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Jere R. Francis Curators’ Professor and KPMG Distinguished

Research Professor, University of Missourifrancis@missouri.edu

Doctoral Consortium

“Researching Audit Quality”

For literature review, see “What do we know about audit quality?” British Accounting Review 36 (2004), pp. 345-368.

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Challenges in Audit Quality Research

Quality (competence/independence) can’t 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 quality1. 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?

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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.

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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

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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

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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

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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 Andersen’s Enron audit begs question, what’s 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?

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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/S’s most affected by (differential) auditing?

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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?

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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?

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Good Research Questions What is the study’s research question?

Should be clearly stated on first page (title, 1st 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)

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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)