Panel on Audit Research and Regulation

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Panel on Audit Research and Regulation. Empirical/Archival Research and How Such Research Can Inform Regulation. Professor Karla Johnstone, University of Wisconsin School of Business. My plan: Discuss the relationship between auditing practice/regulation and research
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Panel on Audit Research and RegulationEmpirical/Archival Research and How Such Research Can Inform RegulationProfessor Karla Johnstone, University of Wisconsin School of BusinessMy plan:
  • Discuss the relationship between auditing practice/regulation and research
  • Provide examples of empirical/archival research and auditing practice/regulation
  • general topic, practice/regulatory motivation, example of related research
  • Discuss inferences that we can draw from these examples
  • Explain how you might pursue research in this area
  • Articulate downsides/challenges to research in this area
  • Explain how empirical/archival and experimental research methods complement one another
  • What is the Relationship Between Auditing Practice/Regulation and Research?Existing Element ofPractice or RegulationInforms NewPractice or RegulationStudied by ResearchersUsed by or To InformPractice or RegulationStudied by ResearchersEmpirical/Archival Research andAuditing Practice/RegulationLet’s talk about some examples:General Topic: Auditor Independence and Audit Pricing
  • Motivation: Art Levitt’s (Chairman of the SEC) “Numbers Game” Speech and the “Renewing the Covenant with Investors” Speech
  • Expresses concern over earnings management.
  • Points the blame at management, analysts, and auditors.
  • Auditors are under pressure to retain their clients: they may not stand up to aggressive management and may not charge fees sufficient to ensure a quality audit.
  • Auditors are also under pressure to “sell” non-audit services, thereby causing concern about auditor independence.
  • Empirical/Archival Research about Independence and Audit Pricing
  • Research Relating to this Topic
  • Kinney et al. (2004, JAR)
  • Studies whether non-audit services compromise auditor independence.
  • Report that some, but not all, non-audit services are associated with a higher likelihood of subsequent restatements; thus, results provide some (but not complete) support for Levitt’s concerns.
  • Johnstone and Bedard (2001, TAR)
  • Studies how client risk factors and providing non-audit services affect audit planning and pricing.
  • Report that audit hours overall are not responsive to risk, but audit firms respond by assigning more high-risk specialists, industry experts, applying more intensive review, and performing additional review; counter to concerns expressed by Levitt.
  • Audit firms charge a risk premium in pricing to respond to fraud and error risks; counter to concerns expressed by Levitt.
  • For clients purchasing non-audit services, audit firms plan more audit hours and use industry experts more often; counter to concerns expressed by Levitt.
  • Empirical/Archival Research andAuditing Practice/RegulationLet’s talk about another example:General Topic: Materiality and Detected Financial Statement Misstatements
  • Motivation/Data Source: SEC’s Staff Accounting Bulletin No. 108
  • This guidance notes diversity in audit practice about how to quantify and respond to (book-or-waive) detected misstatements.
  • Implementation of SAB 108 provided disclosure data on detected misstatements that were initially waived as immaterial, but that under the new guidance are material.
  • Empirical/Archival Research about Materiality and Detected Misstatements
  • Research Relating to this Topic
  • Keune and Johnstone (2009, AH)
  • Provides descriptive evidence on companies previously waived misstatements using SAB 108 disclosure data.
  • Keune and Johnstone (2012, TAR)
  • Articulates a model and provides empirical evidence on how manager and auditor incentives are associated with materiality judgments about detected misstatements.
  • Uses SAB 108 disclosure data.
  • Results show that managers are more likely to waive misstatements when analyst following is more intensive.
  • But, auditors respond to their reputational incentives, and for larger, more high profile clients (those with relatively high audit fees) they resist management’s preference for waiving material misstatements.
  • Empirical/Archival Research andAuditing Practice/RegulationLet’s talk about another example:General Topic: Audit Firm Rotation
  • Motivation: GAO’s 2003 study and PCAOB’s Concept Release on Auditor Independence and Audit Firm Rotation
  • Motivation/Data Source: Existence of audit firm rotation in non-public entities in U.S. (e.g., some governmental entities) and internationally.
  • Empirical/Archival Research about Audit Firm Rotation
  • Research Relating to this Topic
  • Jackson et al. (2008, MAJ)
  • Reports that audit quality (propensity to issue a going concern opinion) increases with audit firm tenure; no effect when using discretionary accruals as audit quality proxy. These results are counter to calls for mandatory audit firm rotation.
  • Ruiz-Barbadill et al. (2009, AJPT)
  • Mandatory audit firm rotation had been in effect in Spain from 1988-1995, but that requirement was abandoned in the post 1995 period.
  • Results reveal that auditors are no more likely to issue a going concern report (audit quality proxy) in the mandatory audit firm rotation period. These results are counter to calls for mandatory audit firm rotation.
  • Empirical/Archival Research andAuditing Practice/RegulationLet’s talk about briefly about other examples:General Topic: Audit Partner Signature and Audit Partner Rotation
  • Motivation: PCAOB’s Concept Release on the Transparency of Audits proposes such disclosure in the U.S.
  • Motivation/Data Source: European Union’s 8th Directive (Article 28) mandates signature disclosure in Europe.
  • Motivation/Data Source: SOX Section 203 requires partner rotation at 5 years
  • Related papers: Zerni (2012, CAR) provides evidence using partner identity information from Sweden; Bedard and Johnstone (2010, AJPT) shows how partner signatures can provide data to study effects of partner rotation.
  • General Topic: Fraud, Audit Failures, and Subsequent Regulatory Change
  • Motivation: Enron, WorldCom and other frauds and subsequent passage of SOX. PCAOB inspection reports and enforcement actions by PCAOB and SEC.
  • Related papers: Too many to mention!
  • What inferences can we draw from these examples?
  • Regulatory focus provides motivation for research.
  • Research may confirm or refute regulatory concerns, policies, or proposals.
  • Regulatory change provides unique data availability.
  • High quality journals will publish “descriptive” papers that provide a springboard for further “theory-driven” research.
  • What inferences can we draw from these examples? (cont.)
  • International differences provide motivation for research, and data may be available in some countries but not others (providing for interesting contrasts).
  • Setting-specific research (i.e., based on relatively small samples in one or two countries) is valued by high quality journals.
  • Massive shifts in regulation provide an outstanding opportunity for a researcher to specialize in the relevant topic.
  • Such regulation and change provide an excellent setting for longitudinal studies and the use of relevant empirical methodologies(e.g., panel data).
  • How might you pursue research in this area?
  • Stay up to date in your profession.
  • Monitor the SEC, IFAAC, AICPA and PCAOB websites to keep current.
  • Think about how U.S. and international requirements differ, and look for settings in which differences may have theoretical implications.
  • Use change to your advantage – change presents opportunities for data availability and motivation to conduct research.
  • Look to ground your research in theory, but consciously consider practical insights and implications, along with data availability.
  • What are the downsides/challenges to research in this area?
  • Publicly available data in research databases is over-used. Implication: don’t be lazy…hand data collection is often necessary.
  • Available data is often a messy proxy for theoretical constructs, e.g., how to proxy accurately for audit quality?
  • Auditing firms are very hesitant to provide data because of confidentiality rules. You’ll need to foster relationships with powerful partners within the firms in order to gain access; and you’ll need to provide a practical reason for the firms to say “yes” to your requests.
  • There are continual econometric/statistical developments on which to keep current (e.g., Keune and Johnstone 2012, TAR for interactions in logistic regression).
  • How do empirical/archival and experimental research methods complement one another?
  • They generally share the same motivation, e.g., studying audit quality is conceptually the same whether an empirical or experimental method is used.
  • You can use results from an experimental setting to motivate an investigation using empirical data; and vice versa.
  • Experimental methods provide control and tend to be high on internal validity; empirical methods tend to be high on external validity.
  • ReferencesBedard, J.C., and K.M. Johnstone. 2010. Audit partner tenure and audit planning and pricing. Auditing: A Journal of Practice & Theory 29 (2): 45-70.Jackson, A.B., M. Moldrich, and P. Roebuck. 2008. Mandatory audit firm rotation and audit quality. ManagerialAuditing Journal 23 (5): 420-437.Johnstone, K.M., and J.C. Bedard. 2001. Engagement planning, bid pricing, and client response in the market for initial attest engagements. The Accounting Review. 76 (2): 199-220. Keune, M.B., and K.M. Johnstone. 2009. Staff Accounting Bulleting No. 108 disclosures: Descriptive evidence fromthe revelation of accounting misstatements. Accounting Horizons 23 (1): 19-53.Keune, M.B., and K.M. Johnstone. 2012. Materiality judgments and the resolution of detected misstatements: The role of managers, auditors, and audit committees. The Accounting Review 87 (5): 1641-1677.Kinney, W.R., Z.V. Palmrose, and S. Scholz. 2004. Auditor independence, non-audit services, and restatements: Was the U.S. government right? Journal of Accounting Research 42 (3): 561-588.Levitt, A. 1998. The “Numbers Game” Speech. NYU Center for Law and Business. New York, NY. September 28.Levitt, A. 2000. The “Renewing the Covenant with Investors” Speech. NYU Center for Law and Business. New York, NY. May 10. Public Company Accounting Oversight Board. 2011. Concept Release on Auditor Independence and AuditFirm Rotation. PCAOB Release No. 2011-006, August 16.Public Company Accounting Oversight Board. 2011. Improving the Transparency of Audits: ProposedAmmendments to PCAOB Auditing Standards and Form 2. PCAOB Release No. 2011-007. October 11.Ruiz-Barbadillo, E., N. Gomez-Aguilar, and N. Carrera. Does mandatory audit firm rotation enhance auditorindependence? Evidence from Spain. Auditing: A Journal of Practice & Theory 28 (1): 113-135. Securities and Exchange Commission. 2006. Staff Accounting Bulletin No. 108. September 13. Washington, DC.Zerni, M. 2012. Audit partner specialization and audit fees: Some evidence from Sweden. ContemporaryAccounting Research 29 (1): 312-340.Questions?
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