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Jong-Hag Choi (Seoul National University).  December 2001, the 4 th largest company and the largest energy corporation in the U.S. – Enron – filed for.

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Presentation on theme: "Jong-Hag Choi (Seoul National University).  December 2001, the 4 th largest company and the largest energy corporation in the U.S. – Enron – filed for."— Presentation transcript:

1 Jong-Hag Choi (Seoul National University)

2  December 2001, the 4 th largest company and the largest energy corporation in the U.S. – Enron – filed for bankruptcy.  The larges bankruptcy in the U.S. history.  June 2002 – Xerox (about $6b)  August 2002 – Worldcom (about $5b)  Similar events occurred at France and Germany

3  Bankruptcy of Enron and prosecution of management (CEO Jeff Skilling)  Arthur Andersen- under SEC investigation, the lawyer ordered to shred audit working papers (shredded reputation)  Firms start to change auditors from AA to others – AA’s collapse  Enforcement of SOX

4  Media and regulators propose three possible reasons why audit failure occurred at Enron, which potentially lead to impaired auditor independence. (1) AA audits Enron for about 20 years in a row (i.e., long tenure) (2) AA makes more money from consulting service to Enron ($2.5m vs. $2.7m) (3) AA engagement partner and Enron CFO (and others) had private meetings and maintain inappropriate relationship

5  Longer tenure: auditors come to know the clients’ business characteristics better, potentially lead to better audit competence.  Consulting (non-audit) service: providing both non-audit and audit service generates synergy effect such that auditors better understand clients’ business.  Close relationship: auditors better understand clients’ business.  In sum, effect of these three factors on audit quality is not clear.

6  Johnson et al. (2003), Myers et al. (2004) report that as audit tenure increases, client tends to manage earnings less. – independence in fact  Ghosh and Moon (2004) [Mansi et al. (2004)] report that as auditor tenure increases, equity [debt market] investors behave as if audit quality increases. Thus, ERC [cost of debt capital] increases [decreases]. – independence in appearance

7  Frankel et al. (2002): clients with more NAS tend to manage earnings more. – This study is used as a supporting evidence for the SOX.  Chung and Kallapur (2003), Ashbaugh et al. (2003) could not confirm the findings in Frankel et al.  DeFond et al. (2003), Craswell et al. (2003) report that NAS is not related to AQ.

8  It is difficult to measure the degree of close relationship.  Lennox (2005) uses the setting in which an audit partner quits audit firm and joins a client and the audit firm audits the client – AQ (measured by audit opinion) is impaired (a similar finding in Menon and Williams (2005) using DA).

9 Tenure (Year) Big Four GCQ (%) Non-Big 4 GCQ (%) Average Zmijewski score 18.7830.45-0.93 28.4827.49-1.39 39.1322.41-1.53 46.5421.45-1.59 57.9719.23-1.57 104.379.88-1.78 18-1.362.51-1.97 Average6.1020.70-1.68

10  B4 clients: Frequency of GCO does not decreases after controlling for client characteristics.  NB4 clients: Frequency of GCO decreases as auditor tenure increases, however, the trend does not exist post-SOX period.  The findings are relate to those in Davis et al. (2009) that used MBE. As auditor tenure increases up to a certain level, AQ increases. However, AQ decreases after the point. But the decreasing trend does not exist in the post-SOX period. Davis et al.’s study has a flaw in interpreting the findings. In reality, they fail to find the evidence of AQ decreases after a certain point. What they find is the decreasing tendency of AQ increases after the point.

11  Cahan and Zhang (2006) compare ex-AA clients that switched auditors to other Big 4 auditors with ongoing clients of the Big 4 auditors, and conclude that auditors treat ex-AA clients more conservatively than ongoing clients – due to suspected AQ of AA.  We find that auditors treat all new clients (including ex-AA clients) more conservatively in post-SOX period, while they treat new clients more leniently in pre-SOX period, compared with ongoing clients.  We also find that the conservatism toward the new clients lessens as auditor tenure increases.  Thus, we expand Cahan and Zhang’s study to other (except for ex-AA) new clients and pre-SOX period.

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13  Although there is no relationship between NAS and AQ in general samples, there are some sub-samples that AQ could be impaired.  Lim and Tan (2008): clients of non-industry specialist auditors  Kanagaretnam et al. (2010): small banks that are not closely monitored by regulators  Causholli et al. (2014): auditor’s opportunity to sell future NAS.

14  We use the distance between clients and audit office to measure the degree of interactions between the two.  Close distance: more interactions – may reduce auditor independence but increase auditor competency.  About 18% of clients hire auditors from different MSAs and about 13% hire from more than 100 km away.  We find that AQ increases as the distance decreases.

15  Audit market is dominated by 4 large auditors (Big 4): auditor concentration increases.  Audit fee skyrocketed (at least 50%), NAS fee decreased, and total fees increased slightly (Ghosh and Pawlewich 2009).  Small auditors exit from audit market for listed companies (DeFond and Lennox 2012).  Clients switch from accrual-based earnings management to real activity-based earnings management (Cohen et al. 2008)

16  Old studies focused on the effect of audit firm level characteristics on audit quality. However, more recent studies tend to switch the focus to audit office-level and engagement partner-level characteristics. - office size (Francis and Yu 2009; Choi et al. 2010) - office-level industry expertise (Ferguson et al. 2003; Reichelt and Wang 2010) - partner tenure (Carey and Simnett 2006; Chen et al. 2009) - partner-level industry expertise (Chi and Chin 2011; Zerni 2012) - other partner-level characteristics (Gul et al. 2013)

17  Lawrence et al. (2011) report that, using propensity score matching (PSM), rather than auditor characteristics, client characteristics yield observed difference in financial reporting quality in Big N and office size effect.  Minutti-Meza (2013) report that, using the PSM, industry-expertise effect disappears.  DeFond et al. (2014) report that Big N effect still exist even after controlling for endogeneity using PSM. Different first-stage model yield different results.  Thus, the findings are controverisal.

18  In 1998, Price Waterhouse and Coopers & Lybrand merged to form PwC.  The merger may impact AQ differently depending on local market situation. - overlapping office merger vs. non- overlapping office merger  We document that AQ of PwC improves after the merger only in the case of overlapping office merger.

19 Audit office-level effect of PwC merger Price Waterhouse (Phoenix, AZ) Coopers & Lybrand (Phoenix, AZ) Overlapping offices PwC (Phoenix, AZ) Price Waterhouse (Buffalo, NY) Non-overlapping offices PwC (Buffalo, NY) Coopers & Lybrand (Tulsa, OK) PwC (Tulsa, OK) 7 clients ($9.9 bil) 7 clients ($10.7 bil) 15 clients ($21.9 bil) 7 clients ($3.1 bil)7 clients ($3.9 bil) 8 clients ($2.6 bil)6 clients ($1.9 bil)

20  AQ is function of audit office size.  The reason for the better AQ in large audit office is mainly due to the industry expertise.  Thus, documented differences in financial reporting quality in prior research is not due to client characteristics only – but auditors play an important role.  Regulators’ concern on the dominance of a few large auditors (GAO 2003, 2008). However, studies document mixed findings on the audit market concentration’s effect on AQ (Boone et al. 2012; Newton et al. 2012). Our findings suggest that more concentration is not detrimental to AQ.


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