Does the Organization and Culture of the Largest Audit ... · ANECDOTAL EVIDENCE ON THE INFLUENCE...

Does the Organization and Culture of the

Largest Audit Firms Influence their Audit

Quality and Efficiency?

October 14, 2016

Daniel Aobdia

Kellogg School of Management, Northwestern University

DISCLAIMERS

I completed this study while a Senior Economic Research

Fellow in the Center for Economic Analysis at the PCAOB

The PCAOB, as a matter of policy disclaims responsibility for

any private publication or statement by any of its Economic

Research Fellows and employees

The views expressed are my own and do not necessarily

reflect the views of the Board, its members, or staff of the

PCAOB

RESEARCH QUESTIONS

How much influence do audit firms’ quality control (QC)

systems, have on audit quality, audit efficiency, and audit

pricing (in the U.S.)?

Do all QC systems matter? Are some, such as culture and

audit tools, more important than others?

To answer these questions, use of a unique dataset: The

deficiencies identified by the PCAOB in the firms’ QC

systems (Part II Findings)

Is remediation of QC issues (identified by the PCAOB)

associated with better audit quality? Efficiency?

THEORETICAL BACKGROUND

ON THE ROLE OF QC SYSTEMS AND CULTURE

Only the audit opinion is observed, whereas effort is

unobservable, giving incentives to individual auditors to

shirk. This moral hazard can be reduced if mutual monitoring

takes place (Balachandran and Ramakrishnan 1987)

While audit firms have reputation and litigation incentives

to provide high quality audits, these incentives do not

necessarily apply to their individual employees

Company culture is relevant because employees will face

choices that cannot be properly regulated ex-ante, leading

culture to act as a safeguard (O’Reilly 1989, Kreps 1989,

Guiso et al. 2015)

ANECDOTAL EVIDENCE ON THE INFLUENCE

OF CULTURE AND QC SYSTEMS IN AN AUDIT FIRM:

ARTHUR ANDERSEN IN THE 90s / EARLY 2000s

The rise of consulting at Arthur Andersen led to a culture

change focusing on revenue to the detriment of audit quality,

contrary to the founder’s principles

This lead to several failed audits, including Boston

Chicken, Waste Management and Enron (Brown and

Dugan 2002, Eichenwald and Norris 2002, Richard and

Thurm 2002, Toffler and Reingold 2003, Wyatt 2004,

Gendron and Spira 2009)

Enron: The engagement team was able to overrule the

authority of their national specialists on the engagement

(Eichenwald and Norris 2002)

MOTIVATION

Despite theoretical predictions and anecdotal evidence, very limited

prior empirical literature about firm-wide QC systems

Francis 2011, p138: “Research on the relation between

accounting firms and audit quality is severely limited by the

availability of data on characteristics of accounting firms. To

date, research on this topic has relied on variables that can be

constructed from public disclosures such as client-based measures

of industry expertise or office size. However, these measures do

not go inside the “black-box” of the accounting firm’s

organizational structure and operations” Francis, 2011 p138

DeFond and Zhang 2014, p304: “We currently know little about

basic characteristics of audit firms such as their choice of

ownership structure, governance systems, audit quality control

systems, compensation schemes, or audit technology.”

MOTIVATION

The question is also informative about the role of the PCAOB

inspections of the firms’ QC systems, and the Part II Findings

From an audit quality standpoint: Given outside concerns,

do PCAOB inspections measure true deficiencies in audit

quality? Or only documentation issues?

Are the results in inspections of individual engagements (risk

based) generalizable to the remainder of the firm?

Does remediation of QC issues identified by the PCAOB

improve audit quality?

Are there some other undocumented potential benefits from

the PCAOB inspections process, besides potential

improvement in audit quality?

BACKGROUND ON PCAOB INSPECTIONS

The PCAOB (established by SOX) regularly inspects audit firms

that audit public companies (issuers)

Annual inspections for firms with more than 100 issuers and

triennial inspections for firms with less than 100 issuers

A typical PCAOB inspection incorporates two elements:

A review of selected portions of individual audit

engagements (chosen using a risk-based approach)

Deficiencies are called Part I Findings

A Part I Finding: The audit work is not sufficient to

support the audit opinion, based on applicable standards

A review of the audit firm’s quality control (QC) systems

Deficiencies are called Part II Findings

OVERVIEW OF THE PCAOB REVIEW OF

LARGE AUDIT FIRMS’ QC SYSTEMS

Eight Major Top-Down areas inspected by the PCAOB Based on specific analyses that focus on the firm’s QC policies, and

from inferences from review of individual engagements: Tone at the top (culture), partner management, Independence policies, Client acceptance / retention, Internal inspections, Audit methodology,

Policies related to foreign affiliates, Other practice monitoring

Audit 1 Audit 2 Audit 3 Audit 4 Audit 5 Audit 6

Audit Performance Deficiencies Identified from inspections of individual engagements

Inspection Of QC

Systems:

Inspection Of QC

Systems:

Inspection Of

individual audits:

AN EXAMPLE OF A PART I FINDING

FROM PUBLIC 2011 INSPECTION REPORT OF DELOITTE

1. Issuer A

In this audit, the Firm failed to identify a departure from generally accepted

accounting principles ("GAAP") that it should have identified and addressed

before issuing its audit opinion. Specifically, the issuer inappropriately

allocated to goodwill, rather than to a definite-lived intangible asset, a

portion of the purchase price of a group of assets.

In addition, the Firm failed to perform sufficient procedures to test the

valuation of goodwill for one of the issuer's segments. The issuer used

revenue and earnings projections in its evaluation of the possible impairment of

goodwill and, for this segment, the projected growth rates were significantly

higher than the issuer's recent historical results and projections for the issuer's

industry, which were included in the Firm's work papers. The Firm failed to

sufficiently test the projected growth rates for this segment. Specifically, the

Firm relied on controls related to the issuer's budget without testing the

effectiveness of controls over the development of the assumptions used in the

budget process, and the Firm failed to evaluate, beyond inquiry of

management, the reasonableness of the issuer's revenue and earnings

projections.

PART II FINDING SECTION

FROM 2011 INSPECTION REPORT OF DELOITTE

Section 104(g)(2) of SOX: All Part II Findings will remain

nonpublic if “remediated” within one year


FROM EXPANDED 2007 INSPECTION REPORT OF DELOITTE

A. Audit Performance

A firm's system of quality control should provide reasonable assurance that the

firm's audit work will meet professional standards and regulatory requirements. Not

every deficiency in an audit indicates that a firm's quality control system is

insufficient to provide that assurance, and this report does not discuss every

auditing deficiency observed by the inspection team. On the other hand, some

deficiencies, or repeated instances of a similar deficiency, may indicate a

potentially significant defect in a firm's quality control system even if the

deficiency has not resulted in an insufficiently supported audit opinion. As

described below, some deficiencies reported by the inspection team do suggest that

the Firm's system of quality control may in some respects fail to provide sufficient

assurance that the Firm's audit work will meet applicable standards and requirements.


FROM EXPANDED 2007 INSPECTION REPORT OF DELOITTE

A. Audit Performance

…

b. Management Estimates

The engagement reviews provide cause for concern that the Firm's system of

quality control may not do enough to assure that the Firm performs appropriate

procedures to audit significant estimates, including evaluating management's

assumptions and testing the data supporting the estimates. In addition to

seven engagements described in Part I.A, the inspection team identified eight

engagements (two of which are also discussed in Part I.A with respect to different

estimates) with deficiencies in the Firm's testing of management estimates.

Specifically -

…


FROM EXPANDED 2012 INSPECTION REPORT OF BDO

Deficiencies in Quality Controls Related to the Firm's Internal Inspection

Program

…

In 2012, the PCAOB inspection team inspected three audits that the internal

inspection team had reviewed, including two audits that the internal inspection team

had rated as "unsatisfactory." In each of these three audits, the PCAOB inspection

team identified one or more deficiencies that were not identified by the internal

inspectors but are of such significance that they are included in Part I.A of this

report. The inspection team identified a total of six such deficiencies in these audits

that were not identified by the internal inspectors, even though they had reviewed the

relevant area.

The above discrepancies may suggest that the Firm's internal inspection teams

do not always appropriately apply professional skepticism to the performance of

internal inspections or to the evaluation of the results of those inspections.

…

DATA AND SAMPLE

PCAOB data:

Part II Findings identified from nonpublic parts of the PCAOB

reports

Restricted to the U.S. operations of the largest eight audit

firms (Big 4, GT, BDO, McGladrey and Crowe Horwath) for

comparability purposes

Use of individual engagement inspection deficiencies (Part I

Findings) as one (but not the only one) measure of audit

quality

Audit hours for 2008 till 2012, for the U.S. engagements of

the largest auditors

Merged with S&P Compustat and Audit Analytics data (2004

till 2013) for measures of audit quality (restatements…), audit

fees, client switches and other control variables

MEASURE OF QC DEFICIENCIES

Word count in the Part II Section of the report

Split between audit performance deficiencies and others

(top-down) to determine whether they matter differently

Index of top-down deficiencies

Indices are commonly used in the academic literature (e.g.,

La Porta et al., 1998; Gompers et al., 2003; Bebchuk et al.,

2009; Garmaise, 2011)

Main concern: Remove any element of subjectivity in the measures

and use natural sections in each report

INDEX OF TOP DOWN QC DEFICIENCIES

One point is added to the index for each category if Part II Findings

are identified in the following areas

1. Tone at the top

2. Partner management

3. Independence policies

4. Client acceptance and retention policies

5. Internal inspection program

6. Audit policies, procedures and methodologies, and training

7. Policies related to foreign affiliates

8. (Other) practice monitoring

Index = 0: No major deficiencies in QC system (“good”)

Index = 8: Deficiencies identified in all categories of the index (“bad”)

Later on, separate Tone at the top and Audit methodology issues

and create a sub-index

PROPORTION OF FIRM-YEARS WITH DEFICIENCIES IN

Proportion of firm-years (%)

0 20 40 60 80 100

Tone at the top

Partner management

Independence policies

Client acceptance and retention policies

Internal inspection program

Audit policies, methodology and training

Policies related to foreign affiliates

(Other) practice monitoring

SUMMARY OF RESULTS

H1: An audit firm’s QC deficiencies are negatively associated with audit

quality

Negative association between QC issues and audit quality

For both “audit performance” and “top-down” deficiencies, including

tone at the top

H2: There is no association between audit firm’s QC deficiencies and audit

pricing

No relationship between QC issues and audit pricing

SUMMARY OF RESULTS

H3: There is no association between audit firms’ QC deficiencies and audit

efficiency

Positive association between top-down QC issues and audit hours

Consistent with “inefficiency” hypothesis

Mainly driven by tone and methodology issues

Additional results:

Some evidence that remediation improves audit quality and efficiency

Positive association between QC deficiencies and client switches

TYPICAL INSPECTION PROCESS TIMELINE

Year t-1 Year t Year t+1

End of Fiscal Year t-1

End of Audit Year t-1

Fieldwork (March to November) • Year t-1 audits inspected • QC systems at t? t-1? inspected

End of Fiscal Year t

End of Audit Year t

The analysis of the firm’s QC systems is related to the prior year’s

audits, but some analyses appear to use current information (in

contrast with the inspection of individual audits)

Use the deficiencies in the firm’s QC systems identified in

Year t for audit quality and efficiency measured in Year t

(results also robust if look at Year t-1 output variables)

Also use the inspection findings identified in Year t+1 for the

Year t audits as a measure of audit quality (different year)

Fieldwork (March to November) • Year t audits inspected • QC systems at t? t+1? inspected

RESEARCH DESIGN:

CROSS-SECTIONAL REGRESSION

For several measures (audit quality, hours, fees), run the

following regression

Measure = α + β.QC Issues + γ.Controls + ε

QC issues: Number of words (audit performance and others) in

report, QC Index, Reduced Index, Tone, Methodology

Measures of audit quality (see Aobdia 2015): Restatements,

propensity to meet/beat the zero earnings threshold, accruals,

Part I Findings (for inspected engagements the following year)

Extensive battery of controls, including year fixed effects (results

are not particularly sensitive to inclusion)

AUDIT QUALITY RESULTS (*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding |Accruals/CFO|

Number_Words 0.202*** 0.077*** 0.220*** -0.032

[5.905] [2.784] [3.288] [-0.901]

Year Fixed Effects Yes Yes Yes Yes

Control Variables Yes Yes Yes Yes

Observations 27,837 27,837 2,452 27,837

Pseudo R-squared 0.038 0.087 0.101

Adjusted R-squared 0.134

Clustering Issuer Issuer Issuer Issuer

Model Logistic Logistic Logistic OLS



Number_Words 0.202*** 0.077*** 0.220*** -0.032

[5.905] [2.784] [3.288] [-0.901]


Control Variables Yes Yes Yes Yes

Observations 27,837 27,837 2,452 27,837



Clustering Issuer Issuer Issuer Issuer

Model Logistic Logistic Logistic OLS



Number_Words_Perf 0.208*** -0.000 0.135* -0.050

[5.459] [0.003] [1.860] [-1.333]

Reduced_QC_Index -0.003 0.030* 0.095** 0.044**

[-0.134] [1.824] [2.260] [2.128]

Tone 0.026 0.098** -0.014 -0.026

[0.430] [1.838] [-0.093] [-0.408]

Methodology 0.139** 0.126** 0.233* -0.009

[2.328] [2.426] [1.668] [-0.137]

Full Set of Controls Yes Yes Yes Yes


Observations 27,837 27,837 2,452 27,837






[5.459] [0.003] [1.860] [-1.333]

Reduced_QC_Index -0.003 0.030* 0.095** 0.044**

[-0.134] [1.824] [2.260] [2.128]

Tone 0.026 0.098** -0.014 -0.026

[0.430] [1.838] [-0.093] [-0.408]

Methodology 0.139** 0.126** 0.233* -0.009

[2.328] [2.426] [1.668] [-0.137]



Observations 27,837 27,837 2,452 27,837






[5.459] [0.003] [1.860] [-1.333]

Reduced_QC_Index -0.003 0.030* 0.095** 0.044**

[-0.134] [1.824] [2.260] [2.128]

Tone 0.026 0.098** -0.014 -0.026

[0.430] [1.838] [-0.093] [-0.408]

Methodology 0.139** 0.126** 0.233* -0.009

[2.328] [2.426] [1.668] [-0.137]



Observations 27,837 27,837 2,452 27,837



AUDIT HOURS RESULTS (*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables:

Audit

Hours

Partner

Hours

EQR

Hours

Fees per

Hour

Number_Words_Perf -0.071*** -0.133*** -0.229*** 18.522***

[-8.829] [-14.468] [-27.969] [10.979]

Reduced_QC_Index -0.000 0.038*** 0.039*** 1.386

[-0.085] [7.232] [8.899] [1.134]

Tone 0.125*** 0.136*** 0.279*** -33.041***

[10.402] [8.003] [19.761] [-10.841]

Methodology 0.092*** 0.075*** 0.048*** -18.401***

[6.553] [4.928] [3.458] [-5.574]



Observations 13,802 13,793 13,698 13,802

Adjusted R-squared 0.735 0.578 0.384 0.095



Audit

Hours

Partner

Hours

EQR

Hours

Fees per

Hour


[-8.829] [-14.468] [-27.969] [10.979]

Reduced_QC_Index -0.000 0.038*** 0.039*** 1.386

[-0.085] [7.232] [8.899] [1.134]

Tone 0.125*** 0.136*** 0.279*** -33.041***

[10.402] [8.003] [19.761] [-10.841]

Methodology 0.092*** 0.075*** 0.048*** -18.401***

[6.553] [4.928] [3.458] [-5.574]



Observations 13,802 13,793 13,698 13,802




Audit

Hours

Partner

Hours

EQR

Hours

Fees per

Hour


[-8.829] [-14.468] [-27.969] [10.979]

Reduced_QC_Index -0.000 0.038*** 0.039*** 1.386

[-0.085] [7.232] [8.899] [1.134]

Tone 0.125*** 0.136*** 0.279*** -33.041***

[10.402] [8.003] [19.761] [-10.841]

Methodology 0.092*** 0.075*** 0.048*** -18.401***

[6.553] [4.928] [3.458] [-5.574]



Observations 13,802 13,793 13,698 13,802


EVIDENCE ON REMEDIATION: AUDIT QUALITY (*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding ScaledAccrualsCFO

Number_Words 0.189*** 0.074*** 0.157** -0.032

[5.433] [2.630] [2.219] [-0.853]

Proportion_Remediated -0.401** 0.011 -2.454*** 0.135

[-2.284] [0.072] [-5.369] [0.623]



Observations 23,572 23,572 2,089 23,572

Adjusted/Pseudo R-squared 0.032 0.085 0.126 0.136

EVIDENCE ON REMEDIATION: AUDIT QUALITY (*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Restatement Meet/Beat PartIFinding ScaledAccrualsCFO

Number_Words 0.189*** 0.074*** 0.157** -0.032

[5.433] [2.630] [2.219] [-0.853]

Proportion_Remediated -0.401** 0.011 -2.454*** 0.135

[-2.284] [0.072] [-5.369] [0.623]



Observations 23,572 23,572 2,089 23,572


EVIDENCE ON REMEDIATION: AUDIT HOURS (*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Logaudithours Logpartnerhours Logeqrhours Fees_per_hour

Number_Words -0.003 -0.056*** -0.061*** 1.192

[-0.580] [-7.487] [-9.684] [0.934]

Proportion_Remediated -0.075*** -0.135*** 0.129*** 16.750***

[-3.235] [-4.555] [4.237] [3.399]



Observations 13,802 13,793 13,698 13,802


EVIDENCE ON REMEDIATION: AUDIT HOURS (*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Logaudithours Logpartnerhours Logeqrhours Fees_per_hour

Number_Words -0.003 -0.056*** -0.061*** 1.192

[-0.580] [-7.487] [-9.684] [0.934]

Proportion_Remediated -0.075*** -0.135*** 0.129*** 16.750***

[-3.235] [-4.555] [4.237] [3.399]



Observations 13,802 13,793 13,698 13,802


CLIENT SWITCHES RESULTS (*: Statistically significant at 10%, **: 5%, ***, 1%)

Dependent Variables: Switch Switch Switch Switch

Number_Words_Perf 0.142*** 0.136*** 0.111** 0.105*

[2.721] [2.597] [2.050] [1.915]

QCIndex 0.090*** 0.080***

[3.349] [3.000]

Reduced_QC_Index 0.071** 0.062**

[2.503] [2.190]

Methodology 0.265*** 0.247***

[3.036] [2.803]

Tone 0.113 0.111

[1.450] [1.419]

Full Set of Controls No Yes No Yes

Reduced Set of Controls Yes No Yes No


Observations 25,675 25,675 25,675 25,675

Pseudo R-squared 0.101 0.123 0.102 0.123

CONCLUSION

QC systems matter from an audit quality, efficiency, and client

standpoint

Remediation of QC deficiencies has the potential to improve both

audit quality and efficiency

Some of the QC deficiencies identified by the PCAOB appear to

measure nontrivial issues

To a certain extent, the results of individual PCAOB inspections, risk

based, can be generalized to the remainder of the firm

THANK YOU

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