Largest Audit Firms Influence their Audit Quality and Efficiency? - PowerPoint PPT Presentation

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 Inspection from inferences from review of individual engagements: Of QC Tone at the top (culture), partner management, Independence policies, Systems: Client acceptance / retention, Internal inspections, Audit methodology, Policies related to foreign affiliates, Other practice monitoring Inspection Of Audit 1 Audit 2 Audit 3 Audit 4 Audit 5 Audit 6 individual audits: Inspection Audit Performance Deficiencies Of QC Identified from inspections of individual engagements Systems:

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

PART II FINDING SECTION 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.

PART II FINDING SECTION 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 - …

PART II FINDING SECTION 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. …