01 Auditing (AUD)
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ItemSubsequent event reporting and audit quality among U.S. state and local governments( 2021)We examine subsequent event reporting and audit quality among state and local governments. We find that ten percent of governments report at least one matter in the subsequent event note that does not appear to meet the criteria for subsequent events under GASB No. 56 and that twenty-nine percent of governments omit presumptively material bond-related events from the subsequent event note. Using a sample of audit work-papers for 150 audit engagements, we find that governments have weak internal controls surrounding subsequent events and their auditors experience difficulty identifying and classifying the severity of these internal control deficiencies. Two-thirds of subsequent events detected through the auditor’s search procedures are judged to be immaterial and are not reported in the financial statements. These findings suggest that governments and their auditors experience difficulty implementing financial reporting and auditing standards surrounding subsequent events and support the need for further guidance from standard-setters.
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ItemUninvolved: Effects of Misstatement-Independent Auditor Oversight( 2021)Researchers in prior studies assume the current auditor is responsible for misstated financials or attempt to perform filtering to assign responsibility. However, for a minimally filtered sample of restatements within Audit Analytics, 20 percent of the restatements annually correspond to cases where the auditor engaged at the time of a restatement announcement was not engaged during the misstatement period. I refer to these observations as uninvolved. Using a similar model from prior literature, I find that companies with involved audit firms are negatively associated with the abnormal return around the restatement announcement. Following the restatement announcement, companies with uninvolved audit firms have a lower likelihood of experiencing audit turnover, and uninvolved auditor departures are characterized by a positive abnormal market reaction around the departure date. These findings suggest that involvement is an informative dimension to the market and is associated with different audit outcomes.
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ItemHow Does Accountability and Role Drive Valuation Specialists’ Determination of Fair Value?( 2021)We interview valuation specialists (specialists) employed by accounting firms (in North America, Europe, and the Asia-Pacific region) to understand how their felt accountability to internal (auditors) vs. external clients (managers) influence the estimation and financial reporting and audit quality of complex financial instruments reported in audited financial statements. Specialists are integral to determining the fair values reported in audited financial statements because managers and auditors lack the necessary skill to do so and seek specialists’ assistance to fulfill their financial reporting responsibilities. Thus, the same specialists, at different times, act as either preparers (helping managers estimate fair values) or evaluators, supporting auditors’ assessments of their client’s fair value estimates. Our interviews reveal that differences across the specialists’ roles activate different types of felt accountability to managers and auditors. These felt accountability differences can result in lower commitment to ensure the adequacy of the specialist’s scope of services when evaluating versus preparing fair estimates. Specialists also exploit the subjectivity in fair value estimates to support balances that meet management’s preferences and complete valuations that avoid material audit differences. Importantly, such specialists’ behaviors and the consequences of their actions impact the amount of the fair values reported in financial statements yet are unobservable. Thus, financial statement users do not have access to potential bias existing in the estimates.
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ItemEmbracing a Paradoxical Environment to Promote Technological Advancements in the Auditing Profession: Prospective from Paradox Theory( 2021)Data analytics is fundamentally changing the way enterprises operate. Despite the acknowledged power of data analytics to significantly transform the auditing profession and the significant financial investments that organizations make in data analytic tools, internal audit departments and auditing firms are slow to incorporate data analytics fully. Through interviews with 27 internal and external auditors, we explain why the audit profession is slow to adopt. The auditing environment contains pressures for stability (i.e., pressure to change and transform the profession) and pressures to change (i.e., pressure for the profession to remain the same). Through our interviews, we find evidence that our participants’ responses to the environmental contradictions (stability vs change) are the primary reason the audit profession has been slow to incorporate data analytics. Consistent with paradox theory, we identify the underlying assumptions that our participants use when experiencing the stability/change contradiction during the audit process. We find that our participants’ assumptions toward the stability/change are consistent with Either/Or or moderation assumptions. For example, when participants use an Either/Or assumption to interpret the stabilize/change contradiction, the actors create unintended consequences by reinforcing traditional and outdated audit practices that do not promote technological advancement in the audit profession. When actors use a Moderation assumption to interpret the stabilize/change contradiction, we find evidence consistent with hindering technological change, suggesting that the actors perform redundant audit tasks that affect audit efficiencies and effectiveness.
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ItemAudit Regulation and Debt Financing: Evidence from PCAOB International Inspections( 2021)We examine how audit regulation affects a non-US listed firm’s debt financing by exploiting the staggered introduction of the Public Company Accounting Oversight Board’s (PCAOB) auditor regulatory oversight of foreign audit firms from 2005 to 2017. We find that clients of auditors who are subject to PCAOB international inspections increase their propensity to issue public debt (i.e., bonds) rather than private debt (i.e., bank loans) after controlling for other determinants of the choice of public versus private debt. We also find a differential impact of PCAOB inspection access on the cost of debt, with a more significant decrease in the cost of public debt than private debt for countries that allow PCAOB inspections. Cross-sectional tests reveal that the effects of PCAOB auditor regulatory oversight depend on the importance of a borrower’s home country bond market and the institutional mechanisms that mitigate the agency costs of debt. Additional analyses using a sample of PCAOB inspection reports show that ex ante threat to auditors dominates the ex post effect for clients of the inspected auditors, and PCAOB inspection access affects loan contracts by encouraging fewer and loosened covenants. Collectively, these results suggest a spillover of audit regulation to non-U.S. listed firms that affects the firm’s choice of debt instruments, cost of debt financing, and the private debt contract design.
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ItemAuditor Responses to Estimation Uncertainty in Financial Statements( 2021)Estimation uncertainty around accounting estimates poses unique challenges for auditors when conducting their audits. Moreover, auditors face heightened expectations from investors and regulators to improve audit quality of accounting estimates and better communicate risks related to material accounting estimates. Given these challenges and expectations, we examine auditor responses to estimation uncertainty. We find that auditors increase communication to financial statement users in the form of topic-specific explanatory langue and, in more recent years, critical audit matters in response to estimation uncertainty. This association is more pronounced when investor information needs are higher. Further, we demonstrate that auditors also charge higher risk premiums and extend more effort in response to estimation uncertainty. We believe this study can provide insights to regulators, investors, and other financial statement users by demonstrating that auditors respond to the overall level of estimation uncertainty in the financial statements in response to investor information needs and regulatory standards.
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ItemLong term trends in Auditor Choice( 2021)The division of the market for audit services across the Big-4 (KPMG, PWC, D&T, and E&Y) and non-Big-4 (NB-4) auditors reflects both demand side effects (perceptions of higher Big-4 quality) and supply side effects (the difference in fees across these two auditor types). Using empirical evidence from long-term changes in Big-4 market shares over the period 2001-2015, we demonstrate a counter-intuitive result that a larger increase of audit fees by Big-4 auditors relative to NB-4 auditors results in a lower likelihood of switching to an NB-4 auditor. By analyzing switching behavior across different industries and client firm’s asset quintiles, and by separating switches into resignations (auditor initiated or supply-side effects) as opposed to dismissal (client initiated or demand-side effects) we provide insights into the effects of different economic causes on the choice of a Big-4 auditor by client firms.
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ItemAre Audit Fees Linear in Accruals?( 2021)This study examines the role of accruals in the pricing of financial statement audits. We posit that both large positive and large negative accruals represent increases in the auditor’s inherent risk, resulting in a nonlinear relation between accruals and audit fees. Consistent with our expectations, we find that both large negative and large positive total accruals are associated with higher audit fees. Further, the nonlinear relation between total accruals and audit fees is asymmetric, with a steeper slope on positive total accruals than negative total accruals. We next partition total accruals into specific asset accruals using an approach developed by Casey, Gao, Kirschenheiter, Li, and Pandit (2016, 2017) and find that accruals originating from different transactions exhibit predictably nonlinear relations with audit fees. On the whole, our results suggest that auditors respond asymmetrically to accruals based on the magnitude and source of the accrual.
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ItemAuditors as a Vector for Diffusing Forecasting Knowledge( 2021)We explore auditors’ role in diffusing knowledge about forecasting among their clients. While management forecasts are not audited, prior research suggests that auditors affect management forecasting by serving a governance role that improves companies’ internal information environments and the credibility of managerial forecasts. We hypothesize that auditors influence managerial forecasting beyond the governance role by diffusing forecasting process knowledge and best practices across clients. We find that companies whose auditors have greater forecasting knowledge exposure forecast more accurately. However, auditor forecasting knowledge exposure is not associated with audit quality or auditor independence, consistent with auditors affecting management forecasting in a novel manner. Our results persist through a variety of robustness tests, including an extra-industry instrumental variable regression. Our research indicates a novel source of valuable knowledge auditors provide to clients and suggests that auditors improve their clients’ unaudited information environment by sharing knowledge across clients.
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ItemDelegated Leadership at Public Accounting Firms( 2021)Public accounting firms are owned and controlled by all equity partners but, in practice, many leadership decisions are delegated to a smaller team of managing partners. Using novel data from China, our study examines which equity partners are selected (not selected) for national leadership positions at their firms. We find that partners are selected as leaders after they have accumulated significant experience in public company auditing and large equity stakes in their firms. We find no evidence that partners are appointed as leaders based on their ability to generate abnormally high fees from clients. We predict (and find) a positive association between a firm’s audit quality and the leadership team’s past experience in public company auditing. However, a firm’s audit quality is not significantly related to other attributes of the leadership team, such as team size, equity ownership, or gender composition.