The consequences of protecting audit partners’ personal assets from the threat of liability

Clive Lennox (NTU)  and Bing Li (City U HK)

Journal of Accounting and Economics 54(2012) 154–173

• This study investigates the audit firm’s decision to protect its partners’ personal assets by becoming a limited liability partnership (LLP).
• We find that the likelihood of an audit firm switching from unlimited to limited liability is increasing in its size and exposure to litigation risk.We find no evidence that audit firms supply lower audit quality,lose market share,or charge lower audit fees after they become LLPs.
•  However, the mix of public and private clients in audit firms’ portfolios exhibits a significant shift toward riskier publicly traded companies after the switch to limited liability.

Do Individual Auditors Affect Audit Quality?

Evidence from Archival Data

Ferdinand A. Gul

Monash University Sunway Campus

Donghui Wu

The Chinese University of Hong Kong

Zhifeng Yang

City University of Hong Kong

THE ACCOUNTING REVIEW 

Vol. 88, No. 6 2013

pp. 1993–2023

• We examine whether and how individual auditors affect audit outcomes using a large set of archival Chinese data. 
• We analyze approximately 800 individual auditors and find that they exhibit significant variation in audit quality. The effects that individual auditors have on audit quality are both economically and statistically significant, and are pronounced in both large and small audit firms. 
• We also find that the individual auditor effects on audit quality can be partially explained by auditor characteristics, such as educational background, Big N audit firm experience, rank in the audit firm, and political affiliation. 
• Our findings highlight the importance of scrutinizing and understanding audit quality at the individual auditor level

The Effect of the Social Mismatch between

Staff Auditors and Client Management on the

Collection of Audit Evidence

G. Bradley Bennett

University of Massachusetts

Richard C. Hatfield

The University of Alabama

THE ACCOUNTING REVIEW 

Vol. 88, No. 1 2013

pp. 31–50

ABSTRACT

• This study provides both survey and experimental evidence to consider how social interactions between staff-level auditors and client management may affect staff auditors’ perceptions and influence their decisions regarding the collection of audit evidence.
•  During fieldwork, staff-level auditors have extensive interaction with client management. Survey evidence suggests that these staff-level auditors are often ‘‘mismatched’’ with client management, in terms of their experience, age, and accounting knowledge. 
• Experimental results indicate that staff-level auditors may reduce the extent to which they collect evidence to avoid these interactions. 
• Finally, the use of email communication with client management helped to mitigate the reduction in evidence collected caused by avoiding in-person interactions. 
• Interestingly, when not collecting all the evidence, approximately half of the participants documented their findings in a vague or inappropriate manner, which would likely reduce the likelihood that reviewing auditors would identify a problem. 
• Given the extent of audit evidence collected by young staff auditors, these findings have direct implications for workpaper and audit quality.

Discussions:

This paper is a must read!

This paper highlights probably one of the biggest challenge faced by young auditors and associated behaviors that follows, though I think this problem is more severe in Asia due to our strong culture to respect people who are older than us. One trick that I normally employ to mitigate this issue of mismatch is to start from the bottom: question the lowest level staff first than move upwards to higher rank staff to confirm understanding. Normally, based on my short experience, the lower level staff is much more willing to help with our mundane questions. Anw, great paper to read! BUT please make sure you read the limitations of the paper at the conclusion section. 

How Do Auditors Behave During Periods of Market Euphoria?

The Case of Internet IPOs

ANDREW J. LEONE, University of Miami

SARAH RICE, University of Connecticut

JOSEPH P. WEBER, Massachusetts Institute of Technology

MICHAEL WILLENBORG, University of Connecticut

Contemporary Accounting Research Vol. 30 No. 1 (Spring 2013) pp. 182–214

Abstract:

• We are interested in how auditors behave during periods of market euphoria. Given their gatekeeper responsibility to act in the public’s interest, along with the seeming inevitability of bubbles (Rampell 2009), it is important to study how auditors behave during euphoric market conditions.
•  To address this question, we examine auditor going-concern (GC) opinions around the time of the wave of stressed Internet firms filing to go public on NASDAQ, the capital markets entry point for the companies that went on to constitute ‘‘dotcom mania’’.
• Consistent with literature on stressed public companies, we find that the presence of GC opinion in the IPO registration statement of a stressed Internet company varies positively with financial distress and negatively with company age (for Big 5 registrants) or start-up status (for non–Big 5 registrants). 
• In addition, a GC opinion for Big 5 registrants varies positively with IPO cash burn and negatively with the presence of a prestigious underwriter and venture backing.  
• Consistent with the descriptive statistics, regression results show that the Big 5 firms rendered significantly fewer GC opinions during the audit market bubble from January 1999 to April 2000 in comparison to the surrounding periods and to the non–Big 5. 
• We also document negative associations between a GC opinion and the fees a given Big 5 firm received from auditing stressed Internet IPO clients during the three months prior to signing their opinion and whether the Securities and Exchange Commission (SEC) filing date follows soon after audit opinion date. 
• These latter two findings, also new to the literature, are not reconcilable by appeal to professional audit standards and, instead, are suggestive of less independence or less skepticism on the part of the Big 5 during the Internet IPO bubble.

Discussions:

A rather disturbing findings. "Independent auditors play a crucial role in the capital-raising process, though this role is largely invisible. Indeed, from a financial statement user’s perspective, the two visible aspects are the audit firm and their opinion. While these facets have ongoing value, they are of special value during periods of market euphoria because auditors are in arguably the best position among gatekeepers to be objective".

How Does an Initial Expectation Bias   Influence Auditors’ Application and

Performance of Analytical Procedures?

Byron J. Pike

Minnesota State University, Mankato

Mary B. Curtis

University of North Texas

Lawrence Chui

University of St. Thomas

THE ACCOUNTING REVIEW 

Vol. 88, No. 4 2013 pp. 1413–1431

Abstract:

• Prior research demonstrates that knowledge of unaudited balances biases auditors’ expectations during analytical procedures. What is less understood is how these biases affect auditors’ subsequent investigations and their conclusions about the reasonableness of a particular balance. 
• We employ the selective accessibility model to examine the differences in analytical procedure performance when auditor expectations are formed with versus without knowledge of the client’s unaudited financial statement balances. 
• In an experimental setting, we found that auditors with knowledge of unaudited balances favored hypotheses and supporting information indicating that the client’s balance was reasonably stated. 
• Auditors who formed expectations without current-year figures were more willing to evaluate competing alternatives, could better identify the most pertinent information, and were significantly more likely to identify a material misstatement using an analytical procedure.

Discussions:

This is a very relevant finding indeed. I just did an analytical procedure few days ago, and I do agree that auditors performing an analytical procedure should not have seen the unaudited balance for the very reason stated in the abstract. However, I am not sure that many auditors actually do this (e.g. restraining themselves from checking current year balance). Nor do I aware that the ISA prevents auditors from doing so. I guess the key take away is auditors should resist the temptation to check current year figures and simply find factors to support these current year figures during analytical procedures as doing so may prevent auditors to find misstatements. But from my brief auditing experience, not knowing the current year figures may also make the analytical procedure more difficult and requires the auditor to stay "a bit" longer in the office. So auditors, are you up for the challenge?

Accounting misstatements following lawsuits against auditors.

Clive Lennox & Bing Li 

Journal of Accounting and Economics

In Press (2013)

Abstract:

• This study investigates whether an auditor's experience of litigation in the recent past affects subsequent financial reporting quality.
• At the audit firm level,we find accounting misstatements occur significantly less (more) often after audit firms are sued (not sued).
• At the audit office level,the negative association between past litigation and future misstatements is stronger for offices who were directly implicated in the litigation than for the non-accused offices of sued audit firms.
• Therefore,the litigation experiences of both audit firms and audit offices are incrementally significant predictors of future financial reporting quality.

Discussions:

Prof Lennox is from NTU (probably one of the most reputable univ for accounting research in Asia Pacific?) while Prof Li is from City Univ of HK (NTU alumni). The findings here are not very surprising as they cogently explained in the introduction: drivers who are caught speeding are less likely to speed in the future while drivers who never caught speeding  feel that they will never get caught and speed more! Same here with auditors. Litigation experience improves auditors' performance. 

So a key take away for companies that intend to improve their FS quality is this: Hire auditor that has been sued before! So,  Arthur Andersen anyone?

Interesting data:

Table 3: Total Law suits against audit firms and audit offices (2001–2010)

Ernst &Young                         182
PricewaterhouseCoopers         194
Deloitte&Touche                     139
KPMG                                   161
Grant Thornton                        35

BDO Seidman                         40

Does Risk Committee Matter? Evidence from the US Financial Institutions

Sebastian J. Widodo

March 2013

Abstract:

• In July 2010, the US government passed the Dodd-Frank Act which requires US banks with $10 billion or more in total assets to establish a standalone risk committee on board level. The Federal Reserve further requires these banks to appoint a CRO. This paper aims to analyze the potential usefulness of risk committee and CRO in light of these new requirements. 
• Using hand collected data from 310 US banks from 2007-2011, we find evidence that (1) the presence of a standalone risk committee is associated with lower risk taking activities in banks. Furthermore, we find evidence that (2) specific risk committee and corporate governance characteristics are associated with lower risk taking. 
• However, our findings suggest that (3) the presence of a CRO does not reduce risk taking.
• Moreover, our findings highlight a potential shortcoming of the Act since we find that (4) risk committee is only associated with lower risk taking for banks with less than $10 billion in total assets.

Discussions:

We shall kick start this blog with an unpublished honor thesis written by none other than yours truly. Significant findings have been highlighted in the abstract. Perhaps the greatest pain in writing this paper is in the data collection since the author need to hand collect the data from thousands of DEF 14A forms. Nonetheless, the findings are worth the efforts as we believe that this is the first paper that directly discusses the potential usefulness of the Dodd-Frank Act. 

Practical Implications:

Risk Committee (RC) may not be able to do much to manage risk, especially in the big banks, perhaps due to the complexity of their operations. So shall we just do away with this whole RC to save cost for shareholders? and should banks just sack their CROs? These are tricky questions considering the high degree of public scrutiny towards the FIs in the recent years. Do governments/regulators create tones of regulations just to show the public that at least  they try to do something without actually considering the usefulness of the regulations?