audit firm tenure, non-audit services and internal assessments of audit quality t. bell, m....

Audit Firm Tenure, Non-Audit Services and Internal

Assessments of Audit Quality

T. Bell, M. Causholli and W.R. Knechel

The Issues that Will Not Go Away …• Auditor tenure and non-audit services

• Accounting firm commercial self-interest.

• Regulatory obsession:

▫PCAOB and GAO report

▫EU Green Paper and related proposals

▫PCAOB Concept Release (2011) and Public Meeting on Firm Independence and Rotation (2012)

• Academic attention and (debatable) audit quality proxies.

The Arguments• Conflicted expertise?

• Improves auditor knowledge (spillovers, learning).

• Reduces audit costs and improves efficiency.

• Natural reaction to increasing complexity (globalization, IT change, financial complexity).

• Needed due to integration of control and governance.

• Uninformed independence?

• Economic bonds and incentives increasingly complex.

• Creates inappropriate incentives.

• Undermines independence.

Summary of Some Key Results

• Audit quality is significantly lower in year one but not later.

• Lowballing occurs in year one but this is when the intensity of auditor effort is highest.

Hard work cannot completely compensate for lack of familiarity.

• Some types of NAS are associated with higher audit quality, especially MAS.

• NO evidence of any loss of audit quality from NAS in general.

Academic Research: Tenure

• Association of tenure and audit quality:▫Evidence of decline in early year(s) of an

engagement (Johnson et al. 2002, Myers et al. 2003).

▫Association may not be linear (Davis et al. 2009, Brooks

et al. 2012).• Would results be different in mandatory setting?

▫Actual or proxy settings (Cahan and Zhang 2006, Blouin et al. 2007, Cameran et al. 2009).

• On balance: Short tenure can have negative consequences for audit quality, but in some cases so does very long tenure

• Few clear benefits to mandatory rotation.

Academic Research: Tenure

• Most prior research suggests that financial reporting quality is lower when auditor tenure is short (see Myers et al. 2003).

• But what is causing this association?▫Deficiencies in audit process?▫Economic bonding?▫Lack of knowledge? ▫Poor proxies?

H1: Audit firm tenure is associated with the internally assessed quality of the audit process.

Academic Research: Non-audit Services• Association between NAS and audit quality:

• Some evidence of a problem (Frankel et al. 2002)

• But majority of later evidence is to the contrary (Habib 2009)

• Types of NAS may matter:▫Tax vs. MAS vs. other (Kinney et al. 2004)

▫Recurring vs nonrecurring (Paterson and Valencia 2011)

H2: Different types of non-audit services are differentially associated with internally assessed audit quality.

Our Data

• Data come from internal assessments of the quality of US-based audits in a Big 4 firm.

• Data was collected form late spring to early fall of 2003 and pertain to audits before SOX (FYE = 2002 or 2003).▫Firm personnel knew that PCAOB inspections

were on the horizon.• Final sample = 265 engagements in 4 industries

▫Consumer & industrial products; financial services; information, communication and entertainment; health care.

▫Includes high number of former AA clients

Audit Quality Measures

• A review team assessed 55 individual audit activities:▫Audit planning (analytical procedures, fraud risk

assessment)▫ Internal controls (testing of controls;

understanding of processes)▫Substantive testing (tests of details; inventory

observations, rev, recognition)▫Wrap up (subsequent events, GCOs, related party)

• For each activity the team judged whether audit performance was satisfactory or deficient.

• Data included number of deficiencies (Range: 0 to 14).


• At conclusion review team made 4 composite assessments ▫The sufficiency of evidence obtained to support

the audit opinion▫The appropriateness of the accounting principles ▫The appropriateness and completeness of

presentations and disclosures embodied in the financial statement

▫The appropriateness of the auditor opinion• The review team also made and documented a

final composite assessment of the overall audit quality for the engagement


• Rating of overall audit quality

▫Rating = 1: Unqualified Satisfactory (N= 112; 42%)

▫Rating = 2: Satisfactory with comments (N=133; 50%)

▫Rating = 3: Needs improvement (N=18; 7%)

▫Rating = 4:Unsatisfactory (N=2; 1%)

• Primary Analysis: AQ = 1 if rating = 1 (Unqualified Satisfactory); 0 otherwise

Audit Deficiencies

TOTDEFIC

Percent of Sample

0 17%

1 28%

2 20%

3-12 35%

TOTDEFIC

Rating

1 2 3-4

0-2 94% 47% 20%

3-12 6% 53% 80%

Average 0.94 2.96 5.30

“Satisfactory with Comments”

• Alternative analysis: Some audits rated “Satisfactory with comments” have only minor issues and are comparable to “satisfactory”.

• No engagements rated 3 or 4 had fewer than 2 deficiencies.

• Secondary Analysis: AQREV = 1 for engagements receiving “Unqualified Satisfactory” (RATING=1) plus the subset of engagements receiving “Satisfactory with Comments” (RATING=2) that had less than 2 deficiencies .

Audit Quality by Industry

AQ=1 AQREV=1

N

Financial 57% 63% 68

Health care

30% 44% 27

CIB/ICE 38% 52% 170

N=112 (42%)

N=143 (54%)

265

Test Variables: Tenure

• Dummy FIRST = 1 for first year clients; 0 otherwise

• Supplementary analyses:

▫Continuous tenure

▫Non-linear (alternative cut-offs, tenure squared etc)

Test Variables: NAS

• Classify NAS by type:▫Tax services (TAX)▫Management Advisory Services (MAS)▫Services relating to new securities offerings

(OFFER)▫Services relating to M&A activities (MA)▫Other (OTHER)

• Scale fees by the square root of total assets:▫TAXFEESQRT▫MASFEESQRT▫OFFRFEESQRT▫OTHFEESQRT (includes MA + OTHER)

Empirical Specification

AQ/AQREV= a0 + a1(LAST) +a2(PUB) + a3(ROMM) + a4(LEV) + a5(FIRST) + a6(TAXFEESQRT) +

a7(MASFEESQRT) + a8(OFFRFEESQRT) + a9(OTHFEESQRT) + u

whereLAST = natural log of total assets.LEV = long-term debt divided by total assets.ROMM = 1 if the assessed risk of material

misstatement at the overall financial statement level is moderate or high, 0 otherwise.

PUB = 1 if the client is publicly-listed, 0 otherwise.

Tenure Results: Table 4, Panel A

AQ AQREVIndependent Variables Coeff. p-value Coeff. p-valueConstant 3.8899 0.010 2.945 0.044FIRST -0.624 0.019 -0.6741 0.009TAXFEESQRT -0.014 0.509 -0.0229 0.252MASFEESQRT -0.002 0.942 -0.0208 0.515OFFRFEESQRT 0.0337 0.256 0.1917 0.023OTHFEESQRT -0.03 0.483 -0.0553 0.201

ControlsLAST -0.15 0.046 -0.0954 0.185PUB -0.456 0.085 -0.3466 0.181ROMM -0.235 0.369 -0.1823 0.475LEV -1.02 0.009 -0.5119 0.098

Tenure Results: Table 4, Panel BAQ AQREV

Independent Variables Coeff. p-value Coeff. p-value

Constant 4.2578 0.049 4.627 0.027

FIRST -0.7492 0.046 -0.848 0.019

TAXFEESQRT -0.0016 0.961 0.003 0.933

MASFEESQRT 0.9603 0.015 1.061 0.042

OFFRFEESQRT 0.0268 0.330 0.159 0.083

OTHFEESQRT -0.0359 0.541 -0.066 0.260

Controls

LAST -0.1868 0.089 -0.18 0.084

ROMM -0.7722 0.043 -0.56 0.128

LEV -0.6377 0.325 -0.637 0.312

Tenure Results: Table 5, Panel AAQ AQREV


Constant 8.9054 0.001 4.9524 0.012

FIRST -0.7596 0.029 -0.824 0.012

TAXFEESQRT -0.015 0.588 -0.042 0.128

MASFEESQRT 0.454 0.016 0.6088 0.021

OFFRFEESQRT 0.0205 0.442 0.1971 0.077

OTHFEESQRT 0.0595 0.306 0.0328 0.571

Controls

LAST -0.4187 0.001 -0.183 0.068

PUB -0.4674 0.227 -0.541 0.147

ROMM 0.0709 0.843 0.2493 0.462

LEV -1.2122 0.044 -1.161 0.044

Tenure Results: Table 5, Panel BAQ AQREV


Constant 6.5906 0.015 4.3151 0.074

FIRST -0.6969 0.110 -2.1121 0.035

TAXFEESQRT -0.0034 0.925 -0.0226 0.515

MASFEESQRT 1.252 0.036 1.6758 0.111

OFFRFEESQRT 0.0216 0.411 0.1789 0.125

OTHFEESQRT 0.0127 0.850 0.0115 0.870

Controls

LAST -0.3202 0.023 -1.2664 0.295

ROMM -0.2861 0.529 -0.3225 0.747

LEV -0.9892 0.228 -1.883 0.06

Tenure: Additional Analyses

• Add dummy LONG = 1 if tenure ≥9 years ▫LONG is not significant

• Use TENURE and TENURE squared▫TENURE w/o including the square term is

positive and marginally significant▫TENSQ not significant▫ no evidence of a non-linear relationship

• Define SHORT as tenure ≤ 3▫Not significant

• Exclude AA clients▫ FIRST no longer significant (power?)

Additional Analysis: Lowballing/Effort• Audit intensity = labor hours by ranks divided by

assets• Audit Fees = f(FIRST, controls) (Bell et al. 2008)• Audit intensity = f(FIRST, controls)

• Results: Evidence of lowballing, but audit intensity is higher for first year engagements

• Interpretation: • Competitive pressures lead to low initial fees.• Increased intensity suggests auditors lack

knowledge of the client in the initial year and will obtain this knowledge in spite of lowballing (Schelleman and Knechel, 2010).

• Initial audits still likely to be lower quality.

NAS Results: Table 4, Panel A

AQ AQREVIndependent Variables Coeff. p-value Coeff. p-valueConstant 3.8899 0.010 2.945 0.044FIRST -0.624 0.019 -0.6741 0.009TAXFEESQRT -0.014 0.509 -0.0229 0.252MASFEESQRT -0.002 0.942 -0.0208 0.515OFFRFEESQRT 0.0337 0.256 0.1917 0.023OTHFEESQRT -0.03 0.483 -0.0553 0.201

ControlsLAST -0.15 0.046 -0.0954 0.185PUB -0.456 0.085 -0.3466 0.181ROMM -0.235 0.369 -0.1823 0.475LEV -1.02 0.009 -0.5119 0.098

NAS Results: Table 4, Panel BAQ AQREV


Constant 4.2578 0.049 4.627 0.027

FIRST -0.7492 0.046 -0.848 0.019

TAXFEESQRT -0.0016 0.961 0.003 0.933

MASFEESQRT 0.9603 0.015 1.061 0.042

OFFRFEESQRT 0.0268 0.330 0.159 0.083

OTHFEESQRT -0.0359 0.541 -0.066 0.260

Controls

LAST -0.1868 0.089 -0.18 0.084

ROMM -0.7722 0.043 -0.56 0.128

LEV -0.6377 0.325 -0.637 0.312

NAS Results: Table 5, Panel AAQ AQREV


Constant 8.9054 0.001 4.9524 0.012

FIRST -0.7596 0.029 -0.824 0.012

TAXFEESQRT -0.015 0.588 -0.042 0.128

MASFEESQRT 0.454 0.016 0.6088 0.021

OFFRFEESQRT 0.0205 0.442 0.1971 0.077

OTHFEESQRT 0.0595 0.306 0.0328 0.571

Controls

LAST -0.4187 0.001 -0.183 0.068

PUB -0.4674 0.227 -0.541 0.147

ROMM 0.0709 0.843 0.2493 0.462

LEV -1.2122 0.044 -1.161 0.044

NAS Results: Table 5, Panel BAQ AQREV


Constant 6.5906 0.015 4.3151 0.074

FIRST -0.6969 0.110 -2.1121 0.035

TAXFEESQRT -0.0034 0.925 -0.0226 0.515

MASFEESQRT 1.252 0.036 1.6758 0.111

OFFRFEESQRT 0.0216 0.411 0.1789 0.125

OTHFEESQRT 0.0127 0.850 0.0115 0.870

Controls

LAST -0.3202 0.023 -1.2664 0.295

ROMM -0.2861 0.529 -0.3225 0.747

LEV -0.9892 0.228 -1.883 0.060

NAS: Additional Analyses

• Consider total NAS fees▫ No significant results

• Use dummy variables for each type of NAS▫ Results are qualitatively similar to primary results

• Exclude AA clients▫ Results are qualitatively similar to primary results

Conclusions• First year audits are more likely to be of lower audit

quality, but the lower audit quality does not extend beyond the first year.

• Evidence that the lower quality in first year audits is due to lack of client specific knowledge.

• Some types of NAS provide benefits to audit quality• Regulatory implications:

• Provides little support for mandatory rotation, which may increase costs and reduce audit effectiveness.

• Regarding NAS, our results suggest a more nuanced approach rather than outright prohibition

audit firm tenure, non-audit services and internal assessments of audit quality t. bell, m....

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