1 Under the SOX (2002), the PCAOB is required to conduct - PowerPoint PPT Presentation

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Under the SOX (2002), the PCAOB is required to conduct inspections of a sample of conducted audits ◦ Significant deficiencies are reported to investors in public portion of report ◦ Engagements are selected using a risk-weighted approach ◦ Provides process-based information on audit quality ◦ However, more research is needed on;  How investors interpret the findings in these reports in making assessments about audit quality; and  The extent to which they affect investment decisions 2

Only deficiencies in issuer audits are disclosed ◦ Audits are complex and multifaceted  Not including significant audit strengths results in potentially less  balanced assessments of audit quality Risk-weighted inspection selection method instead of  random selection Findings may not be representative of the audit quality of the audit ◦ firm’s work Potential to negatively bias investors’ assessments of audit quality ◦ and thus impact efficiency of capital markets Disclosed late in report – may not be noticeable to investors ◦ 3

 Although evidence is somewhat mixed, there is growing literature to support the assertion that the inspection process has helped improve audit quality Lennox and Pittman (2010) find deficiencies in inspection reports ◦ were not associated with subsequent changes in clients’ choices of audit firms. Carcello et al. (2011) found a significant decrease in client’s ◦ earnings management following findings in firms’ inspection reports. Gunny and Zhang (2013) find significant positive association ◦ between abnormal accruals of clients and deficiencies identified in inspection reports. 4

 What is the effect of disclosure in the inspection report of both strengths and deficiencies, and the inspection selection method (risk-weighted vs. random), on investors’ investment decisions? 5

Anderson 1971; Anderson 1981 ◦ Predicts that the inferential value of a piece of information is predicted on two basic parameters:  Direction – how a piece of information is evaluated  Weight – the importance of the information ◦ Posits that new pieces of information are integrated with existing information to arrive at beliefs and assessments 6

H1: Investors’ investment decisions will be progressively more favorable when the inspection report moves from deficiencies only, to more deficiencies than strengths, and then to more strengths than deficiencies. We do not predict a significant main effect for inspection selection approach because: Risk-weighted approach could be viewed as more  conservative and hence signal higher audit quality Random approach could be viewed as providing a more  unbiased assessment and hence may be viewed as signaling higher audit quality. 7

Burgoon 1978; Burgoon and Hale 1988; Hastie 1984 ◦ More favorable behavior or outcome than expected = positive violations ◦ Less favorable behavior or outcome than expected = negative violations ◦ When observations depart from expectations, the response is more pronounced than when observations conform to expectations. 8

 When inspection method is random, the expectation is for a more balanced report with both deficiencies and strengths. Hence, a negative violation will occur when only deficiencies are disclosed.  Conversely, when inspection method is risk- weighted, the expectation is for a report with more deficiencies. Hence, a positive violation will occur when more strengths than deficiencies are disclosed. 9

H2a: Investors’ investment decisions will be the least favorable when the inspection report indicates deficiencies only and the inspection selection method is random. H2b: Investors’ investment decisions will be the most favorable when the inspection report indicates more strengths than deficiencies and the inspection selection method is risk-weighted. 10

 Design: 3 x 2 Between-Participant Design Independent Variables ◦ Inspection Report Findings  Deficiencies only (DO)  More deficiencies than strengths (D>S)  More strengths than deficiencies (S>D) ◦ Inspection Selection Method  Risk-weighted selection  Random selection 11

 Company in the retailing industry  Company received unqualified audit opinions in prior years from audit firm  Participants were provided with: ◦ Background information about the company ◦ Auditing and financial reporting environment ◦ Summary of financial data from past two years ◦ Information regarding PCAOB and its inspection process (including selection method) ◦ Summary of most recent inspection report issued by PCAOB 12

 Inspection Report Findings: Strength (Deficiency)  Stow and Taunton appropriately followed (did not appropriately follow) adequate procedures to evaluate the reliability of management explanations for the valuation of inventory.  Stow and Taunton appropriately performed (did not appropriately perform) cut-off tests to ensure inventory is matched to the appropriate reporting period.  Stow and Taunton appropriately compared (did not appropriately compare) various inventory ratios at the business unit level to industry segment averages. 13

 Inspection Selection Method: risk-weighted [ra rando dom]  …areas of inspection focus are selected on a risk-weighted basis and not randomly [ra rando dom ba basis is, a and nd not on not on a risk-weig ighted ba d basis is]. A risk-weighted basis implies that audit work is generally selected for inspection based on factors that, in the inspection team's view, heighten the possibility that auditing deficiencies are present, rather than identify a representative sample [A ra rando dom ba basis is im implie plies t that audit dit w work rk is is generally ly s sele lected f d for r in inspe pectio ion ba based o d on a pro process that, in in the in inspe pectio ion t team’s vie iew, is , is in intended t to ide identif ify a a repr re presentativ ive sample ple, ra , rather t r than h heighten t the po possibilit ibility t that audit diting de defic iciencies a are re pre present]. 14

 Dependent variables ◦ Investment Decision  (a) likelihood of investing in the company (0 = not at all likely; 10 = extremely likely)  (b) attractiveness of the company as an investment (0 = not at all attractive; 10 = extremely attractive)  In order to provide a more comprehensive measure they were combined into a single scale 15

 Participants: Graduate business student from two universities in Northeastern U.S. (n=147) ◦ Considered reasonably informed investors:  An average experience investing in stock for 11 months (SD = 25)  An average experience investing in mutual funds of eight months (SD = 23) ◦ On average two years of work experience (SD = 3.57)  Involving finance or accounting for six moths (SD = 13) 16

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H1: Investors’ investment decisions will be progressively more favorable when the inspection report moves from deficiencies only, to more deficiencies than strengths, and then to more strengths than deficiencies. H2a: Investors’ investment decisions will be the least favorable when the inspection report indicates deficiencies only and the inspection selection method is random. H2b: Investors’ investment decisions will be the most favorable when the inspection report indicates more strengths than deficiencies and the inspection selection method is risk- weighted. 21

 Path Analysis ◦ To provide further evidence on the theoretical link between manipulated variables and the consequent investment decision.  Mediating Effect of Audit Quality ◦ To examine the extent to which the assessment of audit quality explains participants’ investment decisions  Incremental Effect of Audit Strength vs. Deficiencies ◦ To examine whether investors consider both strengths and deficiencies as relevant information in assessing audit quality and making investment decisions  Qualitative Responses ◦ To obtain additional insights regarding investor reliance on the PCAOB inspection reports in the experiment 22

Inspection Selection 0.09 Method (0.44) 0.35 0.63 Credibility of Audit Investment (<0.01) (<0.01) Financial Decision Quality Reports 0.72 Inspection (<0.01) Report Findings 23

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 Results suggest that there is a significant interaction effect between report findings and the inspection selection method  Investment decisions are the least favorable when DO and random selection  Investment decisions are the most favorable when S>D and risk weighted selection  Results also provide limited evidence on negativity bias in investors’ judgments, since investors’ decision processes appear to be more heavily influenced by negative findings in the PCAOB inspection report  Should PCAOB consider adopting a more balanced approach to the disclosure of the inspection findings?  Future research could examine if there is potential contagion effect for investors if for example, client industry is disclosed. 25