The Effects of Significant Changes in
Auditor Clientele and Auditor-Client
Mismatches on Audit Quality
Kenneth L. Bills
University of Oklahoma
May 2012
Presentation Overview
• Research Topic
• Regulatory Concerns
• Hypothesis Development
• Methodology and Results
Research Topic
Research Topic
Regulators’ Concerns
Mandatory Audit Firm Rotation
•
•
•
•
Arguments For
Arguments Against
↑ Auditor Independence
↑ Audit Firm Competition
Fresh Viewpoint
Concern about what New
Audit Firm will Find
• Forced Switch from Most
Experienced Audit Firm
• Company-Specific
Knowledge is a GOOD Thing
• Cost to Companies is
Burdensome
Additional Potential Concerns
• 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
Mandatory Audit Firm Rotation
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
Regulators’ Concerns
Contingency Planning for Significant Changes in
Audit Firm Capacity in a Geographic Area
2008 Technical Committee Report
International Association of Securities and Exchange
Commissions (IOSCO)
Strained and Excess Capacity
• 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
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);
Steps to Reduce Strained or Excess
Capacity
•
•
•
•
•
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
Hypothesis
Development
Hypotheses – Audit Quality
• Production Economics Literature
– Maintaining Delivery Dependability and Quality is More
Difficult in Tightly Constrained Systems
• Lovelock (1984) and Sridharan (1998)
Components of
Service Quality
(Parasuraman et al. 1985)
Audit Quality
(DeAngelo 1981)
Competence
Probability that Auditor will Detect
Material Misstatement
Credibility 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
Reduce Risk
Failure
to
Detect
Failure
to
Report
Type I
Error
Don't Issue GC
Opinion
Proper
Proper
Judgment
Judgment
Poor
Judgment
Relationship
Concerns
Failure
to
Detect
Failure
to
Report
Type II
Error
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
Hypothesis – Audit Firm Size
• 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.
Hypotheses – Portfolio Management Decisions
• 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 – Mismatches and Audit Quality
• 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.
Methodology- H1
• Estimate the Following Model Under Two
Specifications
+/-
+/-
ERRORit = μ0 + μ1STRAINft + μ2EXCESSft + μ3LATit + μ4Zit + μ5ΔZit + μ6AFEESit
+ μ7NFEESit + μ8GDPit + μ9ΔGDPit + μjYearit + εit
ERRORit
= 1 if a Type I error occurred, 0 otherwise;
= 1 if a Type II error occurred, 0 otherwise;
• Null Hypotheses: μ1 = 0 , μ2 = 0
Methodology- H2
• Add to Each of the Models
LGAUDITORi
1 if company i is audited by a Big 4 or second-tier audit firm, 0 otherwise;
• Add an Interaction of LGAUDITOR with Each Variable
of Interest
• Test Significance
– LGAUDITOR*STRAIN & LGAUDITOR*EXCESS
Results of Going-Concern Opinion Error Test
Methodology- H1
• Estimate the Following Model
+/-
+/-
ABSPDAit = β0 + β1STRAINft + β2EXCESSft + β3LTAit + β4CFOit + β5LEVit +
β6MKTBKit + βjYeart + εit
ABSPDAit
Absolute value of performance-matched (Kothari et al. 2005) modified
Jones model (Dechow et al. 1995)
• Null Hypotheses: β1 = 0 , β2 = 0
Results of Discretionary Accruals Test
December and Non-December Year End
Methodology- H3
• Sample Restricted to First Year Audit Engagements
• Estimate the Following Model Under Two Specifications
+ σ STRAIN
+
MISMATCH(1 or 2)ft = σ0 1
ft + σ2EXCESSft + σ3AFEESit + σ4NFEESit
+ σ5GDPit + σ6ΔGDPit + σ7HERFft + σkYeart + εit
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;
• Hypotheses = σ1 < 0 , σ2 > 0
Results of Mismatch Test
Methodology- H4
• Estimate the Following Model
+
-
ABSPDAit = λ0 + λ1MISMATCH1ft + λ2MISMATCH2ft + λ3LTAit + λ 4CFOit
+ λ5LEVit + λ5MKTBKit + λjYeart + εit
ABSPDAit
Absolute 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;
• Hypotheses = λ1 = 0 , λ2 = 0
Results of Discretionary Accruals-Mismatch Test
Conclusion
• Audit Quality may be Negatively Affected by Strained and
Excess Capacity
• The Negative Effect of Strained Capacity is Less for Larger
Audit Firms
Conclusions Continued…
• 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.
Thank You for Your Comments