1 Jere R. Francis Curators Professor and KPMG Distinguished Research Professor, University of Missouri Doctoral Consortium Researching Audit Quality For literature review, see What do we know about audit quality? British Accounting Review 36 (2004), pp

2 Challenges in Audit Quality Research Quality (competence/independence) cant be directly observed The exception is proven ex-post audit failures (very rare) Auditor choice is endogenous (selection problem) i.e., is audit quality the result of good audits or do good companies simply choose better quality auditors endogeneity/selection is perhaps the biggest challenge Three broad proxies for audit quality 1. Auditor characteristics firm size (big/small), brand name (B4), industry expertise, litigation and sanctions – these measures are correlated locale/unit of analysis (global, country, city/office, partner/team) 2. Engagement-specific characteristics audit/nonaudit fees (client influence), auditor alumni, tenure 3. Financial statement characteristics (audit outcomes) Is audit quality=auditor conservatism, and is this a good thing?

3 Genres of Research (complementary) Experiments experimental economics audit judgment research Archival/empirical audit markets research Qualitative research field studies socio-historical studies Modeling-Analytical studies Mathematics, economics, logic, simulations, etc.

4 Units of Analysis Audit testing & evidence-gathering procedures Auditor judgments about testing/evidence individual auditors auditors work in teams Accounting firms auditors work in firms Publicly observable audit outcomes audit firms issue audit reports firms-clients jointly produce audited financial statements Audit markets firms operate/compete in audit markets Regulatory institutions auditors, firms and markets are subject to regulations

5 Audit Testing Procedures Purpose Understanding, evaluating and improving the quality of audit testing and evidence-gathering procedures Historical examples Effectiveness of accounts receivable confirmations Caster (AJPT 1990) [archival working papers] Development of dollar-unit statistical sampling more efficient and effective than classical sampling Current examples How do risk assessments affect other audit testing procedures? Mock and Wright (AJPT 1999) [archival working papers] How effective is the new business risk audit methodology? University of Illinois/KPMG case research program

6 Auditor Judgments Descriptive lens models (1970s) What information cues affect auditor decision-making? Heuristics and biases (1970s-80s) Are auditors different than other decision-makers? Memory and cognition (1990s) What do auditors know, and why? Some current examples How does justification affect performance quality? How does accountability affect judgment? Do groups outperform individuals in brainstorming fraud risk? new SAS fraud requirement for U.S. auditors

7 Accounting Firms (mostly a black box) Understanding the structure/administration of firms How centralized/decentralized are firms? how much autonomy for local offices/partners? a central issue in Andersens Enron audit begs question, whats the appropriate unit of analysis? How do partners share profits? large v. small pools, awarding of partnership units incentive effects? SOX eliminated NAS-based compensation (cross-selling) Do firm reputations (audit quality) vary across offices? Across countries? if so, why, and what are the consequences?

8 Observable Audit Outcomes Audit reports issued by accounting firms limited opportunities as only 10% are GC reports Audited financial statements jointly produced by auditors-clients Examples of research questions: do audit firm characteristics (size, reputation, locale, etc.) affect observable audit outcomes? what factors affect modified audit reports? are modified audit reports informative? what are the discretionary/judgmental elements of F/Ss most affected by (differential) auditing?

9 Audit Industry & Markets (IO) Why is the industry dominated by large firms? scale economies (Banker et al. JAE 2003) Are there barriers to entry in auditing? Are audit markets competitive, or monopolistic? Are there positive spillovers in the joint production of audits and other services? Is there demand for (supply of) differential audit quality, and why? agency, signaling, insurance, and litigation stories, If so, how are differential audits priced, and are audit outcomes (e.g., earnings quality) different?

10 Regulatory Institutions How do professional bodies & regulatory institutions affect audits and accounting firms? Examples of research questions: How do regulator (SEC) sanctions affect firms? Wilson & Grimlund (AJPT 1990) How do other regulations/institutions affect audits/firms? e.g. SOX, and role of audit committees How do legal liability regimes affect audits/firms? changes in the U.S. (Lee and Mande AJPT 2003) cross-county studies of alternative regimes How would a ban on nonaudit services affect audits? many current studies on nonaudit services/auditor independence How have mergers/consolidations affected audits/industry?

11 Good Research Questions What is the studys research question? Should be clearly stated on first page (title, 1 st sentence?) Introductions should be 2-3 pages max (simple overview) Who cares, and why? 1. Answers a fundamental core question in the field e.g., is there differential auditor reputation/audit quality and how does it affect earnings quality? 2. Investigates important public policy issues, e.g., auditor rotation, nonaudit services and auditor independence 3. Examines hot topic e.g. Sarbanes-Oxley (competition) 4. Research design/methodological issues (least interesting) Recognize the limitation of any single study auditor differentiation (pricing), then evidence on outcomes (reporting and accruals conservatism)

12 Data Innovation in Empirical Audit Research Key driver is doing what you enjoy, and finding the right data Novel data sources Use new data to answer old questions better or to answer new questions that could not previously be investigated public data – new U.S. audit fee data risky because of competition private data collection risky because costly and outcome is unknown Novel use of existing data sources (most studies) Creatively uses existing data in new ways link financial statements (abnormal accruals) with auditor characteristics Becker et al. (CAR 1998), Francis et al. (AJPT 1999) city-level unit of analysis Francis et al. (ABACUS 1999), Reynolds &Francis (JAE 2000)