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Jong-Hag Choi (Seoul National University)
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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
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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
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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
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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.
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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
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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.
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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).
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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
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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.
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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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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.
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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.
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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)
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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)
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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.
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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.
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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)
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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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