02 Auditing

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    Does Italy Have a Stronger National Level of Industry Expertise Than a Local Level?
    ( 2019-09-02) Simonov, Andrey ; Mazza, Tatiana ; Reichelt, Kenneth
    We examine whether national industry expertise in Italy is more dominant than local expertise. Prior studies from Australia, U.S., and U.K. show that audit fees for industry experts are priced at a higher premium at the local level than the national level. These countries have voluntary audit firm rotation, while Italy has mandatory audit firm rotation (MAFR). We predict that Italy has a stronger national level of industry expertise than a local level, in order to better retain and transfer industry expertise. To investigate, we compare audit fee premiums of national industry experts to local levels. Using hand-collected audit fees, we find that the audit fee premium for industry expertise is greater at the national level than the local level. We find corroborating results with audit hours. To provide further support, we conduct analysis for a neighboring country that does not have audit firm rotation. Using hand-collected data from Germany, we find that audit fee premiums for national industry expertise does not dominate over local industry expertise. Our study has implications for countries that recently adopted mandatory audit firm rotation and for countries that discuss such adoption in the future. However, the larger size of Germany does not rule out that size is a factor.
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    Skill Demands in the Audit Labor Market: Evidence from Job Postings
    ( 2019-08-31) Hann, Rebecca ; Ham, Charles ; Rabier, Maryjane ; Wang, Wenfeng
    This study examines how the demand for auditor skill sets has changed over the past decade as well as how these changes relate to audit quality and audit fees. Using a novel dataset that contains the near-universe of online job postings by accounting firms from 2007 to 2017, we find that audit firms have decreased their demand for auditors and increased their demand for IT-related personnel. We also find that audit firms are increasingly demanding expanded skill sets from their auditors—the portion of cognitive, social, and IT-related skills has increased over our sample period whereas financial skills have remained relatively flat. Further, we find substantial variation in the demand for skills not only across audit firms, but also across offices within an audit firm. More importantly, these differences in skill requirements have a significant effect on audit quality—specifically, audit offices that demand more social and cognitive skills are less likely to have clients experience subsequent restatements. Taken together, our findings provide new insights on the changing dynamics of the auditor labor market and their relations to audit quality.
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    Familiarity Bias and the Propensity to Issue Going Concern Opinions
    ( 2019-08-31) Westfall, Tiffany ; Ayres, Douglas
    This study examines the association between familiarity bias and audit firm judgements using going concern opinion modifications. We conjecture that familiarity bias is highest when an audit firm is least familiar with its clients. We measure familiarity bias using auditor changes because familiarity bias is likely to be the highest on the initial year of an audit relationship. We find the propensity to issue a going concern modification to be much higher during this initial period, even after controlling for a multitude of factors known to be determinants of going concern modifications. Our findings also suggest the phenomenon appears to slowly dissipate over a five-year auditor client tenure. Supporting our theoretical prediction, further results find that as the auditor is more familiar with the client’s industry (e.g. industry expertise) the main effect is moderated. Our results are also strongest when the successor auditor is located in a different locale than the previous auditor, situations leading an even more pronounced lack of familiarity. We also examine SOX 404 internal controls impact, finding auditors are more likely to deem internal controls ineffective when they are unfamiliar with clients.
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    Does Common Ownership Impact Auditor Incentives?
    ( 2019-08-31) Raman, K.K. ; Ye, Chunlai ; Yu, Lin-Hui
    Prior research suggests that common ownership (i.e., institutional investors owning significant equity stakes in companies within the same industry) impairs companies’ incentives to compete since owners are less likely to support an aggressive competitive strategy. In this paper, we examine whether common ownership impacts auditor incentives. Using a sample of US firms during the 2003–2017 period, we find that common ownership lowers audit fees and audit effort without impairing audit quality. We perform cross-sectional tests as well as a quasi-natural experiment based on institutional owner mergers to help mitigate concerns about omitted variable bias or reverse causality. Overall, our findings are consistent with the view that common-owners internalize governance externalities and have accumulated more industry-specific monitoring experience, which in turn decreases audit risk.
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    Does Prompt Compliance with the COSO 2013 Framework Signal a Commitment to a Strong Internal Control Environment?
    ( 2019-08-30) Park, Kunsu ; Qin, Juan ; Seidel, Timothy ; Zhou, Jian
    In this study, we investigate the determinants of compliance with the Committee of Sponsoring Organizations of the Treadway Commission (COSO) 2013 framework and whether prompt compliance provides a signal of a commitment to a strong internal control environment. COSO 2013 framework represents the biggest change to the internal control framework in more than two decades. In firms’ first fiscal year following the supersession of the COSO 1992 framework, only 91 percent of firms in our sample were in compliance with the updated COSO 2013 framework. We find that compliance with the updated framework is more likely among firms that are larger, older, more highly leveraged, less complex, that operate in more litigious industries, and that have an effective internal control environment. Controlling for potential selection bias, we next examine whether compliance with the updated framework is indicative of a higher level of control consciousness and governance as evidenced by more conservative financial reporting. Finally, we use short-window market reactions to quarterly earnings surprises to examine whether investors perceive compliance with the updated framework as an indication of the overall control consciousness and governance of the firm. We find that firms that comply with the COSO 2013 framework exhibit more conservative financial reporting and that investors react more positively to these firms’ quarterly earnings surprises following initial compliance. Importantly, these results hold among a sample of firms without reported material weaknesses in internal controls. These results provide evidence that firms can help alleviate agency costs by signaling their commitment to a strong internal control environment.
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    Auditor Skepticism and Client Ill Will
    ( 2019-08-30) Curtis, Mary ; Eutsler, Jared ; Holderness, Kip ; Robertson, Jesse
    Professional skepticism is considered an essential component of audit quality. Consequently, research has focused on ways to increase skepticism by identifying factors that either limit or encourage its practice. However, research has yet to explore potential negative consequences of professional skepticism. We conduct two experiments to investigate if high levels of skepticism create ill will in audit clients, and how ill will affects the auditor-client relationship and audit quality. In the first experiment, we find that high skepticism creates ill will in the client, which increases the likelihood the client recommends switching auditors and decreases the amount of evidence provided to the auditor. We find that auditors can ingratiate themselves with the client as an intervention to decrease the development of ill will and mitigate its adverse effects. In our second experiment, we examine if client pressure to persuade the auditor of their accounting position mitigates the relationship between high skepticism and ill will. We find an interaction such that if the evidence does not support the accounting treatment the client recommends, a high level of auditor skepticism does not cause clients to experience as much ill will toward the auditor. We contribute to the literature by investigating a new empirical construct, client ill will, and developing a more nuanced perspective of the interactions between auditors and their clients.
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    How do Auditors Respond to Accounting Restatements? Evidence on Audit Staff Allocation
    ( 2019-08-30) Pan, Chien-Min Kevin ; Chi, Wuchun
    This paper examines how auditors respond to accounting restatements using Japanese audit input data. We find that audit fees, the number of Certified Public Accountant (CPA) licensed staff, and the number of signing partners are higher for firms in the restatement year than the year prior to the restatement. Our results also show that the increase in audit fees and the higher numbers of CPA licensed staff and signing partners persists after the restatement year. Overall, our findings suggest that audit firms charge higher fees and assign more experienced staff in response to accounting restatements, implying that we can attribute part of the increased audit fees to increased efforts, not the risk premium alone. We believe that ours is the first study to document auditors increase the numbers of licensed staff and signing partners in response to their own responsibilities (i.e., a restatement could result from a previously failed audit).
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    The Stock Market and Audit Market Effects of a Big 4 Security Breach
    ( 2019-08-29) Tanyi, Paul ; Watson, Marcia
    This research provides insights into how audit clients and investors respond to a breach of confidential client data by an audit firm. Specifically, on September 25, 2017, Deloitte & Touche (a.k.a., Deloitte), an international Big 4 audit firm, reported that its systems had sustained a six month long cyber-attack lasting from October 2016 to March 2017 (Hopkins 2017). We examine whether Deloitte’s reputation was impacted. We find that Deloitte’s audit clients at the time of the breach did not experience a change in audit fees, nor were they more likely to dismiss Deloitte. However, Deloitte experienced a decrease in the number of new audit clients after the breach announcement as well as decreased first year audit fees for new clients. A negative market reaction was only found for clients that dismissed Deloitte. Thus, Deloitte’s reputation appears to be only tarnished for companies searching for a new auditor.
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    Going Concern Audit Opinions: Good News for Corporate Insiders?
    ( 2019-08-27) Hodgson, Allan ; Ho, Sandra ; Xiong, Zhengling
    We report that corporate insiders are able to profit from conservative first time going concern audit opinions (GCOs). GCOs comprise a high percentage of Type I error that transforms into a going concern opinion withdrawal (GCOW) within one year. We conjecture and affirm that the anticipatory trading of corporate insiders, who have access to firm based private information, drives positive abnormal returns before a GCOW and this increased trading volume is associated with firms that have audit determined financial issues. The degree of economic significance is highlighted by constructing arbitrage hedge portfolios that follow the trading of all corporate insiders in GCOW firms, by returning abnormal profits of 25.36% over 60 days.
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    Audit Committee Disclosure of Auditor Reappointment Factors: Vigilant Monitoring or Window Dressing
    ( 2019-08-26) Akamah, Herita ; Asante-Appiah, Bright
    Audit committees are responsible for initial and subsequent appointment of the external auditor but are not required to disclose reasons for their choice of the auditor. Investors have raised concerns about the lack of audit committee transparency, particularly considering longer auditor tenure in U.S public companies. In recent years, some firms are voluntarily disclosing factors the audit committee considers when reappointing the external auditor. We investigate whether these disclosures are mere representations of favorable impressions or depict audit committees’ vigilant monitoring of the auditor. First, we find that the likelihood of disclosure increases with higher perceived impaired auditor independence, investor activism pressure on the board of directors, and audit committee quality. Next, we find that these disclosures negatively moderate the positive association between egregious financial restatements and audit committee member turnover. Finally, we find that the disclosures decrease the likelihood that the financial statements the auditor is reappointed to audit will be restated in future periods. Our results are robust to several additional analyses, including controlling for endogeneity using propensity-score matching and instrumentation. The evidence is relevant to various stakeholders including the SEC, investors and others interested in audit committee transparency. We provide evidence that although some firms voluntarily disclose auditor reappointment factors to create favorable impressions, overall, these disclosures are more indicative of audit committee substantive monitoring of the external auditor. These findings should be relevant to the SEC that has proposed mandating these disclosures.