Largest Audit Firms Influence their Audit Quality and Efficiency? - - PowerPoint PPT Presentation

Does the Organization and Culture of the Largest Audit Firms Influence their Audit Quality and Efficiency?

October 14, 2016 Daniel Aobdia Kellogg School of Management, Northwestern University

DISCLAIMERS

I completed this study while a Senior Economic Research Fellow in the Center for Economic Analysis at the PCAOB The PCAOB, as a matter of policy disclaims responsibility for any private publication or statement by any of its Economic Research Fellows and employees The views expressed are my own and do not necessarily reflect the views of the Board, its members, or staff of the PCAOB

RESEARCH QUESTIONS

How much influence do audit firms’ quality control (QC) systems, have on audit quality, audit efficiency, and audit pricing (in the U.S.)? Do all QC systems matter? Are some, such as culture and audit tools, more important than others?

• To answer these questions, use of a unique dataset: The

deficiencies identified by the PCAOB in the firms’ QC systems (Part II Findings) Is remediation of QC issues (identified by the PCAOB) associated with better audit quality? Efficiency?

THEORETICAL BACKGROUND ON THE ROLE OF QC SYSTEMS AND CULTURE

 Only the audit opinion is observed, whereas effort is unobservable, giving incentives to individual auditors to

• shirk. This moral hazard can be reduced if mutual monitoring

takes place (Balachandran and Ramakrishnan 1987)

• While audit firms have reputation and litigation incentives

to provide high quality audits, these incentives do not necessarily apply to their individual employees  Company culture is relevant because employees will face choices that cannot be properly regulated ex-ante, leading culture to act as a safeguard (O’Reilly 1989, Kreps 1989, Guiso et al. 2015)

ANECDOTAL EVIDENCE ON THE INFLUENCE OF CULTURE AND QC SYSTEMS IN AN AUDIT FIRM: ARTHUR ANDERSEN IN THE 90s / EARLY 2000s

 The rise of consulting at Arthur Andersen led to a culture change focusing on revenue to the detriment of audit quality, contrary to the founder’s principles

• This lead to several failed audits, including Boston

Chicken, Waste Management and Enron (Brown and Dugan 2002, Eichenwald and Norris 2002, Richard and Thurm 2002, Toffler and Reingold 2003, Wyatt 2004, Gendron and Spira 2009)  Enron: The engagement team was able to overrule the authority of their national specialists on the engagement (Eichenwald and Norris 2002)

MOTIVATION

Despite theoretical predictions and anecdotal evidence, very limited prior empirical literature about firm-wide QC systems  Francis 2011, p138: “Research on the relation between accounting firms and audit quality is severely limited by the availability of data on characteristics of accounting firms. To date, research on this topic has relied on variables that can be constructed from public disclosures such as client-based measures

• f industry expertise or office size. However, these measures do

not go inside the “black-box” of the accounting firm’s

• rganizational structure and operations” Francis, 2011 p138

 DeFond and Zhang 2014, p304: “We currently know little about basic characteristics of audit firms such as their choice of

• wnership structure, governance systems, audit quality control

systems, compensation schemes, or audit technology.”

MOTIVATION

The question is also informative about the role of the PCAOB inspections of the firms’ QC systems, and the Part II Findings

• From an audit quality standpoint: Given outside concerns,

do PCAOB inspections measure true deficiencies in audit quality? Or only documentation issues?

• Are the results in inspections of individual engagements (risk

based) generalizable to the remainder of the firm?

• Does remediation of QC issues identified by the PCAOB

improve audit quality?

• Are there some other undocumented potential benefits from

the PCAOB inspections process, besides potential improvement in audit quality?

BACKGROUND ON PCAOB INSPECTIONS

The PCAOB (established by SOX) regularly inspects audit firms that audit public companies (issuers)

• Annual inspections for firms with more than 100 issuers and

triennial inspections for firms with less than 100 issuers A typical PCAOB inspection incorporates two elements:

• A review of selected portions of individual audit

engagements (chosen using a risk-based approach)  Deficiencies are called Part I Findings  A Part I Finding: The audit work is not sufficient to support the audit opinion, based on applicable standards

• A review of the audit firm’s quality control (QC) systems

 Deficiencies are called Part II Findings

OVERVIEW OF THE PCAOB REVIEW OF LARGE AUDIT FIRMS’ QC SYSTEMS

Eight Major Top-Down areas inspected by the PCAOB Based on specific analyses that focus on the firm’s QC policies, and from inferences from review of individual engagements: Tone at the top (culture), partner management, Independence policies, Client acceptance / retention, Internal inspections, Audit methodology, Policies related to foreign affiliates, Other practice monitoring

Audit 1 Audit 2 Audit 3 Audit 4 Audit 5 Audit 6

Audit Performance Deficiencies Identified from inspections of individual engagements

Inspection Of QC Systems: Inspection Of QC Systems: Inspection Of individual audits:

AN EXAMPLE OF A PART I FINDING FROM PUBLIC 2011 INSPECTION REPORT OF DELOITTE

• 1. Issuer A

In this audit, the Firm failed to identify a departure from generally accepted accounting principles ("GAAP") that it should have identified and addressed before issuing its audit opinion. Specifically, the issuer inappropriately allocated to goodwill, rather than to a definite-lived intangible asset, a portion of the purchase price of a group of assets. In addition, the Firm failed to perform sufficient procedures to test the valuation of goodwill for one of the issuer's segments. The issuer used revenue and earnings projections in its evaluation of the possible impairment of goodwill and, for this segment, the projected growth rates were significantly higher than the issuer's recent historical results and projections for the issuer's industry, which were included in the Firm's work papers. The Firm failed to sufficiently test the projected growth rates for this segment. Specifically, the Firm relied on controls related to the issuer's budget without testing the effectiveness of controls over the development of the assumptions used in the budget process, and the Firm failed to evaluate, beyond inquiry of management, the reasonableness of the issuer's revenue and earnings projections.

PART II FINDING SECTION FROM 2011 INSPECTION REPORT OF DELOITTE

Section 104(g)(2) of SOX: All Part II Findings will remain nonpublic if “remediated” within one year

PART II FINDING SECTION FROM EXPANDED 2007 INSPECTION REPORT OF DELOITTE

• A. Audit Performance

A firm's system of quality control should provide reasonable assurance that the firm's audit work will meet professional standards and regulatory requirements. Not every deficiency in an audit indicates that a firm's quality control system is insufficient to provide that assurance, and this report does not discuss every auditing deficiency observed by the inspection team. On the other hand, some deficiencies, or repeated instances of a similar deficiency, may indicate a potentially significant defect in a firm's quality control system even if the deficiency has not resulted in an insufficiently supported audit opinion. As described below, some deficiencies reported by the inspection team do suggest that the Firm's system of quality control may in some respects fail to provide sufficient assurance that the Firm's audit work will meet applicable standards and requirements.

PART II FINDING SECTION FROM EXPANDED 2007 INSPECTION REPORT OF DELOITTE

• A. Audit Performance

…

• b. Management Estimates

The engagement reviews provide cause for concern that the Firm's system of quality control may not do enough to assure that the Firm performs appropriate procedures to audit significant estimates, including evaluating management's assumptions and testing the data supporting the estimates. In addition to seven engagements described in Part I.A, the inspection team identified eight engagements (two of which are also discussed in Part I.A with respect to different estimates) with deficiencies in the Firm's testing of management estimates. Specifically - …

PART II FINDING SECTION FROM EXPANDED 2012 INSPECTION REPORT OF BDO

Deficiencies in Quality Controls Related to the Firm's Internal Inspection Program … In 2012, the PCAOB inspection team inspected three audits that the internal inspection team had reviewed, including two audits that the internal inspection team had rated as "unsatisfactory." In each of these three audits, the PCAOB inspection team identified one or more deficiencies that were not identified by the internal inspectors but are of such significance that they are included in Part I.A of this

• report. The inspection team identified a total of six such deficiencies in these audits

that were not identified by the internal inspectors, even though they had reviewed the relevant area. The above discrepancies may suggest that the Firm's internal inspection teams do not always appropriately apply professional skepticism to the performance of internal inspections or to the evaluation of the results of those inspections. …

DATA AND SAMPLE

 PCAOB data:

• Part II Findings identified from nonpublic parts of the PCAOB

reports

• Restricted to the U.S. operations of the largest eight audit

firms (Big 4, GT, BDO, McGladrey and Crowe Horwath) for comparability purposes

• Use of individual engagement inspection deficiencies (Part I

Findings) as one (but not the only one) measure of audit quality

• Audit hours for 2008 till 2012, for the U.S. engagements of

the largest auditors  Merged with S&P Compustat and Audit Analytics data (2004 till 2013) for measures of audit quality (restatements…), audit fees, client switches and other control variables

MEASURE OF QC DEFICIENCIES

 Word count in the Part II Section of the report

• Split between audit performance deficiencies and others

(top-down) to determine whether they matter differently  Index of top-down deficiencies

• Indices are commonly used in the academic literature (e.g.,

La Porta et al., 1998; Gompers et al., 2003; Bebchuk et al., 2009; Garmaise, 2011) Main concern: Remove any element of subjectivity in the measures and use natural sections in each report

INDEX OF TOP DOWN QC DEFICIENCIES

One point is added to the index for each category if Part II Findings are identified in the following areas 1. Tone at the top 2. Partner management 3. Independence policies 4. Client acceptance and retention policies 5. Internal inspection program 6. Audit policies, procedures and methodologies, and training 7. Policies related to foreign affiliates 8. (Other) practice monitoring Index = 0: No major deficiencies in QC system (“good”) Index = 8: Deficiencies identified in all categories of the index (“bad”) Later on, separate Tone at the top and Audit methodology issues and create a sub-index

PROPORTION OF FIRM-YEARS WITH DEFICIENCIES IN

Proportion of firm-years (%) 20 40 60 80 100 Tone at the top Partner management Independence policies Client acceptance and retention policies Internal inspection program Audit policies, methodology and training Policies related to foreign affiliates (Other) practice monitoring

SUMMARY OF RESULTS

H1: An audit firm’s QC deficiencies are negatively associated with audit quality  Negative association between QC issues and audit quality

• For both “audit performance” and “top-down” deficiencies, including

tone at the top H2: There is no association between audit firm’s QC deficiencies and audit pricing  No relationship between QC issues and audit pricing

SUMMARY OF RESULTS

H3: There is no association between audit firms’ QC deficiencies and audit efficiency  Positive association between top-down QC issues and audit hours

• Consistent with “inefficiency” hypothesis
• Mainly driven by tone and methodology issues

Additional results:  Some evidence that remediation improves audit quality and efficiency  Positive association between QC deficiencies and client switches

TYPICAL INSPECTION PROCESS TIMELINE

Year t-1 Year t Year t+1 End of Fiscal Year t-1 End of Audit Year t-1 Fieldwork (March to November)

• Year t-1 audits inspected
• QC systems at t? t-1? inspected

End of Fiscal Year t End of Audit Year t

The analysis of the firm’s QC systems is related to the prior year’s audits, but some analyses appear to use current information (in contrast with the inspection of individual audits)

• Use the deficiencies in the firm’s QC systems identified in

Year t for audit quality and efficiency measured in Year t (results also robust if look at Year t-1 output variables)

• Also use the inspection findings identified in Year t+1 for the

Year t audits as a measure of audit quality (different year)

Fieldwork (March to November)

• Year t audits inspected
• QC systems at t? t+1? inspected

RESEARCH DESIGN: CROSS-SECTIONAL REGRESSION

 For several measures (audit quality, hours, fees), run the following regression Measure = α + β.QC Issues + γ.Controls + ε  QC issues: Number of words (audit performance and others) in report, QC Index, Reduced Index, Tone, Methodology  Measures of audit quality (see Aobdia 2015): Restatements, propensity to meet/beat the zero earnings threshold, accruals, Part I Findings (for inspected engagements the following year)  Extensive battery of controls, including year fixed effects (results are not particularly sensitive to inclusion)

AUDIT QUALITY RESULTS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding |Accruals/CFO| Number_Words 0.202*** 0.077*** 0.220***

• 0.032

[5.905] [2.784] [3.288] [-0.901] Year Fixed Effects Yes Yes Yes Yes Control Variables Yes Yes Yes Yes Observations 27,837 27,837 2,452 27,837 Pseudo R-squared 0.038 0.087 0.101 Adjusted R-squared 0.134 Clustering Issuer Issuer Issuer Issuer Model Logistic Logistic Logistic OLS

AUDIT QUALITY RESULTS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding |Accruals/CFO| Number_Words 0.202*** 0.077*** 0.220***

• 0.032

[5.905] [2.784] [3.288] [-0.901] Year Fixed Effects Yes Yes Yes Yes Control Variables Yes Yes Yes Yes Observations 27,837 27,837 2,452 27,837 Pseudo R-squared 0.038 0.087 0.101 Adjusted R-squared 0.134 Clustering Issuer Issuer Issuer Issuer Model Logistic Logistic Logistic OLS

AUDIT QUALITY RESULTS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding |Accruals/CFO| Number_Words_Perf 0.208***

• 0.000

0.135*

• 0.050

[5.459] [0.003] [1.860] [-1.333] Reduced_QC_Index

• 0.003

0.030* 0.095** 0.044** [-0.134] [1.824] [2.260] [2.128] Tone 0.026 0.098**

• 0.014
• 0.026

[0.430] [1.838] [-0.093] [-0.408] Methodology 0.139** 0.126** 0.233*

• 0.009

[2.328] [2.426] [1.668] [-0.137] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 27,837 27,837 2,452 27,837 Pseudo R-squared 0.040 0.087 0.102 Adjusted R-squared 0.134

AUDIT QUALITY RESULTS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding |Accruals/CFO| Number_Words_Perf 0.208***

• 0.000

0.135*

• 0.050

[5.459] [0.003] [1.860] [-1.333] Reduced_QC_Index

• 0.003

0.030* 0.095** 0.044** [-0.134] [1.824] [2.260] [2.128] Tone 0.026 0.098**

• 0.014
• 0.026

[0.430] [1.838] [-0.093] [-0.408] Methodology 0.139** 0.126** 0.233*

• 0.009

[2.328] [2.426] [1.668] [-0.137] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 27,837 27,837 2,452 27,837 Pseudo R-squared 0.040 0.087 0.102 Adjusted R-squared 0.134

AUDIT QUALITY RESULTS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding |Accruals/CFO| Number_Words_Perf 0.208***

• 0.000

0.135*

• 0.050

[5.459] [0.003] [1.860] [-1.333] Reduced_QC_Index

• 0.003

0.030* 0.095** 0.044** [-0.134] [1.824] [2.260] [2.128] Tone 0.026 0.098**

• 0.014
• 0.026

[0.430] [1.838] [-0.093] [-0.408] Methodology 0.139** 0.126** 0.233*

• 0.009

[2.328] [2.426] [1.668] [-0.137] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 27,837 27,837 2,452 27,837 Pseudo R-squared 0.040 0.087 0.102 Adjusted R-squared 0.134

AUDIT HOURS RESULTS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Audit Hours Partner Hours EQR Hours Fees per Hour Number_Words_Perf

• 0.071***
• 0.133***
• 0.229***

18.522*** [-8.829] [-14.468] [-27.969] [10.979] Reduced_QC_Index

• 0.000

0.038*** 0.039*** 1.386 [-0.085] [7.232] [8.899] [1.134] Tone 0.125*** 0.136*** 0.279***

• 33.041***

[10.402] [8.003] [19.761] [-10.841] Methodology 0.092*** 0.075*** 0.048***

• 18.401***

[6.553] [4.928] [3.458] [-5.574] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 13,802 13,793 13,698 13,802 Adjusted R-squared 0.735 0.578 0.384 0.095

AUDIT HOURS RESULTS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Audit Hours Partner Hours EQR Hours Fees per Hour Number_Words_Perf

• 0.071***
• 0.133***
• 0.229***

18.522*** [-8.829] [-14.468] [-27.969] [10.979] Reduced_QC_Index

• 0.000

0.038*** 0.039*** 1.386 [-0.085] [7.232] [8.899] [1.134] Tone 0.125*** 0.136*** 0.279***

• 33.041***

[10.402] [8.003] [19.761] [-10.841] Methodology 0.092*** 0.075*** 0.048***

• 18.401***

[6.553] [4.928] [3.458] [-5.574] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 13,802 13,793 13,698 13,802 Adjusted R-squared 0.735 0.578 0.384 0.095

AUDIT HOURS RESULTS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Audit Hours Partner Hours EQR Hours Fees per Hour Number_Words_Perf

• 0.071***
• 0.133***
• 0.229***

18.522*** [-8.829] [-14.468] [-27.969] [10.979] Reduced_QC_Index

• 0.000

0.038*** 0.039*** 1.386 [-0.085] [7.232] [8.899] [1.134] Tone 0.125*** 0.136*** 0.279***

• 33.041***

[10.402] [8.003] [19.761] [-10.841] Methodology 0.092*** 0.075*** 0.048***

• 18.401***

[6.553] [4.928] [3.458] [-5.574] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 13,802 13,793 13,698 13,802 Adjusted R-squared 0.735 0.578 0.384 0.095

EVIDENCE ON REMEDIATION: AUDIT QUALITY

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding ScaledAccrualsCFO Number_Words 0.189*** 0.074*** 0.157**

• 0.032

[5.433] [2.630] [2.219] [-0.853] Proportion_Remediated

• 0.401**

0.011

• 2.454***

0.135 [-2.284] [0.072] [-5.369] [0.623] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 23,572 23,572 2,089 23,572 Adjusted/Pseudo R-squared 0.032 0.085 0.126 0.136

EVIDENCE ON REMEDIATION: AUDIT QUALITY

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding ScaledAccrualsCFO Number_Words 0.189*** 0.074*** 0.157**

• 0.032

[5.433] [2.630] [2.219] [-0.853] Proportion_Remediated

• 0.401**

0.011

• 2.454***

0.135 [-2.284] [0.072] [-5.369] [0.623] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 23,572 23,572 2,089 23,572 Adjusted/Pseudo R-squared 0.032 0.085 0.126 0.136

EVIDENCE ON REMEDIATION: AUDIT HOURS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Logaudithours Logpartnerhours Logeqrhours Fees_per_hour Number_Words

• 0.003
• 0.056***
• 0.061***

1.192 [-0.580] [-7.487] [-9.684] [0.934] Proportion_Remediated

• 0.075***
• 0.135***

0.129*** 16.750*** [-3.235] [-4.555] [4.237] [3.399] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 13,802 13,793 13,698 13,802 Adjusted/Pseudo R-squared 0.731 0.565 0.322 0.082

EVIDENCE ON REMEDIATION: AUDIT HOURS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Logaudithours Logpartnerhours Logeqrhours Fees_per_hour Number_Words

• 0.003
• 0.056***
• 0.061***

1.192 [-0.580] [-7.487] [-9.684] [0.934] Proportion_Remediated

• 0.075***
• 0.135***

0.129*** 16.750*** [-3.235] [-4.555] [4.237] [3.399] Full Set of Controls Yes Yes Yes Yes Year Fixed Effects Yes Yes Yes Yes Observations 13,802 13,793 13,698 13,802 Adjusted/Pseudo R-squared 0.731 0.565 0.322 0.082

CLIENT SWITCHES RESULTS

(*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Switch Switch Switch Switch Number_Words_Perf 0.142*** 0.136*** 0.111** 0.105* [2.721] [2.597] [2.050] [1.915] QCIndex 0.090*** 0.080*** [3.349] [3.000] Reduced_QC_Index 0.071** 0.062** [2.503] [2.190] Methodology 0.265*** 0.247*** [3.036] [2.803] Tone 0.113 0.111 [1.450] [1.419] Full Set of Controls No Yes No Yes Reduced Set of Controls Yes No Yes No Year Fixed Effects Yes Yes Yes Yes Observations 25,675 25,675 25,675 25,675 Pseudo R-squared 0.101 0.123 0.102 0.123

CONCLUSION

 QC systems matter from an audit quality, efficiency, and client standpoint

• Remediation of QC deficiencies has the potential to improve both

audit quality and efficiency  Some of the QC deficiencies identified by the PCAOB appear to measure nontrivial issues  To a certain extent, the results of individual PCAOB inspections, risk based, can be generalized to the remainder of the firm

THANK YOU