The Effects of Significant Changes in Auditor Clientele and Auditor-Client
Mismatches on Audit QualityKenneth L. BillsUniversity of Oklahoma
May 2012
Presentation Overview
• Research Topic
• Regulatory Concerns
• Hypothesis Development
• Methodology and Results
Strained Capacity at Local Audit Offices
Excess Capacity at Local Audit Office
Audit Quality
Portfolio Management Decisions
Research Topic
Audit Firm Size
Research Topic
Auditor-ClientMismatches Audit Quality
Mandatory Audit Firm Rotation
Regulators’ Concerns
Arguments For• ↑ Auditor Independence• ↑ Audit Firm Competition• Fresh Viewpoint• Concern about what New
Audit Firm will Find
Arguments Against• Forced Switch from Most
Experienced Audit Firm• Company-Specific
Knowledge is a GOOD Thing• Cost to Companies is
Burdensome
• Increased Frequency of Auditor Changes May – Disrupt Audit Firms’ Operations– Interfere with their Ability to Focus on Perform High Quality Audits
• Audit Firms May Not Have the Capacity to Assign Appropriately Qualified Personnel to New Engagements
• Rotation Requirement May Limit a Company’s Choice of Auditor
Additional Potential Concerns
Volatility in Audit Firms’ Clientele Portfolios
Strained or Excess Audit Firm Capacity
Audit Quality
Mandatory Audit Firm Rotation
Mandating Auditor Changes &
Limiting a Company’s Choice in Audit Firm
Auditor-Client “Mismatches”
Audit Quality
Mandatory Audit Firm Rotation
Contingency Planning for Significant Changes in Audit Firm Capacity in a Geographic Area
2008 Technical Committee ReportInternational Association of Securities and Exchange
Commissions (IOSCO)
Regulators’ Concerns
• Causes
– External Shocks to the Audit Market
– Changes in Capacity Inputs
– Changes in Capacity Outputs
Strained and Excess Capacity
Significant Changes in Local Audit Office Clientele
Strained and Excess Capacity
STRAINft = 1 if company i’s auditor was in the top decile of audit firms having an increase in metropolitan statistical area (MSA) total sales audited (t-2) to (t-1);
EXCESSft = 1 if company i’s auditor was in the bottom decile of audit firms having a decrease in MSA total sales audited from the prior year (t-2) to (t-1);
• Hiring/Firing Employees• Hiring/Firing Clients• Use of Built in Cushion• Use of Flexible Capacity (Overtime, Outsourcing)• Transferring Employees (Larger Audit Firms)
May Be Insufficient for Extreme Changes in Clientele
Steps to Reduce Strained or Excess Capacity
Hypothesis Development
• Production Economics Literature– Maintaining Delivery Dependability and Quality is More
Difficult in Tightly Constrained Systems• Lovelock (1984) and Sridharan (1998)
Hypotheses – Audit Quality
Components of Service Quality
(Parasuraman et al. 1985)Audit Quality
(DeAngelo 1981)Competence Probability that Auditor will Detect
Material MisstatementCredibility and Reliability Probability that Auditor will Report
Material Misstatement
Hypotheses – Audit Quality
Auditor Opinion
Factor Driving Auditor Opinion
Audit Quality Failure
(DeAngelo1981a)
Error Type
Issue GC Opinion
Proper Judgment
Poor Judgment
Failure to
Detect
Type I Error
Reduce Risk
Failure to
Report
Don't Issue GC Opinion
Proper Judgment
Poor Judgment
Failure to
Detect
Type II Error
Relationship Concerns
Failure to
Report
Reduce RiskPoor
JudgmentRelationship
ConcernsProper
JudgmentProper
JudgmentProper
JudgmentProper
Judgment
Hypotheses – Audit Quality
H1: Companies audited by local audit offices with strained (excess) capacity will have audit quality similar to companies audited by local audit offices
without strained (excess) capacity.
Hypotheses – Audit Quality• Discretionary Accruals Model
– Modified Jones Model (Dechow et al. 1995)– Kothari et al. (2005) Performance Matched– Absolute Value
• A Broad Measure of Audit Quality
• Reputational Concerns– “More to Lose” (DeAngelo 1981)– National Office
• Established Client-Acceptance Procedures• Established Audit Performance Standards
• Ability to Transfer Personnel– Greater Flexibility to Reduce Excess and Strained
Capacity
Hypothesis – Audit Firm Size
H2: The effects of strained (excess) capacity on audit quality will be smaller for Big 4 and second-tier audit firms than for other firms.
Hypothesis – Audit Firm Size
• Strained Capacity– Ability to Discriminate Among Clients ↑– Select “Most Preferred” Clients
• Excess Capacity– Need to Fill Capacity– Client Acceptance Criteria May be Loosened
Hypotheses – Portfolio Management Decisions
• Shu (2000) and Landsman et al. (2009)– Mismatches Occur when Large Audit Firms Align with Clients Typically
Served by Smaller Audit Firms and Vice Versa– Mismatches Are Not Preferred
H3: Auditor-client mismatches are less (more) likely to occur when an audit firm has strained (excess) capacity.
Hypotheses – Portfolio Management Decisions
• Mandatory Auditor Rotation may Increase the Occurrence of Mismatches– Especially where there are Few or No Viable Alternatives
• Large Audit Firms Correlated with Higher Audit Quality– Francis et al. (1999), Becker et al. (1998) , etc.
• Correlation Goes Away when Matched Sample Design is Used– Lawrence et al. 2011 TAR
Hypotheses – Mismatches and Audit Quality
H4a: Auditor-client mismatches where clients expected to be served by large audit firms are served by small audit firms have lower audit quality than where no mismatches are present.
H4b: Auditor-client mismatches where clients expected to be served by small audit firms are served by large audit firms have higher audit quality than where no mismatches are present.
Hypotheses – Mismatches and Audit Quality
• Estimate the Following Model Under Two Specifications
ERRORit = μ0 + μ1STRAINft + μ2EXCESSft + μ3LATit + μ4Zit + μ5ΔZit + μ6AFEESit + μ7NFEESit + μ8GDPit + μ9ΔGDPit + μjYearit + εit
• Null Hypotheses: μ1 = 0 , μ2 = 0
Methodology- H1
ERRORit= 1 if a Type I error occurred, 0 otherwise;= 1 if a Type II error occurred, 0 otherwise;
+/- +/-
• Add to Each of the Models
• Add an Interaction of LGAUDITOR with Each Variable of Interest
• Test Significance – LGAUDITOR*STRAIN & LGAUDITOR*EXCESS
Methodology- H2
LGAUDITORi 1 if company i is audited by a Big 4 or second-tier audit firm, 0 otherwise;
Results of Going-Concern Opinion Error Test
• Estimate the Following Model
ABSPDAit = β0 + β1STRAINft + β2EXCESSft + β3LTAit + β4CFOit + β5LEVit + β6MKTBKit + βjYeart + εit
• Null Hypotheses: β1 = 0 , β2 = 0
Methodology- H1
ABSPDAitAbsolute value of performance-matched (Kothari et al. 2005) modified Jones model (Dechow et al. 1995)
+/- +/-
Results of Discretionary Accruals Test
December and Non-December Year End
• Sample Restricted to First Year Audit Engagements• Estimate the Following Model Under Two Specifications
MISMATCH(1 or 2)ft = σ0 + σ1STRAINft + σ2EXCESSft + σ3AFEESit + σ4NFEESit
+ σ5GDPit + σ6ΔGDPit + σ7HERFft + σkYeart + εit
• Hypotheses = σ1 < 0 , σ2 > 0
Methodology- H3
MISMATCH1it= 1 if a client is audited by a small audit firm when it is expected to be
audited by a large audit firm, zero otherwise;
MISMATCH2it= 1 if a client is audited by a large audit frm when it is expected to be
audited by a small audit firm, zero otherwise;
+-
Results of Mismatch Test
• Estimate the Following Model
ABSPDAit = λ0 + λ1MISMATCH1ft + λ2MISMATCH2ft + λ3LTAit + λ 4CFOit
+ λ5LEVit + λ5MKTBKit + λjYeart + εit
• Hypotheses = λ1 = 0 , λ2 = 0
Methodology- H4
ABSPDAitAbsolute value of performance-matched (Kothari et al. 2005) modified Jones model (Dechow et al. 1995)
MISMATCH1it= 1 if a client is audited by a small audit firm when it is expected to be
audited by a large audit firm, zero otherwise;
MISMATCH2it= 1 if a client is audited by a large audit firm when it is expected to be
audited by a small audit firm, zero otherwise;
+ -
Results of Discretionary Accruals-Mismatch Test
• Audit Quality may be Negatively Affected by Strained and Excess Capacity
• The Negative Effect of Strained Capacity is Less for Larger Audit Firms
Conclusion
• Large Audit Offices with Strained Capacity are Less Likely to Accept New Clients that are Mismatches
• Small Audit Firms with Strained Capacity are More Likely to Accept New Clients that are Mismatches
• Mismatches may increase or decrease audit quality, depending on the size of the audit firm providing the audit.
Conclusions Continued…
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