General Audit Flashcards
(37 cards)
Theory and evidence on the nature of audit quality
DeAngelo 1981
Auditor size and audit quality
Findings:
“Audit firm size matter b/c larger firms have more to lose (incentives). Larger firms have more clients, which means they have more clients to lose and more incentives to perform a higher quality audit
Auditor output: independent audit of financial statements
Auditor input: Quality of audit service: Detection of error (competence) & reporting error (independence)
Clients seek auditors with diff AQ levels “
Contribution:
Larger firms=higher AQ bc they have more clients to lose if they underperfom
Relevant papers:
Hackenback & Nelson 1996
Seminal
Defound & Zhang 2014
A review of archival auditing research
Findings:
“AQ combo of: Detection/Reporting & assurance of higher financial reporting quality…Not visible for investors (agency cost) so they rely on reputation, litigation threats (Client insurance) & perceived competency
AQ demand (driven by agency cost): Client incentives & competencies (corp gov)
AQ supply: Auditor independence/incentives (reputation & litigation threat)=audit failure=client loss in market value + loss of audit clients & competencies (expertise)
AQ PROXIES:
Output: GC..material mistatements, auditor communication, financial reporting quality, & perceptions based proxies (cost of capital)
Input: Size (reputaion cost & deep pock)…auditor chracteristics & auditor fees (combo of effort & supply risk premiums)
Recommend using multiple proxies to triangulate findings
“
Review
Watts & Zimmerman 1983
Agency problems, auditing, and the theory of the firm: Some evidence
Data:
Historical records from merchant guilds, regulated firms, joint-stock companies (UK, US)
IV:
Organizational structure (guilds, joint-stock, regulated); evolution of audit mechanisms
DV:
Existence, evolution, and structure of audit and bonding practices
Findings:
Auditing existed before regulations; evolved to mitigate agency problems. Committee-based monitoring replaced by professionals as firm complexity grew. Reputation, bonding, and penalties ensured independence.
Contribution:
Audits emerged from firm contracting needs, not regulation. Reputation and incentive structures historically shaped audit quality.
The importance of auditor choice to equity pricing
Khurana & Raman 2004
Litigation risk and the financial reporting credibility of Big 4 versus non-Big 4 audits: Evidence from Anglo-American countries
Data:
“Anglo American countries
90-99”
IV:
“AQ Reputation: Big N vs Non Big N firms
AQ litigious aspect: per country”
DV:
Perceived AQ: Cost of equity: Price investors willing to pay to invest in company
Findings:
AQ measured by firm size impact cost of equity in more litigious countries (US)…Bigger firm=lower cost of equity
Contribution:
Litigation exposure (US) has a bigger impact on perceived AQ (cost of capital) than reputation (Big N vs non Big N)
Limitation:
“Used 1 cost of capital model
Didn’t control for dot.com bubble in sample or diff in market competitiveness amongst the countries sampled”
El Ghoul et al 2016
Cross-country evidence on the importance of Big Four auditors to equity pricing: The mediating role of legal institutions
Data:
“multi country
94-2005”
IV:
AQ Reputation: Big N vs Non Big N firms
DV:
Perceived AQ: Cost of equity: Price investors willing to pay to invest in company (used multiple models)
Findings:
“Motivated prior studies mixed results:
Big 4= cheaper cost of equity
Big 4 effect larger in countries w/ higher audiotr litigation risk (US)”
Contribution:
“Motivated prior studies mixed results:
Big 4= cheaper cost of equity
Big 4 effect larger in countries w/ higher audiotr litigation risk (US)”
Limitation:
Endogeniety concern: Big 4 auditors only select firms that are less risky w/ lower cost of capital
Notes:
Survey investors to corroborate findings
PSM of firms within same country that have Big 4 auditor vs Non Big 4 auditor
Many fixed effects: country, industry, year
Relevant Papers:
Replicate Khurana & Raman 2004
Lawrence, Minutti-Meza, and Zhang 2011
Can Big 4 versus non-Big 4 differences in audit-quality proxies be attributed to client characteristics?
Data:
Propensity-score matching and attribute-based matching models US data 1988-2006; Compustat, I/B/E/S, CRSP
IV:
BIG4 (Big 4 vs Non-Big 4 auditor choice)
DV:
“Three audit quality proxies:
- Discretionary accruals (absolute)
- Ex ante cost-of-equity capital
- Analyst forecast accuracy”
Findings:
“Full sample results replicate prior studies showing Big 4 superiority
After propensity-score matching to control for client characteristics: Big 4 treatment effects become insignificant across all three audit quality proxies
Attribute-based matching shows client size is the primary driver of apparent Big 4 superiority
Big 4 vs Non-Big 4 differences largely reflect client characteristics rather than auditor quality differences”
Contribution:
“Challenges conventional wisdom about Big 4 audit quality superiority
Demonstrates importance of controlling for client characteristics in audit quality research
Shows that commonly used audit quality proxies may confound client and auditor effects
Cautions against discriminatory practices based on auditor size”
Notes:
This paper is particularly significant because it questions a fundamental assumption in audit research - that Big 4 firms inherently provide higher quality audits - by showing this may be an artifact of the types of clients they serve rather than superior audit quality.
The demand for audit quality: US evidence on the role of reputation forces
Chaney & Philipich 2002
Shredded reputation: The cost of audit failure
Data:
Sample of Andersen US clients during Enron scandal
IV:
4 key events in the enron scandal
DV:
Perceived AQ: cumulative abnormal returns CAR (expected returns-actual returns) of Andersen clients
Findings:
Find Andersen clients faced a negative stock market reaction following the Andersen shredding of Enron documents. & Houston clients (Andersen office that audited Enron) faced the largest neg market reaction
Contribution:
Show auditors reputation impact markets actions (perceived AQ)…actions of 1 or 2 offices can negatively impact a firm nationally
Limitation:
“Failed to match nonandersen clients with andersen clients. Other events could have caused the CAR to be lower 4 all firms during the days they find results: ommitted variable problems
Assumes events are independent..prior events impact future events”
Notes:
Enron scandal eogeneous shock to other Andersen clients
Relevant Papers:
Nelson et al 2008
Nelson et al 2008
The market reaction to Arthur Andersen’s role in the Enron scandal: Loss of reputation or confounding effects
IV:
4 key Andersen events surrounding the enron scandal
DV:
“Perceived AQ: 1.cumulative abnormal returns CAR (expected returns-actual returns) of Andersen clients
2. Earning Response Coefficient (ERC): market unexpected response to financial statement releases. CAR surrounding earnings announcements
“
Findings:
Contrary to Chaney & Philipich 2002 finding, the neg market reaction surroundig andersen’s shredddng event is not due to reputational losses, confounding news events + andersen’s industry composition caused the neg. returns around shredding event
Contribution:
When performing event studies, it is imp to control for other confounding variables (indusry specific factors (oil prices), other news reports that market will respond to)…Matching can help alliviate this problem
Notes:
Controlled for other news events that could impact market & matched Andersen & nonandersen clients
Relevant Papers:
Chaney & Philipch 2002
Audit firm quality control structures
Lennox, Wang, and Wu 2023
Delegated leadership at public accounting firms
Data:
Archival analysis using partner-level data from China; interviews with 11 senior partners Chinese MOF, CSRC, and CSMAR databases (2013-2018); 35 CSRC-licensed accounting firms; 3,714 equity partners
IV:
“-Leadership selection determinants: Partner experience in public company auditing (EXP_PAST), past audit adjustments (ADJ_PAST), past record of attracting new clients (NEW_PAST)
-Leadership attributes: Firmwide leadership team characteristics (AFLEAD_EXP, AFLEAD_ADJ, AFLEAD_NEW)”
DV:
“-Leadership selection: AFLEAD (whether partner selected as national leader)
-Audit quality: Audit adjustments (LnADJMAG), qualified opinions (QUAL), material misstatements (MISST)”
Findings:
“Leadership Selection: Partners more likely to be selected as leaders if they have more public company audit experience and stronger track record of attracting new clients
Audit Quality Effects: Higher audit quality when leaders are more experienced in public company auditing or have past record of larger audit adjustments; Lower audit quality when leaders have past record of attracting high-risk new clients
Heterogeneity: Leadership attributes have strong association with audit quality at headquarters but weak association at branch offices
25% of leaders have zero public company audit experience”
Contribution:
“First large-sample examination of accounting firm leadership selection and its impact on audit quality
Documents trade-off between commercialism (client acquisition) vs. professionalism (audit quality) in partner selection
Shows firm leaders can influence audit quality through tone-at-the-top, but control varies by organizational structure
Provides evidence relevant to regulatory concerns about audit firm governance”
Christensen, Newton, and Wilkins 2021
How do team workloads and team staffing affect the audit? Archival evidence from U.S. audits
Data:
Archival analysis using proprietary data from a global accounting firm’s U.S. operations Proprietary U.S. data from global accounting firm (2008-2015); employee-level time records; public databases for client characteristics; Sample size >1,000 observations
IV:
“Team workload: Average weekly hours by team members during year-end fieldwork (TeamWorkload), including concurrent work on other clients
Team staffing continuity: Percentage of current-year audit hours incurred by individuals who worked on prior year’s audit (TeamContinuity)
Decomposed by rank: Partners, managers, seniors/staff”
DV:
“Audit quality: Subsequent restatements (Misstated), SEC comment letters (CommentLetter), late material weakness reporting (Late_MW)
Audit efficiency: Total audit hours (AuditHours), audit fees (AuditFees)”
Findings:
“Workload Effects: Higher team workloads associated with lower audit quality, particularly when >60 hours/week or when team members have lower performance ratings; Effects driven by seniors/staff (burnout starts at 55+ hours/week)
Distraction Effect: Audit quality suffers more when team members spend time on concurrent clients vs. primary client
Continuity Effects: Greater year-over-year staffing continuity associated with higher audit quality, efficiency, and profitability; Effects strongest when returning members are highly rated or work in smaller offices
Rank Effects: Quality and efficiency benefits driven by senior/staff continuity; Fee benefits driven by partner continuity”
Contribution:
“First archival evidence on audit team dynamics using granular team-level data
Quantifies specific workload thresholds where audit quality deteriorates (60 hours team, 55 hours seniors/staff)
Documents novel ““distraction effect”” from concurrent client work beyond traditional ““burnout effect””
Shows importance of junior auditors (seniors/staff) in audit quality, challenging focus on partners in prior literature
Provides practical guidance for audit firms on team scheduling and staff retention”
Ownership structures
Fan et al. 2005
Geudhami and Pittman 2006
Fan & Wong 2005
Do external auditors perform a corporate governance role in emerging markets? Evidence from East Asia
Data:
East Asia
IV:
Firm ownership structure: high (agency prob) or low concentration shareholders’ voting rights (greater ability to steal) & cash flow rights (bigger motive to steal)
DV:
“Auditor type (Big N vs Non Big N)
Audit fees
AQ: issuance of modified audit opinion
“
Findings:
Higher concentration firms more likely to: 1. hire big 5 firm (increase monority investors’ confidence or deep pocket incentive) more likely to happen when firm is raising equity, 2. have higher fees (risk premiums) when they hav a Big 5 auditor, 3. more likely to receive a modified opinion when they hav a Big 5 auditor
Limitation:
“Audit opinion not strong test for audit opnion
IV measure should have been gap b/t shareholders cash flow rights & shareholder rights
External validity: emerging Asian markets
“
Relevant Papers:
Khurana & Raman 2004 & El Ghoul et al. 2016. Big 4 auditors results in lower cost of cap, Guedhami & Pittman 2006
Guedhami & Pittman 2006
Ownership concentration in privatized firms: The role of disclosure standards, auditor choice, and auditing infrastructure
Data:
“Privatized companies that were owned by govt & are now privately owned
31 countries”
IV:
“Disclosure Standards Quality
Auditor type (Big N vs Non Big N)
Plaintiffs’ legal ability in civil cases (burden of proof)
Plaintiffs’ legal ability in criminal cases”
DV:
Ownership Concentration based on top 3 owners % of firm shares
Findings:
“Counries’ Disclosure standards & firms’ auditor type don’t impact ownership concentration
Plantiff’s lower civel & criminal burden of proof requirement in order to sue auditor lowers owership concentration”
Contribution:
Contrary to Fan & Wong 2005 disclosure standards & auditor type do not serve a governance role that is evident in ownership concentration. But legal institutions that discipline auditors impact ownership structure, in that minority owners believe auditors lower agency problem b/t them and controlling owners & FS are more credible
Notes:
Drop the countries that were dominanting the sample 1 by 1 and still find results
Relevant Papers:
“Fan & Wong 2005 contradicts
Khurana & Raman 2004 & El Ghoul et al. 2016 litigous env. Impact AQ “
Auditor Distance
Francis, Golshan, and Hallman 2022
Does distance matter? An investigation of partners who audit distant clients and the effects on audit quality.
Data:
Archival analysis using hand-collected partner location data “Sample: 9,403 client-years from 3,464 unique public companies audited by 1,833 unique partners
Time Period: Fiscal years 2016-2019
Data Source: PCAOB Form AP (mandatory partner name disclosures starting 2017) + hand-collected partner home locations from online profiles”
IV:
“Partner Distance to Client (natural log of kilometers between partner home and client headquarters)
Partner characteristics: Experience, education (top school), industry specialization, leadership positions, gender, workload
Audit office characteristics: Office size, office distance to client, office industry specialization
Client characteristics: Geographic dispersion, complexity, S&P 500 membership
Key Moderating Variables:
Direct flight availability between partner and client locations
Client geographic dispersion (operations spread across states)
Local partner availability (Partner Ratio in client’s geographic area)”
DV:
“Partner-Client Matching Analysis:
Partner is Selected (binary indicator of actual partner selection)
Audit Quality Measures:
Misstatement (financial statement restatements)
Meet or Beat (meeting/beating analyst earnings forecasts by ≤1 cent)”
Findings:
“Distance Importance: Partners closer to clients significantly more likely to be selected
Trade-offs Made: Distance less important when other factors matter more:
S&P 500 clients more willing to accept distant partners
Clients in areas with few local partners accept more distant partners
Complex industry clients prioritize industry expertise over proximity
Geographically dispersed clients less concerned with partner distance
Audit Quality Effects
Primary Finding: Audit quality decreases as partner distance increases
Misstatement Risk: As distance increases from 10→100→500km, misstatement probability increases from 2.0%→2.5%→3.0%
Earnings Management: Meet/beat forecast probability increases from 6.0%→7.4%→8.6% across same distance ranges
Economic Significance: Effects are economically meaningful in magnitude”
Contribution:
“First Large-Scale Evidence: First archival study examining partner-specific distance effects on audit quality
Partner-Client Matching: Provides quantitative evidence on trade-offs made in partner selection process
Geographic Information Frictions: Demonstrates that geographic distance creates information asymmetries affecting audit effectiveness
Novel Data Collection: Hand-collected partner home locations from online profiles with validation through property records
Partner vs Office Distinction: Separates partner effects from office effects (prior research only examined office distance)
Comprehensive Matching Analysis: Creates counterfactual partner-client matching dataset to analyze selection process”
Audit Market Regulation
Lennox & Pittman 2010
Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms.
Data:
“PCAOB inspection reports 05-07
Peer review reports 94-97”
IV:
Negative PCAOB report & peer review
DV:
“Market reaction: client switch auditors
Firms propensity to audit public companies
If PCAOB relied on peer review reprts
“
Findings:
“Clients are more likely to switch from auditors that receive a bad peer review report but not a auditor that receive a bad PCAOB report
Some firms stopped auditing public companirs to avoid PCAOB insections
PCAOB chose clients to inpect based on peer review conclusions”
Contribution:
Peer review reports that mainly focus on private clients following SOX, disclose more info. (control weaknesses & overall firm rating) compared to PCAOB inspection reports, as such, clients do not value the information contained in PCAOB reports. Clients do not switch auditors when a negative PCAOB inspection report is publis but they do when a neg. peer review is published. PCAOB= lower AQ transparency
Limitation:
Timing: examine effect of PCAO reports right after their introduction. May see more results now that there is more enforcement in relation to inspection (bhattacharyee & Dauoke 2002)
Relevant Papers:
Wainberg et al 2013: audit client misinterpet inspection reports
Wainberg et al 2013
The impact of anecdotal data in regulatory audit firm inspection reports
Data:
Anecdote bias: ppl tendency to overvalue on anecdote info. & ignore implications from statistical data
IV:
“Number of deficiencies reported & number of audits inspected
Presentation of audit firms AQ in inspection reports: 1. stats only 2. anecdote info only 3. boiler plate state & anecdote 4. decision aid & anecdote 5. include instructions”
DV:
Managers’ acting as AC Audit choice
Findings:
“
Managers correctly chose auditor w/ better AQ:
1. stats only
4. Decision Aid
5. Instructions provided
Managers incorrectly chose auditor w/ fewer number of deficiencies:
2. Anecdote only
3. Boilerplate stats & anecdote (common practice)”
Contribution:
Show that ppl may misperceive AQ based on the number of deficiencies reported in a regulatory report when the deficiencies are listed (common) as opposed to the magnitude of the deficiencies reported (number of deficience over number of inspections). The inclusion of decision aids can aliviate this problem
Relevant Papers:
Lennox & Pittman 2010: audit clients do not misinterpret inspection reports
Is auditing valuable?
Blackwell et al 1998
The value of auditor assurance: Evidence fromstoan pricing
Data:
US private companies with revolving credit loans
IV:
Whether or not private firm is audited
DV:
Interest rate
Findings:
Audited firms have lower interest rates but this effect decreases as firm size increases b/c larger firms are expected to be less riskier
Contribution:
1st archival study to examine the relation b/t firms auditor association & loan inerest rate. Show voluntary audits are valuable
Limitation:
“Could have exploit the 3 diff types of audit functions: audit, compilations, reviews
Could have tested if loan officer are more likely to accept loans from audited clients
Test Big N vs Non Big N impact
Could have exploit ownership structure info.
external validity: firms studied were clients of banks wihin 1 state”
Notes:
“Matched non audited firms with audited firms by firm sized.adresses endogeneity oncern that large firms are the private irms that voluntarily get audits & inherently have lower interest rates.
Corroborate findings with interview
provide economic impacts of findigs”
