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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