1. The Effects of Significant Changes in Auditor Clientele and Auditor-Client Mismatches on Audit Quality Kenneth L. Bills University of Oklahoma May 2012

2. Presentation Overview Research Topic Regulatory Concerns Hypothesis Development Methodology and Results

3. Research Topic

5. Mandatory Audit Firm Rotation Regulators’ Concerns Arguments For ↑ Auditor Independence ↑ Audit Firm Competition Fresh Viewpoint Concern about what New Audit Firm will Find Arguments Against Forced Switch from Most Experienced Audit Firm Company-Specific Knowledge is a GOOD Thing Cost to Companies is Burdensome

6. Increased Frequency of Auditor Changes May – Disrupt Audit Firms’ Operations – Interfere with their Ability to Focus on Perform High Quality Audits Audit Firms May Not Have the Capacity to Assign Appropriately Qualified Personnel to New Engagements Rotation Requirement May Limit a Company’s Choice of Auditor Additional Potential Concerns

7. Volatility in Audit Firms’ Clientele Portfolios Strained or Excess Audit Firm Capacity Audit Quality Mandatory Audit Firm Rotation

8. Mandating Auditor Changes & Limiting a Company’s Choice in Audit Firm Auditor-Client “Mismatches” Audit Quality Mandatory Audit Firm Rotation

9. Contingency Planning for Significant Changes in Audit Firm Capacity in a Geographic Area 2008 Technical Committee Report International Association of Securities and Exchange Commissions (IOSCO) Regulators’ Concerns

10. Causes – External Shocks to the Audit Market – Changes in Capacity Inputs – Changes in Capacity Outputs Strained and Excess Capacity

11. Significant Changes in Local Audit Office Clientele Strained and Excess Capacity STRAIN ft = 1 if company i’s auditor was in the top decile of audit firms having an increase in metropolitan statistical area (MSA) total sales audited (t-2) to (t-1); EXCESS ft = 1 if company i’s auditor was in the bottom decile of audit firms having a decrease in MSA total sales audited from the prior year (t-2) to (t-1);

12. Hiring/Firing Employees Hiring/Firing Clients Use of Built in Cushion Use of Flexible Capacity (Overtime, Outsourcing) Transferring Employees (Larger Audit Firms)  May Be Insufficient for Extreme Changes in Clientele Steps to Reduce Strained or Excess Capacity

13. Hypothesis Development

14. Production Economics Literature – Maintaining Delivery Dependability and Quality is More Difficult in Tightly Constrained Systems Lovelock (1984) and Sridharan (1998) Hypotheses – Audit Quality Components of Service Quality (Parasuraman et al. 1985) Audit Quality (DeAngelo 1981) CompetenceProbability that Auditor will Detect Material Misstatement Credibility and ReliabilityProbability that Auditor will Report Material Misstatement

15. Hypotheses – Audit Quality Auditor Opinion Factor Driving Auditor Opinion Audit Quality Failure (DeAngelo1981a) Error Type Issue GC Opinion Proper Judgment Poor Judgment Failure to Detect Type I Error Reduce Risk Failure to Report Don't Issue GC Opinion Proper Judgment Poor Judgment Failure to Detect Type II Error Relationship Concerns Failure to Report Reduce Risk Poor Judgment Relationship Concerns Proper Judgment

16. Hypotheses – Audit Quality H1: Companies audited by local audit offices with strained (excess) capacity will have audit quality similar to companies audited by local audit offices without strained (excess) capacity.

17. Hypotheses – Audit Quality Discretionary Accruals Model – Modified Jones Model (Dechow et al. 1995) – Kothari et al. (2005) Performance Matched – Absolute Value A Broad Measure of Audit Quality

18. Reputational Concerns – “More to Lose” (DeAngelo 1981) – National Office Established Client-Acceptance Procedures Established Audit Performance Standards Ability to Transfer Personnel – Greater Flexibility to Reduce Excess and Strained Capacity Hypothesis – Audit Firm Size

19. H2: The effects of strained (excess) capacity on audit quality will be smaller for Big 4 and second-tier audit firms than for other firms. Hypothesis – Audit Firm Size

20. Hypotheses – Portfolio Management Decisions Bills and Jensen 2011 – Under Normal Capacity, Audit Firms Have a Standard for the Quality of Client’s they will Accept – Positive Assortative Matching (PAM) 1.Most Preferred 5.Moderately Preferred 10. Least Preferred 1.Most Preferred 5.Moderately Preferred 10. Least Preferred

21. Strained Capacity – Ability to Discriminate Among Clients ↑ – Select “Most Preferred” Clients Excess Capacity – Need to Fill Capacity – Client Acceptance Criteria May be Loosened Hypotheses – Portfolio Management Decisions

22. Shu (2000) and Landsman et al. (2009) – Mismatches Occur when Large Audit Firms Align with Clients Typically Served by Smaller Audit Firms and Vice Versa – Mismatches Are Not Preferred H3: Auditor-client mismatches are less (more) likely to occur when an audit firm has strained (excess) capacity. Hypotheses – Portfolio Management Decisions

23. Mandatory Auditor Rotation may Increase the Occurrence of Mismatches – Especially where there are Few or No Viable Alternatives Large Audit Firms Correlated with Higher Audit Quality – Francis et al. (1999), Becker et al. (1998), etc. Correlation Goes Away when Matched Sample Design is Used – Lawrence et al. 2011 TAR Hypotheses – Mismatches and Audit Quality

24. H4a: Auditor-client mismatches where clients expected to be served by large audit firms are served by small audit firms have lower audit quality than where no mismatches are present. H4b: Auditor-client mismatches where clients expected to be served by small audit firms are served by large audit firms have higher audit quality than where no mismatches are present. Hypotheses – Mismatches and Audit Quality

26. Estimate the Following Model Under Two Specifications ERROR it = μ 0 + μ 1 STRAIN ft + μ 2 EXCESS ft + μ 3 LAT it + μ 4 Z it + μ 5 ΔZ it + μ 6 AFEES it + μ 7 NFEES it + μ 8 GDP it + μ 9 ΔGDP it + μ j Year it + ε it Null Hypotheses: μ 1 = 0, μ 2 = 0 Methodology- H1 ERROR it = 1 if a Type I error occurred, 0 otherwise; = 1 if a Type II error occurred, 0 otherwise; +/-

27. Add to Each of the Models Add an Interaction of LGAUDITOR with Each Variable of Interest Test Significance – LGAUDITOR*STRAIN & LGAUDITOR*EXCESS Methodology- H2 LGAUDITOR i 1 if company i is audited by a Big 4 or second-tier audit firm, 0 otherwise;

28. Measurement of Strained and Excess Capacity

29. Results of Going-Concern Opinion Error Test

30. Estimate the Following Model ABSPDA it = β 0 + β 1 STRAIN ft + β 2 EXCESS ft + β 3 LTA it + β 4 CFO it + β 5 LEV it + β 6 MKTBK it + β j Year t + ε it Null Hypotheses: β 1 = 0, β 2 = 0 Methodology- H1 ABSPDA it Absolute value of performance-matched (Kothari et al. 2005) modified Jones model (Dechow et al. 1995) +/-

31. Results of Discretionary Accruals Test

32. December and Non-December Year End

33. Sample Restricted to First Year Audit Engagements Estimate the Following Model Under Two Specifications MISMATCH(1 or 2) ft = σ 0 + σ 1 STRAIN ft + σ 2 EXCESS ft + σ 3 AFEES it + σ 4 NFEES it + σ 5 GDP it + σ 6 ΔGDP it + σ 7 HERF ft + σ k Year t + ε it Hypotheses = σ 1 0 Methodology- H3 MISMATCH1 it = 1 if a client is audited by a small audit firm when it is expected to be audited by a large audit firm, zero otherwise; MISMATCH2 it = 1 if a client is audited by a large audit frm when it is expected to be audited by a small audit firm, zero otherwise; + -

34. Results of Mismatch Test

35. Estimate the Following Model ABSPDA it = λ 0 + λ 1 MISMATCH1 ft + λ 2 MISMATCH2 ft + λ 3 LTA it + λ 4 CFO it + λ 5 LEV it + λ 5 MKTBK it + λ j Year t + ε it Hypotheses = λ 1 = 0, λ 2 = 0 Methodology- H4 ABSPDA it Absolute value of performance-matched (Kothari et al. 2005) modified Jones model (Dechow et al. 1995) MISMATCH1 it = 1 if a client is audited by a small audit firm when it is expected to be audited by a large audit firm, zero otherwise; MISMATCH2 it = 1 if a client is audited by a large audit firm when it is expected to be audited by a small audit firm, zero otherwise; +-

36. Results of Discretionary Accruals-Mismatch Test

37. Audit Quality may be Negatively Affected by Strained and Excess Capacity The Negative Effect of Strained Capacity is Less for Larger Audit Firms Conclusion

38. Large Audit Offices with Strained Capacity are Less Likely to Accept New Clients that are Mismatches Small Audit Firms with Strained Capacity are More Likely to Accept New Clients that are Mismatches Mismatches may increase or decrease audit quality, depending on the size of the audit firm providing the audit. Conclusions Continued…

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