Auditing Section Doctoral Consortium January 2006

1
Auditing SectionDoctoral
ConsortiumJanuary 2006

• Jere R. Francis Curators Professor
• KPMG Research Professor
• University of Missouri, USAfrancis_at_missouri.edu

2
Data Innovation in Empirical Audit Research

• Do what you enjoy, and find the right data for
  the RQ
• Innovation through new data
• Use new data to answer old questions better or
  to answer new questions that could not
  previously be investigated
• public data new U.S. audit fee data or internal
  control reports
• but risky because of competition
• private data avoids competition
• but can be risky because its costly and the
  outcome is unknown
• Novel use of existing public data
• Creatively use existing data in new ways
• link financial statement properties (e.g.,
  abnormal accruals) with auditor characteristics
• Becker et al. (CAR 1998) Francis et al. (AJPT
  1999)
• office-level analysis of Big 4 accounting firms
• Reynolds Francis (JAE 2000)

3
Audit ResearchIntersection of practice, theory
research design choices

• Practice drives research questions (RQ)
• Some examples (next slides)
• Theory informs/frames RQ
• Economics, agency signaling theory, psychology
• Research design many choices
• Modeling, experimental, archival
• Inherent limits of RQs answerable by a single
  approach/method
• Value of triangulation/complementarity

4
Examples of Practice-Driven Empirical Audit
Research

• 1970s Congressional investigations
• Allegations of large-firm cartel pricing
  predatory pricing
• Motivated first studies of audit pricing
• 1980s effects of deregulation
• Allegations of low-balling and poor audit quality
• Motivated studies of initial engagement pricing
• 1990s legal liability and audit litigation
  crisis (SL, PSLRA)
• Motivated risk-screening studies, effects of
  PSLRA
• 1990s growth of industry specialization and
  non-audit services
• Motivated study of industry expertise and
  non-audit services
• 2000s New regulations/institutions
• The effects of PCAOB and SOX on audit
  practice/quality

5
Triangulation - Low Balling

• Theory -modeling pricing incentives
  consequences on auditor independence
• DeAngelo JAE 1981 Dye JAE 1991
• Experimental evidence
• Economics induce LB in the lab effects on
  audit quality
• Schatzburg (TAR 1990) Schatzburg Sevcik (CAR
  1994) Dopuch King (JAAF 1996)
• Psychology effects of fee pressure on the
  quality of auditor judgments
• Houston (AJPT 1999)
• Empirical evidence
• Initial engagement discounts
• Simon Francis (TAR 1988) Craswell Francis
  (TAR 1999)
• Consequences of LB on audit hours/audit quality
• Deis 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 procedures
• Auditor judgments about testing evidence
• Auditors apply/interpret testing procedures
• As individuals (individual judgments)
• In teams (group judgments)
• Accounting firms
• Auditors work in firms
• Observable audit firm outcomes are audit
  reports audited financial statements (and who
  audits whom)
• Audit industry and audit markets
• Audit firms operate compete in audit markets
• Regulatory institutions and public policy
• Auditors, firms and markets are regulated

7
Audit Testing Procedures(requires accounting
firms)

• Purpose
• Understanding, evaluating and improving the
  quality of audit testing and evidence-gathering
  procedures
• Historical examples
• Are accounts receivable confirmations
  effective/reliable?
• Caster (AJPT 1990)
• Is classical sampling efficient/effective in
  auditing?
• Lead to development of dollar-unit sampling
• Current examples
• Archival - 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?
• ODonnell Schultz (TAR 2005)

8
Auditor Judgment Research

• Purpose
• To understand how auditors implement tests,
  interpret evidence
• Ultimate goal to improve audit judgments in the
  field
• Historical examples
• Descriptive 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 examples
• Do 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
  risk
• Does the business risk model improve auditor
  judgments?

9
Accounting Firms(proprietary largely a black
box)

• Purpose
• Understanding the organization and administrative
  structures of accounting firms
• Field studies e.g., Dirsmith Covaleski (AOS
  1985)
• Examples of RQ
• How centralized/decentralized are firms?
• How much autonomy do local offices/partners have?
• A central issue in Andersens Enron audit
• How do partners share profits? What are incentive
  effects?
• Large vs. small profit-sharing pools, and
  awarding of partnership units
• Burrows 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 reports
• Are reports informative? GC and New I/C reports
• Indirect
• Financial statement/earnings quality
• Jointly produced by companies/auditors
• Work to date is limited mainly to accruals
• Secondary effects of differential audit quality
• Debt markets
• Mansi et al. (JAR 2004)
• Equity markets
• Khurana 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 expertise
• Locale/unit of analysis (global, country, office,
  partner)
• How do engagement-specific characteristics affect
  audit outcomes?
• Proxies for independence
• Fees (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 Structure
• Why 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 Structure
• Are 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) SECs AAER
• Hilary and Lennox (JAE 2006) POB Peer Reviews
• How do legal liability regimes affect audits?
• Analytical/Experimental
• Dye (JPE 1993 JAE 1997) Dopuch et al. (JAE
  1997)
• Empirical
• Francis Krishnan (APJAE 2003) Lee Mande
  (AJPT 2003)
• Current topics
• How 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 proven
• failures are infrequent.
• But this does not necessarily mean audits
• are always of high quality.
• What do we know about audit quality
• from 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 reports
• Standard 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 observations
• Overall Error Rate 9.5
• Type 1 Errors (false negatives) 9
  (over-qualifying or auditor conservatism)
• No bankruptcy within one year, but 9 had GC
  reports
• 5,467 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 assess
• Audit reports issued concurrently with financials
• Most GC reports are repeat offenders
• Evidence that surprise first-time GC reports
  reduce share prices
• Dodd 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 value
• Greater information uncertainty/asymmetry
• Weber and Willenborg (JAR 2003)
• Microcap IPOs lt 10 million
• 23 have GC reports preceding IPO
• Pre-IPO audit reports predict delistings and
  future stock returns
• But more so for large (Big 4 national) auditors

20
Who Audits Whom?

• What do we know about auditor differences and
  audit quality?

21
Differential Audit Quality Research

• Audit quality cannot be directly observed
• Except for proven audit failures (ex post)
  which are rare
• Instead differential audit quality is inferred
• Comparing audit outcomes between classes of
  auditors
• All firms are assumed to meet minimum
  professional legal requirements
• But many different types of firms exist
• Suggests supply of differential auditing
• Implies differential demand (clienteles)

22
Audit Firm SizeIs Bigger Better?

• The big firm/small firm dichotomy
• Big 8 (now Big 4) firms have brand name
  reputation and incentives to protect their
  reputation
• Simunic and Stein (1987 CGA Monograph)
• Auditor size proxies for quality due to less fee
  dependence (DeAngelo, JAE 1981)
• Client dependence 1/n (where nnumber of
  clients)
• Now we can use actual fee dependence
• Doesnt mean Big 4 audits are always better
• It just means that on average they are better
• Individual audit failures can and do occur

23
Evidence of Big 4 Audit Quality Differentiation

• Audit pricing
• Big 4 audit fee premia of 20-50
• US, Australia, Hong Kong, UK
• Implies more quantity and/or better quality
  auditing
• Higher fees imply voluntary demand for higher
  quality audits by some clients
• Demand for quality
• Demand for Big 4 audits is increasing in agency
  costs
• Francis Wilson (TAR 1988), DeFond (AJPT 1992)
• IPOs with larger auditors have less IPO
  underpricing
• Beatty (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 regulators
• Feroz et al. (JAR 1991)
• Alternative explanation is that big firms are
  more powerful and have resources to fight
• But evidence on audit outcomes is more
  consistent with higher quality
• Lets turn to that evidence

25
Evidence from Audit Outcomes

• Audit Reports of Large (Big 4) Auditors
• More 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 Auditors
• Smaller abnormal accruals -- less managerial
  discretion
• Becker et al. (CAR 1998), Francis et al. (AJPT
  1999)
• Accruals/earnings surprises valued higher in the
  stock market
• Teoh Wong (TAR 1993), Krishnan (AJPT 2003)

26
Conclusions on Auditor Size

• Evidence is supportive of higher Big 4 audit
  quality
• But an alternative explanation is endogeneity
• i.e., good companies choose good (Big 4)
  auditors, in which case selection may explain
  outcomes, not audit quality
• Heckman 2-stage approach is trendy
• But most studies using it support prior findings
  on audit quality
• Weber Willenborg (JAR 2003), Hogan (TAR 1997),
  Ireland Lennox (JAAF 2002)
• Chaney et al. (TAR 2004) is an exception
• Can we identify good instruments in accounting
  research?
• Larcker Rusticus (SSRN WP) are skeptical
• If theres reason to think selection exists, an
  alternative is to control through research design
  choices
• e.g., matched pairs, or samples limited to
  smaller clients

27
Moving Beyond the Big-Small Dichotomy

• Differentiation within
• the dominant Big 4 group

28
Within-Big 4 Differentiation

• In past, Big 4 viewed as homogenous group
• B4 (90) NB4 (10) U.S. market shares
• Low power due to small variance in auditor type
• May be more variation within Big 4 firms
• Some plausible within-Big 4 variations
• Industry expertise
• Geographical variation
• Offices (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 judgments
• Solomon et al. (JAR 1999) Low (TAR 2004)
• Auditor clienteles proxy for industry expertise
• More clients create more opportunities to acquire
  deep industry knowledge/expertise
• Industry shares are not evenly distributed
• Using 2000-2001 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 industries
• AA (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 audits
• Financial statement outcomes evidence higher
  quality audits by Big 4 industry leaders
• Smaller abnormal accruals (less discretion)
• Balsam et al. (APJT 2003), Krishnan (AH 2003)
• Higher valuation of earnings surprises
• Balsam et al. (AJPT 2003)
• Less fraudulent reporting (AAERs)
• Carcello Nagy (2004 Managerial Auditing
  Journal)
• Less IPO underpricing and smaller accruals
• Elder and Zhou (2003 WP)

31
What is an Accounting Firm?

• Whats the relevant unit of
• analysis?
• Individual offices, national
• practices, or international
• operations?

32
Arguments for an Office-Level Analysis

• Accounting firms are decentralized networks of
  quasi-independent practice offices
• Engagement partners in local offices contract and
  administer audits to clients in the same locale
• Issue audit reports on office letterhead
• Francis et al. (ABACUS 1999) Reynolds Francis
  (JAE 2000) Ferguson et al. (TAR 2003)
• Client influence/fee dependence is stronger at
  the office level
• Enron lt 2 of Andersen fees nationally
• Over 30 of Houston office fees

33
First Office-Level StudyReynolds Francis (JAE
2000)

• Auditors are more conservative for larger clients
  in U.S. practice offices
• They issue more GC audit reports
• Clients have smaller abnormal accruals
• Client size measured relative to office
  clienteles
• Client size is not significant using national
  clienteles to measure relative client size
• Conclusion
• Office-level data provides better understanding
• No 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 arguments
• Deep expertise is client-specific and cannot be
  fully captured by firms and distributed across
  offices
• Gilson Mnookin (SLR 1985), law firms
• Firm-wide arguments
• Standardized 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 leader
• 18 of US sample
• Engagements where auditor is a national industry
  leader (alone)
• 10 of US sample
• Engagements where auditor is a city-specific
  industry leaders (alone)
• 23 of US sample
• Nonleaders (neither city/national leaders)
• 49 of US sample

36
Evidence

• Joint national-city 1 has 28 premium
• City-alone 1 has 10 premium
• National-alone 1 has no fee premium relative to
  nonleaders (default group is nonleaders)
• Implication - audit quality is office-specific
• Industry premia only when a city leader
• Either alone or joint national-city leader
• National market share is driven by city
  leadership
• National 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 2000-01 first-time cycle
  of fee disclosures to measure industry leaders
• What do we find?
• Clients of city industry leaders have smaller
  abnormal accruals, and smaller income-increasing
  accruals
• Magnitude is 6-12 of pre-tax earnings
• Clients 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
  incentives
• Two research approaches
• A regime change within a single country (over
  time)
• The Private Securities Litigation Reform Act of
  1995
• Lee and Mande (AJPT 2003), Francis Krishnan
  (APJAE 2003)
• Cross-country studies of different legal regimes
• Seetharaman, Gul and Lyn (JAE 2002)
• higher audit fees of UK firms cross-listed in US
• implies higher fees due to increased litigation
  risk exposure
• Khurana 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 Scenarios
• Big 4 are uniform around the world
• Incentives to maintain brand name
  (standardization)
• U.S. is an outlier due to extreme liability
  exposure
• More lawsuits in US than rest of world combined
• Big 4 conservatism is increasing in country-level
  investor protection and auditor litigation risk

40
Big 4 Auditor Conservatism
High
Conservatism
Low
Low
High (U.S.)
Legal Liability/Investor Protection
41
Preliminary Results Indicate that Legal Regime
Matters

• Big 4 conservatism is
• Increasing in investor protection/litigation risk
• Holds both with/without U.S. observations
• Implies less discretion to manage earnings
• Magnitude
• Abnormal accruals are smaller by around 5 of
  earnings in common law countries with stronger
  investor protection
• Non-Big 4 firms are uniform across countries (and
  less conservative than Big 4)
• Less incentive for reputation protection/litigatio
  n avoidance behavior (same as within US)

42
Other Examples of Research on Audit Quality

• Auditor tenure
• Non-audit services (NAS)
• Audit committees/corporate
• governance
• Accounting 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 bias
• The evidence to date
• Audit quality is lower in first 3 years
• Johnson et al. (CAR 2002)
• But longer tenure (5 years) increases audit
  quality
• Meyer et al. (TAR 2003)
• Studies of partner tenure in Australia and Taiwan
• Office level analysis

44
Nonaudit Services (NAS)

• Do NAS impair auditor independence?
• More fee dependence
• Inherent conflict of interest
• SEC attempted to ban NAS in 2000
• Professions defense
• Increases auditors knowledge
• Clients demand and value NAS
• Incentives exist to protect reputations for
  independence

45
Evidence

• Frankel, Johnson Nelson (TAR 2002)
• Compelling set of results against NAS
• Firms with higher NAS are associated with more
  earnings management
• Larger abnormal accruals (more discretion)
• More likely to meet analysts earnings targets
• But also counter-evidence
• Ashbaugh et al. (TAR 2003), Chung Kallapur (TAR
  2003), Reynolds et al. (AJPT 2004), DeFond et al.
  (JAR 2003), Larcker Richardson (JAR 2004)

46
Broader Implications

• Accounting journals generally dont publish
  replications and no-result studies
• But replications show fragility and sensitivity
  to design choices
• e.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 reports
• Carcello and Neal (TAR 2000)
• Less likely to be replaced following GC report
• Carcello and Neal (TAR 2003)
• Auditors are more likely to detect fraud
• Dechow 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 services
• Abbot et al. (SSRN 2001), Abbott et al. (AJPT
  2003)

48
Accounting Firm Alumni and Auditor Independence

• Outplacement to clients impairs audit quality
• Clients know the auditors methods too well
• Auditor is cozy with former colleagues
• Lennox (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
Policy Making

• Whats the role of
• academic auditing research
• on audit quality?

50
The U.S. Experience

• Academic research has little influence on
  regulation and policy-making
• Two recent examples that ignored research
• SECs proposed ban on NAS in 2000
• Arthur Levitt was convinced a ban was needed
• Quick adoption of Sarbanes-Oxley (SOX) in 2002
• Political cover following Enron/Worldcom scandals

51
Why so little impact?

• Partly our fault
• We rarely frame our research around normative
  regulatory issues or sell its policy importance
• We may not appear to be neutral
• Theres often an explicit anti-regulatory posture
• And we may (rightly) be viewed as apologists for
  the accounting profession
• Partly policy-makers fault
• No tradition of basing policy on research
• Policy-making is inherently political (not
  scientific)
• Overtures by the PCAOB are encouraging

52
Some ImportantUnanswered 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 low
• Is 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 countries
• The risk of audit firm failure is real in the
  U.S. but nearly impossible in rest of world
• Does extreme legal risk create the best
  incentive?
• It didnt prevent the Arthur Andersen collapse or
  frauds such as Worldcom, Adelphia, and
  HealthSouth
• Another U.S. audit firm failure could end
  private-sector auditing around the world (global
  Big 4)
• All Big 4 firms have serious legal problems
• Is a Big n lt 3 viable for private-sector
  auditing

54
Follow-up Readings

• J. Francis, What Do We Know About Audit
  Quality? The British Accounting Review (December
  2004), Vo. 34, No. 4 345-36
• DeFond, M., and J. Francis, Audit Research after
  Sarbanes-Oxley? Auditing A Journal of Practice
  and Theory (2005, Supplement) forthcoming.