wu, Pauline
    I study how audit firms match audit partners with client firms. I model the audit firm's decision as a simple expected cost minimization problem and examine empirically whether audit firms match partners with clients based on partners' predicted audit quality on a specific client. I use machine learning algorithms in predicting the audit quality for each client-partner pair within an audit office and find that a partner who has a higher predicted audit quality on the focal client is more likely to be selected to audit it. In addition, audit firms prioritize large clients with higher potential litigation risks when allocating audit partners. On average, client-partner matching quality is higher for Big 4 audit firms and large audit offices. I also find that mandatory partner rotation improves partner matching quality, highlighting the bright side of the policy. Lastly, there are real implications of client-partner matching on ex-post audit quality. Lower matching quality is associated with worse ex-post audit quality, suggesting that machine learning algorithms might help human decision-makers improve their personnel management inside firms.
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    Audit Partner Gender and Financial Statement Comparability
    ( 2022) Afzali, Mansoor ; Jørgensen, Bjørn ; Ittonen, Kim
    We predict that documented gender-based behavioral differences between men and women are likely to influence an audit engagement partner’s ability to implement in-house working rules and enforce auditing standards within their clientele. If female auditors are more risk averse, averse to competition, less overconfident, and process information more comprehensively then two companies audited by two female auditors will exhibit greater financial statement comparability than any other combination of auditors. Using a sample of U.S. firms and Form AP filings from PCAOB, we find that firm-pairs in the same industry and year report more comparable financial statements when they are each audited by a female auditor than when (1) one firm is audited by a female auditor and the other by a male auditor, and (2) when firm-pairs are each audited by a male auditor. We also find that firm-pairs audited by two male auditors have the least comparable financial statements compared to other pairs of auditors. These results are not driven by observable differences in firm characteristics, auditors’ in-house working rules, mechanical bias or randomness, and within-industry pairings. Overall, we provide new evidence on gender differences in auditor style and its implications for financial statement comparability.