discussant comments: “does the organization and … · discussant comments: “does the...

Discussant Comments: “Does the Organization and Culture of the Largest Audit Firms Influence their

Audit Quality and Efficiency”W. Robert Knechel, Director

International Center for Research in Accounting and Auditing

© W.R. Knechel

Overview

• Some thoughts on audit quality research.• Auditing, professional services and the audit

firm.• The hypotheses.• About those deficiencies ...• Deficiencies, audit production and audit

efficiency.• Some interesting results.

© W.R. Knechel

Audit Quality Research

Firms

Offices

Specialists

Teams

Partners/Individuals

Teams

Partners/Individuals

Institutions Institutions

Audit Quality

Firms

Offices

Specialists

Em

piri

cal R

esea

rch

Experim

ental Research

© W.R. Knechel

Auditing is a Professional Service (Part I)

• The output of an audit may be observable (opinion) but the outcome (residual risk) is not observable, and is also uncertain.

• The outcome of the audit is the joint result of the efforts of the auditor and the client.

• The quality of the outcome depends on the expertise of the auditor plus a degree of independence of the auditor.

• Each partner is simultaneously an agent and a principal [Huddart/Liang 2005]

• Individual auditor/partner failure may lead to shared litigation (or other) costs [Amoruso et al. 2010]

• Moral hazard can arise if auditors pursue self-interest over firm-wide interests [Holmstrom 1982; Liu/Simunic 2005]

© W.R. Knechel

Agency in a Professional Partnership (Part II)

• At the same time, each auditor’s compensation and legal exposure depends on decisions made by other auditors.

• But … actual individual performance is hard to measure, possibly leading to undersupply effort? [Alchian and Demsetz 1972]

• Appropriate effort is hard to observe (even by other partners) and partners have a high degree of autonomy to exercise professional judgment [Causholli and Knechel 2012]

The standard agency model does not fit well in a professional partnership.

• Peer pressure can mitigate agency problems when there are few partners [Huddart/Liang 2003; Kandel/Lazear 1992]

• Quality Control systems are critical to maintaining audit quality in a larger practice.

© W.R. Knechel

The Hypotheses (Part I)

• H1a: An audit firm’s QC deficiencies (QCD) are negatively associated with audit quality (AQ).▫ Is there a viable counter-factual?

• H1b: Audit performance deficiencies are not an important factor of the association between QCD and AQ.▫ It is likely that this runs counter to PCAOB behavior

and anecdotal “evidence”.• H1c: Culture is not an important factor of the association

between QCD and AQ.▫ I am not buying this one and simple professional logic

suggests an inverse link.

© W.R. Knechel

The Hypotheses (Part I)

• H1d: Audit methodology issues are not an important factor of the association between QCD and AQ.▫ If firm methodology is based on standards, where is the

problem? Poor design? Standardization? Training?• H1e: There is no association between audit firms’ QCD

and audit pricing.▫ I can almost buy this one assuming Part II is unseen by

clients. What stops an audit committee from asking about the inspection report?

• H1f: There is no association between audit firms’s QCD and the provision of non-audit services.▫ Just because. NAS is always fun.

© W.R. Knechel

The Hypotheses (Part II)

• H3a: There is no association between audit firm’s QCD and audit efficiency.▫ Definitely possible: There are other possible effects

which may not be systemic. Not working enough total hours is only one possibility: Not assessing risk correctly leading to over- (or

under-) auditing in total or in some areas. Misaligning staff skills/experience and needs of

engagement. Misinterpreting evidence and reaching incorrect

conclusions.▫ More important: Audit efficiency ≠ audit effort (or

even the residual of an audit effort regression).

© W.R. Knechel

The Hypotheses (Part II)

• H3b: There is no association between tone at the top deficiencies and engagement hours.▫ What does it mean if the personnel “fit well” and “stay

longer” if the tone at the top is bad? Is a loss of efficiency due to more bad work or more good work?

• H3c: There is no association between audit methodology issues and engagement hours.▫ This strikes me as trying to unravel a tautology. Of

course, work load depends on the designed audit process.

▫ More important: How much does the audit methodology depend on the need to satisfy PCAOB inspectors over time? [Dowling, Knechel and Moroney 2015, Johnson, Keune and Winchel 2015]

© W.R. Knechel

And About Those Deficiencies … (Part I)

• Planning an inspection:▫ Targeted areas?▫ Inspector incentives?▫ Final determination of a deficiency?▫ Types of Part II deficiencies?

© W.R. Knechel

Quality Control (PCAOB vs AICPA)

Tone at the Top

Partner Management

Internal Inspection

Audit Methodology

Foreign Affiliates

Independence

Client Acceptance

Leadership Responsibilities (Tone at the Top)

Internal Inspection

Audit Methodology

Client Acceptance

Relevant Ethical Requiremts(Independence)

Human Resources(???)

Eng

agem

ent A

udit

Qua

lity

© W.R. Knechel

And About Those Deficiencies … (Part I)


• What are the expected longitudinal stochastic properties of the Part II deficiencies?

© W.R. Knechel

Expected Trend in Deficiencies over Time

Time/Years

Num

ber

of d

efic

ienc

ies Part I Deficiencies

Part II Deficiencies

© W.R. Knechel

14

0

0.5

1

1.5

2

2.5

3

3.5

4

2004 2005 2006 2007 2008 2009 2010 2011 2012

Ave

rage

Cou

nt

PCAOB Inspection Year

Part I Inspection Deficiencies

© W.R. Knechel

About Those Deficiencies … (Part I)



• It would be extremely useful to see much more descriptive data on the Part II deficiencies. How many by year? What type? Word count of Part II by year?▫ {Word count} vs. {number of deficiencies} vs {QC Index}

© W.R. Knechel

About Those Deficiencies … (Part I)



• It would be extremely useful to see much more descriptive data on the Part II deficiencies. How many by year? What type? What are raw word counts?▫ {Word count} vs {number of deficiencies} vs {QC Index}

• Does the existence of a Part I deficiency determine the existence of a Part II deficiency?

© W.R. Knechel

Quality Control (PCAOB vs AICPA)Tone at the Top

Partner Management

Internal Inspection

Audit Methodology

Foreign Affiliates

Independence

Client Acceptance

Leadership Responsibilities (Tone at the Top)

Internal Inspection

Audit Methodology

Client Acceptance

Relevant Ethical Requiremts(Independence)

Human Resources(???)

Eng

agem

ent A

udit

Qua

lity

© W.R. Knechel

About Those Deficiencies … (Part II)

• How many deficiencies are remediated and when? • When are the Part II deficiencies made public? Twelve

months after the inspection? …. Well, … not exactly!

© W.R. Knechel

Release of Part II (When?)

Audit Firm

PCAOB Inspection

Report Year

Report Issue Date

Earliest Possible Part II

Disclosure Date

Actual Part II

Disclosure Date

Delay in Part II

Disclosure

Deloitte & Touche 2007 5/19/2008 5/19/2009 10/17/2011 881 days Deloitte & Touche 2008 4/16/2009 4/16/2010 11/21/2013 1,315 days Ernst & Young 2009 7/2/2010 7/2/2011 5/23/2013 691 days Ernst & Young 2010 11/30/2011 11/30/2012 6/11/2014 558 days Grant Thornton 2008 7/9/2009 7/9/2010 6/11/2014 1,433 days Grant Thornton 2009 8/12/2010 8/12/2011 6/11/2014 1,034 days KPMG 2010 11/8/2011 11/8/2012 10/23/2014 714 days KPMG 2011 8/15/2012 8/15/2013 10/23/2014 434 days PricewaterhouseCoopers 2008 3/25/2009 3/25/2010 3/7/2013 1,078 days PricewaterhouseCoopers 2009 8/12/2010 8/12/2011 3/7/2013 573 days

Average delay in Part II disclosure: 871 days (2.4 years)

19

© W.R. Knechel



months after the inspection? …. Not exactly!• How do Part II deficiencies relate to audit quality?

© W.R. Knechel




▫ Propensity to restate: Is there a link between the observed deficiency and nature of the restatement?

© W.R. Knechel





▫ Propensity to meet/beat forecasts: Is that audit quality?▫ Future Part I findings: Set of {Independent variables} Part II deficiencies Set of {Independent variables} Part I deficiencies

© W.R. Knechel





▫ Propensity to meet/beat forecasts: Is that audit quality?▫ Future Part I findings: Set of {Independent variables} Part II deficiencies Set of {Independent variables} Part I deficiencies

▫ More important: Do inspectors in t+1 (t+2, t+3 …) know the results of the inspection in t?

© W.R. Knechel

Audit Effort and Efficiency (Part I)• A positive residual in an hours regression is not necessarily

a sign of “inefficiency”.• Story 1: A firm with more Part II deficiencies does more

work because they take on the “wrong” clients. Is this captured by the residual of an effort regression?(1) The extra work is not significantly different from zero? (2) Due to omitted variables?(3) Due to varying perceptions of the riskiness of a client? (4) Due to ill-fitting production models? [Brown and Knechel, JAR]

© W.R. Knechel

Audit EfficiencyFa

ctor

1

Factor 2

Efficiency Frontier

EA

DC

B

G

HF

Is the market for audit services “complete”?

© W.R. Knechel

Is Audit Supply Complete?Fa

ctor

1

Factor 2

Efficiency Frontier

EA

DC

B

G

HF

Is audit quality constant?

© W.R. Knechel

Audit Effort and Efficiency (Part I)• A positive residual in an hours regression is not necessarily

a sign of “inefficiency”.• Story 1: A firm with more Part II deficiencies does more

work because they take on the “wrong” clients. Is this captured by the residual of an effort regression?(1) The extra work is not significantly different from zero? (2) Due to omitted variables?(3) Due to varying perceptions of the riskiness of a client? (4) Due to ill-fitting production models? [Brown and Knechel, JAR]

• Story 2: They improperly scope the audit The “proper” scope for an engagement is essentially unobservable (credence theory).

© W.R. Knechel

Audit Effort and Efficiency (Part II)

• Story 3: The auditor lacks expertise, training or proper methodology Isn’t this just as likely to lead to under-auditing because the auditor fails to appreciate the riskiness of the client?

• An Alternative Story: Is extra work due to anticipation of PCAOB inspections and focus on standardization, especially in a credence goods world with shadow standards.

• FINALLY: Does the PCAOB really want to be in the business of suggesting audits are inefficient (meaning the auditor should do less work)?

© W.R. Knechel

Interesting, Odd or Unexplained Results

• Table 9: “Proportion remediated” is negative but “number of words” stays positive? If things are in fact getting better, how can they still be getting worse?

• Table 4: “DecYE” is negative for restatements. Is this counter to an efficiency argument?

• Table 5: Positive association of “Number_Words” and fees? Auditors can price their low quality? Is this really a proxy for complexity?

• Table 7 (Panels D and E)/Table 8 (Panels A and C): Results for “QC Index” contradict results for “Number_Words”.

© W.R. Knechel

In the end …. one question

Are more adverse Part II QC deficiencies a

uniformly good thing?

Are increases in auditor effort a uniformly good

thing?

Are the responses to audit inspections Pareto Efficient?

More work More cost More QCD more changes to audit firms

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