Auditor risk management following audit failure
Auditor Risk Management following Audit Failure by Stephan A. Fafatas B.B.A. Texas A&M University, 1997 M.S. Texas A&M University, 1998 A thesis submitted to the Faculty of the Graduate School of the University of Colorado in partial fulfillment Of the requirements for the degree of Doctor of Philosophy Department of Accounting 2006 UMI Number: 3239393 3239393 2007 UMI Microform Copyright All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, MI 48106-1346 by ProQuest Information and Learning Company. This thesis entitled: Auditor Risk Management following Audit Failure written by Stephan A. Fafatas has been approved for the Department of Accounting ______________________________________ (Dr. Steven K. Rock, co-chair) ______________________________________ (Dr. Philip B. Shane, co-chair) Date_____________ The final copy of this thesis has been examined by the signatories, and we find that both the content and the form meet acceptable presentation standards of scholarly work in the above mentioned discipline iii Fafatas, Stephan A. (Ph.D., Accounting) Auditor Risk Management following Audit Failure Thesis directed by Assistant Professor Steven K. Rock and Associate Professor Philip B. Shane. Abstract This study examines the effects of audit failure on Big 4 audit firm monitoring and risk management activities. I use lawsuits and Securities and Exchange Commission actions against auditors to identify serious cases of audit failure and focus my analysis on the audit firm office associated with the event. My results indicate that auditor response to audit failure has changed over time. Auditors implicated in audit failure events occurring post-Enron appear to enforce more conservative accounting choices in the year following the event. Specifically, clients of these auditors report significantly lower abnormal accounting accruals following the audit failure events relative to other auditors in the same local market. However, I do not find a significant decline in abnormal accounting accruals relative to other auditors’ clients following audit failures that occurred prior to 2001. These results are consistent with recent academic research and articles in the financial press which suggest auditors are more concerned with avoiding negative publicity and mitigating increased liability exposure in the post-Enron and Sarbanes- Oxley period. I do not find evidence that relative to other auditors in the same market, implicated auditors increase fees charged to high-risk clients in the year following the audit failure. If these auditors exert more effort or staff more experienced personnel on riskier engagements in the period after an audit failure, the additional costs do not appear to be passed to the client in the form of higher fees. Finally, my results do not support the hypothesis that auditors reduce the level of litigation risk in their portfolio of clients following audit failures. Overall, my results suggest that auditors implicated in audit failure events temporarily increase their monitoring of client accounting discretion. However, implicated auditors do not appear to significantly alter their other risk management practices following these events. Acknowledgements I appreciate the guidance of my dissertation committee: Steve Rock (co- chair), Phil Shane (co-chair), David Frederick, John Jacob, and Robert McNown. This paper has also benefited from helpful comments and suggestions from Dennis Caplan, Li Dang, Katherine Gunny, Scott Hoover, Boochun Jung, Burch Kealey, Wikil Kwak, Atul Rai, Brent Smith, Sunny Yang, and workshop participants at the University of Alabama-Huntsville, The University of Colorado, the University of Nebraska-Omaha, Oregon State University and Washington and Lee University. This dissertation could not have been completed without the great patience and support of my wife, Angie, and loving distraction of my daughter, Sophia. v Contents Chapter 1 Introduction 1 Chapter 2 Background and Related Research 5 2.1 Auditor Reputation 5 2.2 Audit Failure Events 7 2.3 Audit Failure and Auditor Reputation Effects 9 2.4 Auditor Response to Audit Failure 11 2.5 Auditor Risk Management 13 Chapter 3 General Research Design Issues 16 3.1 Office Level Analysis 16 3.2 Audit Failure Events Sample 17 3.3 Measuring Client Litigation Risk 21 Chapter 4 Monitoring Client Financial Reporting following Audit Failure 23 4.1 Hypothesis Development 23 4.2 Measuring Abnormal Accruals 25 4.3 Research Design 27 4.4 Sample Selection 29 4.5 Initial Results 33 4.6 Results by Sub-Period 33 4.7 Sensitivity Tests 39 Chapter 5 Audit Failure and Fees Charged to High-Risk Clients 48 5.1 Hypothesis Development 48 5.2 Research Design 49 5.3 Sample Selection 52 5.4 The Association between Litigation Risk and Audit Fees 55 5.5 Results and Analysis 58 Chapter 6 Changes in Audit Firm Client Portfolios following Audit Failure 66 6.1 Hypothesis Development 66 6.2 Research Design 67 6.3 Sample Selection 68 6.4 Results and Analysis 69 Chapter 7 Conclusion 73 7.1 Summary of Results and Contribution 73 7.2 Limitations and Possible Extensions 75 Bibliography 77 vi List of Tables Table 1 Audit Failures 1997 – 2003 20 Table 2 Descriptive Statistics for Abnormal Accruals Analysis Sample 31 Table 3 Abnormal Accruals following Audit Failures 34 Table 4 Abnormal Accruals following Audit Failure by Time Period 36 Table 5 Abnormal Accruals following Pre- and Post- Enron Audit Failures 38 Table 6 Changes in Abnormal Accruals following Post-Enron Audit Failures 40 Table 7 Results from Estimating Separate Post-Enron Event Regressions 42 Table 8 Abnormal Accruals following Audit Failures over an Extended Time Series 44 Table 9 Abnormal Accruals following Audit Failures over an Extended Time Series and Controlling for Lagged Abnormal Accruals 46 Table 10 Descriptive Statistics for Audit Fee Sample 53 Table 11 Client Litigation Risk and Audit Fees 57 Table 12 Fees Charged to High-Risk Clients following Audit Failures 59 Table 13 Fees Charged to Highest Quintile of Risky Clients following Audit Failures 63 Table 14 Litigation Risk in Client Portfolios following Audit Failures 70 Table 15 Litigation Risk of New Clients following Audit Failures 72 1 Chapter 1 Introduction The recent series of high-profile accounting scandals (e.g. Enron, WorldCom, Xerox, and Tyco) led to intense media scrutiny over public accounting firms and fueled sweeping audit market reform. 1 Indeed, these scandals and similar instances of accounting irregularities are often cited as examples of “audit failure,” defined as an event in which the auditor fails either to enforce generally accepted accounting principles or to issue a modified or qualified report if such report is warranted (Francis 2004). Prior academic research suggests that audit failures result in an impairment of auditor reputation, as evidenced by a loss in market share (Wilson and Grimlund 1990; Firth 1990), lower audit fee premiums for new clients (Davis and Simon 1992) and a decline in client stock price (Franz, Crawford, and Johnson 1998; Chaney and Philipich 2002). 2 Although research supports the notion that audit failures damage auditor reputation, how auditors respond to such events remains an unexplored topic. I use lawsuits and Securities and Exchange Commission (SEC) enforcement actions against Big 4 audit firms to identify audit failure events and test whether implicated audit firm offices increase client monitoring and risk management efforts 1 These events led in part to the passage of the Sarbanes-Oxley Act in 2002. 2 Throughout this paper, the term “auditor” refers to an audit firm as opposed to an individual auditor, unless otherwise specified. 2 following these events. 3 Increased monitoring and risk management may reduce the likelihood of future audit deficiencies, aid in deflecting criticism of the firm, and, in turn, facilitate repairing the auditor’s tarnished reputation. 4 Specifically, I first test whether clients of auditors implicated in audit failures report more conservative earnings, as measured by abnormal accounting accruals, in the period following the audit failure. Further, I expect the implicated firm to intensify audit planning and the required evidence associated with high-risk clients following the audit failure. The additional effort associated with high-risk engagements should result in increased fees charged to these clients. Finally, I investigate changes in risk levels of the implicated firms’ client portfolio following audit failure events. Empirical research indicates that, in general, audit firms actively manage the litigation risk exposure in their portfolio of clients (Johnstone and Bedard 2004). However, an open question remains whether firms increase litigation risk aversion in client acceptance and retention decisions following an audit failure incident. I address this issue by examining whether the litigation risk levels in the implicated firms’ portfolio of clients decline in the period after the audit failure. My results suggest that auditor response to audit failure has changed over time. I find evidence that auditors enforce more conservative accounting choices 3 Prior to the collapse of Arthur Andersen and the merger of Price Waterhouse and Coopers & Lybrand, the merger of Touche Ross and Deloitte, Haskins and Sells, and the merger of Ernst & Whinney and Arthur Young the current Big 4 was known as the Big 8. I refer to the set of the largest public accounting firms as the Big 4, regardless of the time period. 4 Audit firms may also increase public relations and marketing campaigns to repair reputation, but this appears ineffective. In fact, PricewaterhouseCoopers was criticized in 2003 for running ads in national newspapers under headings such as “Integrity 101” at the same time that the SEC was forcing PwC client Tyco to restate up to five years of previously issued financial results (Weil and Maremont 2003). Hillison and Pacini (2004) provide further evidence that advertisements have little immediate impact on auditor reputation. 3 following audit failures in the post-Enron and Sarbanes-Oxley (SOX) period. Relative to clients of other audit firms, clients of the implicated firm experience a 5.8% decrease in discretionary accounting accruals as a percentage of total assets in the year following the audit failure. For the sub-sample of audit failures occurring prior to 2001, I do not find a decline in post-audit failure discretionary accounting accruals relative to clients of other auditors. These results are consistent with recent academic research and articles in the financial press which indicate audit firms are more actively implementing measures to mitigate negative publicity and reduce legal liability exposure in the post-Enron environment (e.g. Frieswick 2003; Geiger, Raghunandan, and Rama 2005). However, additional tests reveal that the decline in discretionary accounting accruals is only temporary. By the second year following the audit failure, there is no significant difference in discretionary accounting accruals reported by clients of implicated auditors and those reported by clients of other firms. Additionally, I find no evidence that, relative to other auditors, implicated firms charge riskier clients higher fees following an audit failure, controlling for other fee determinants. While it is possible that these auditors increase effort related to risky engagements, the added costs are not passed to clients in the form of higher audit fees. Similarly it does not appear that, following audit failures, implicated audit firms modify their risk management strategies relating to client acceptance and retention decisions. Relative to other auditors, the litigation risk level of the portfolio of implicated firm’s clients does not change significantly in the period following the audit failure event. [...]... whether auditors monitoring and risk management activities increase and then revert quickly to pre -audit levels 2.5 Auditor Risk Management Auditor business risk refers to the risk of potential litigation and reputation costs resulting from an alleged audit failure. 18 Prior research indicates that, in general, audit firms take actions to mitigate the level of business risk exposure One way auditors... against auditors Following an audit failure event, I predict that the implicated auditor is more likely to enforce conservative accounting policies that minimize the risk of issuing misleading financial statements This increased monitoring over client financial reporting will reduce the risk of the implicated auditor incurring additional reputation costs from future audit failures If these sanctioned auditors... higher levels of business risk are associated with increases in audit effort and fees Further, Big 4 auditors appear to be generally risk averse in client acceptance and continuance decisions An unresolved issue which I address in this thesis is whether specific audit failure events affect audit firm risk management strategies 22 Overall audit risk is the probability that an auditor may unknowingly fail... research design issues that pertain to multiple sections of this thesis Chapter 4 examines auditor monitoring of client financial reporting following audit failure Chapter 5 includes the analysis of audit fees following audit failure Chapter 6 examines changes in the post -audit- failure risk profiles of sanctioned auditor clienteles and Chapter 7 concludes 5 Companies disclosing alleged reporting violations... between audit firm size and audit quality.6 This argument is based on the theory that the value of an auditor' s services will decline once it is revealed that an auditor either failed to discover or report a client's accounting breach Since incumbent auditors earn client-specific rents, auditors with a greater number of clients stand to lose more in the event of an audit failure Therefore, larger audit. .. changes in auditor behavior may not occur First, auditors might adopt equilibrium strategies with respect to monitoring and risk management Thus, costs associated with potential audit failures are factored into their actions Realizations of at least a portion of these costs are rationally expected and, therefore, significant changes in auditor monitoring or risk management activities are not observed following. .. specific audit failure event This argument highlights the need to focus on the most egregious instances of audit failure to maximize the power of the tests Second, DeFond and Subramanyam (1998) find that managers are more likely to dismiss incumbent auditors when these auditors enforce more conservative accounting choices If auditors are concerned about a decrease in market share following audit failures... implicated auditor (AUDITOR) , and other controls identified in prior studies that are expected to affect a firm’s accrual generating process The following pooled OLS regression is estimated for client i in city c and year t, where c is the city of the audit failure and “year” is the calendar year immediately pre- or post -audit failure: DAi,c,t = β 0 + β 1 POST1 + β 2 AUDITOR + β 3 POST1 * AUDITOR +... with the audit failure appears to suffer the greatest reputation loss Given these results, a natural question to ask is whether firms take actions following audit failure events to mitigate the associated reputation costs 2.4 Auditor Response to Audit Failure A central idea in auditing research is that audit quality is difficult to assess ex ante This difficulty arises due to the fact that auditing... aspect of risk management 14 financial risk and audit risk. 22 Financial risk variables include quantitative measures such as leverage and return-on-assets while audit risk variables include qualitative assessments of the client’s internal controls, financial reporting risk, and management s integrity Similar to the results of Krishnan and Krishnan (1997), Johnstone and Bedard (2004) find the audit office . Research 5 2.1 Auditor Reputation 5 2.2 Audit Failure Events 7 2.3 Audit Failure and Auditor Reputation Effects 9 2.4 Auditor Response to Audit Failure 11 2.5 Auditor Risk Management 13 . on whether auditors monitoring and risk management activities increase and then revert quickly to pre -audit levels. 2.5 Auditor Risk Management Auditor business risk refers to the risk of potential. that relative to other auditors in the same market, implicated auditors increase fees charged to high -risk clients in the year following the audit failure. If these auditors exert more effort