Month: November 2016

Last week I discussed interesting research papers presented at the PCAOB’s Center for Economic Analysis third annual Economic Conference on Auditing and Capital Markets.  In order to make this topic a little more enjoyable, I have divided up the presented papers into two posts.  Today’s post, part two, will focus on the remaining three research papers presented at the conference.

Research presented

Following is the abstract from each research paper:

1. Assessing Initiatives to Improve the Quality of Group Audits Involving Other Auditors

One of the major current concerns of regulators internationally is the quality of the auditing of multinational groups, particularly those involving the coordination by the principal auditor of other auditors.  These concerns resulted in changes to the international auditing standard on group audits, International Standards on Auditing (ISA) No. 600, which are consistent with current initiatives being considered by the PCAOB.  The researchers examined audit quality pre and post-ISA 600 to help inform the International Auditing and Assurance Standards Board (IAASB) as to the efficacy of the ISA 600 amendments and inform the PCAOB with regard their similar initiatives under consideration.  The researchers made use of unique Australian disclosures which allowed them to identify the nature and extent of involvement of other auditors in group audits.  They found that the revisions to ISA 600 have contributed to an improvement in audit quality, specifically for clients of non-Big N (e.g., Big 4) auditors.  Further, they found that the quality of multi-national enterprise (MNE) group audits involving other auditors from the same network is lower, and this appears not to be affected by the ISA 600 revisions.  Consistent with regulatory concerns, the researchers also examined whether there are any incremental costs for group audits involving other auditors.  While the researchers found that group audits involving other auditors are more costly, they did not find evidence of an increase in audit fees associated with these regulatory initiatives.

2. The benefits and costs of Sarbanes-Oxley Section 404(b) exemption: Evidence from small firms’ internal control disclosures

The authors investigated the benefits and costs of exempting firms from auditor oversight of internal control effectiveness disclosures (Section 404(b) of the Sarbanes-Oxley Act of 2002), which I touched on in a previous post.  They measured the benefit of exemption with audit fee savings, which the authors estimated to be an aggregate $388 million from 2007 to 2014 for their sample of exempt firms.  The key concern of exemption is internal control misreporting (i.e., firms with ineffective internal controls disclose effective internal controls).  Misreporting imposes at least two measurable costs on current and prospective shareholders: lower operating performance due to non-remediation, and market values that fail to reflect a firm’s underlying internal control status.  The authors calculated the cost of 404(b) exemption from 2007 to 2014 to be an aggregate $856 million in lower future earnings due to non-remediation, and a $935 million delay in aggregate market value decline due to untimely internal control disclosure. Although the aggregate costs of exemption exceed the benefits, the costs are borne by shareholders of only a fraction of exempt firms, whereas the audit fee savings are shared by all.

In addition to yielding evidence on the benefits and costs of internal control disclosure regulation, their study provides a prediction model for identifying the firms most at risk of inaccurately disclosing internal controls.  The prediction model predicts that approximately 20.2% of exempt firms should disclose ineffective internal controls, whereas only 10.9% do so.  Thus, the authors infer that 46% of exempt firms that maintain ineffective internal controls fail to discover or disclose it.

3. Tell Me More: A Content Analysis of Expanded Auditor Reporting in the United Kingdom

This study examined the effect of expanded audit disclosures required by ISA 700 (UK and Ireland), The Independent Auditor’s Report on Financial Statements, on the communication value of the audit report.  Using content analysis measures, readability and tone, as proxies for communication value, the author found that in the post-ISA 700 period: 1) audit report readability improves and 2) audit report tone changes with a higher occurrence of negative and uncertain words.  The author also evaluated analyst behavior in response to the ISA 700 audit report and found that analyst forecast dispersion decreased in the post-ISA 700 period.  In additional analyses, the author showed that Big N and industry expert auditors wrote audit reports that are more readable.  The author also found that domain-specific word dictionaries, generated from SEC Form-10K’s and earnings press releases, have a lower frequency in audit reports in both the pre and post-ISA 700 period.

With the heightened global interest in improving the historical pass/fail audit report, these results show that expanded audit disclosures can be communicated in a manner that is accessible and meaningful to the financial statement user.

In summary

Again, we find similar take-aways from these academic papers, which shed light on the impact that professional standards have on audit firms and their clients.

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A few weeks ago the PCAOB’s Center for Economic Analysis (CEA) held its third annual Economic Conference on Auditing and Capital Markets.  Some readers may be yawning by now.  In reality, this conference is an important way that the PCAOB brings together academic researchers and audit policymakers to look at the effectiveness of audit standards and practices.  Moreover, the academic research prepared for and presented at this conference helps to identify the economic impact of auditing on the capital markets.

Of interest is that there were six research papers presented at the conference, selected from a total of 83 papers submitted.  These six papers were selected for presentation following a review by a committee of leading academics assembled by the editorial board of the Journal of Accounting Research and Luigi Zingales, the Center’s Founding Director and the Robert C. McCormack Professor of Entrepreneurship and Finance and the David G. Booth Faculty Fellow at the University of Chicago Booth School of Business.

Today’s post will discuss some interesting research findings from three of these six research papers along with what this research might mean for the future auditing and audit standards.  In a future post I will discuss interesting findings from the remaining three research papers presented to make it a little more palatable.

Research presented

The authors of the following research papers include university professors both within and outside of the United States.  Following is the abstract from each research paper:

1. Is Audit Behavior Contagious? Teamwork Experience and Audit Quality by Individual Auditors

This paper discussed how bad audit behavior is transmitted through the teamwork experience of individual auditors.  The researchers found that auditors who have previously worked in a team (team auditors) with those who are sanctioned by the regulators for audit failure (contagious auditors) are more likely to issue lenient audit opinions, and their audited accounting numbers are more likely to be downward restated in the future, compared to those who have no overlap with contagious auditors in their teamwork experience.  This contagion effect is, however, absent among auditors who previously worked in the same audit firm but not in the same team (colleague auditors) as contagious auditors.  The researchers’ findings highlight the importance of analyzing social learning via teamwork experience in understanding how audit quality at the individual level is shaped.  To note is that the research populations were associated with Chinese individuals and businesses, including stock market activity of publicly traded firms listed in the Shanghai or Shenzhen Stock Exchanges and sanctions imposed by the China Securities Regulatory Commission.

Certainly, this research puts back in the spotlight the recently adopted PCAOB rule requiring audit firms to disclose the name of the engagement partner, among other things.  This PCAOB rule takes effect in 2017.

2. Do Auditors Correctly Identify and Assess Internal Control Deficiencies? Evidence from the PCAOB Data

The researchers found that auditors routinely fail to disclose material weaknesses prior to a material error (i.e., restatements).  One potential reason is that auditors misclassify the severity of identified internal control deficiencies due to complexity in judging the materiality and likelihood of potential related errors.  Another reason is that auditors face disincentives to report a material weakness without a clear indication of an existing error.  The paper evaluated these possibilities using a proprietary database on auditor-identified control deficiencies that are not deemed material weaknesses, hence not publicly disclosed.  The authors then compared the severity of the control deficiency with the severity of ex-post reporting errors.  Even though the authors found some evidence consistent with auditor and management incentives to misclassify material weaknesses as less serious deficiencies, the authors generally found that 1) the severity of identified control deficiencies is properly assessed and 2) the auditor is able to provide reasonable assurance about whether financial statements are materially misstated in the presence of identified deficiencies.  Their evidence indicates that the inability of auditors to properly identify relevant internal controls is a contributing reason why material weaknesses are not discovered and disclosed prior to material error restatements.

With this in mind, readers may find of interest a former blog post wherein I discussed the SEC cracking down on a publicly-traded company for ineffective ICFR, even though there were no material misstatements in its financial statements at the time.

To sum up a critical finding from this research, Martin Baumann, Chief Auditor at the PCAOB, stated in a 2010 speech:

It has been observed that disclosures of material weaknesses, which should be a leading indicator of potential financial reporting problems, have instead become a lagging indicator.  That is, Material Weaknesses seem to be reported, generally, only in connection with a restatement – where the material weakness is often obvious.  In many cases a material weakness likely existed before the restatement as well, but unfortunately the ICFR audits are often not identifying them.

3. Auditors With or Without Styles? Evidence from Unexpected Auditor Turnovers

Using unexpected auditor turnovers as a quasi-experiment, in this study the authors examined whether individual auditors exhibit a significant impact on audit quality.  More specifically, focusing on auditor turnovers precipitated by the incumbent auditor’s sudden death or by resignation due to health issues or a career change, they investigated audit quality changes surrounding these unexpected events.  While the authors found some evidences that unexpected auditor turnovers are associated with significant audit quality changes for non-Big 4 audit firms, this is not the case for auditor turnovers at Big 4 firms even though there are greater differences in personal characteristics between outgoing and successor auditors in Big 4 firms. This finding suggests that notwithstanding differences in auditors’ personal characteristics, standardized audit procedures and strong internal controls can constrain individual auditors in large audit firms from impacting audit quality.

Because data on disclosures of signing audit partners does exist in Taiwan, the authors relied on financial data and the names of signing audit partners for all public firms from the Taiwan Economic Journal.  In my view it will be interesting to research this topic using U.S. data once the PCAOB’s rule on audit firm disclosures is in full effect.

In summary

The take-aways from these academic papers impact a number of areas for auditors (including their audit clients).  These include, among other things, the timely identification and assessment of risks of material misstatement, internal control deficiencies, and audit team culture and influence.  Stay tuned for a future post wherein I will discuss interesting take-aways from the remaining three research papers.

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