pike - 2003 - studies on audit quality [aq]

Studies on Audit Quality Joel E. Pike A dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy (Business) at the UNIVERSITY OF WISCONSIN - MADISON 2003 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 3101327 UMI UMI Microform 3101327 Copyright 2003 by ProQuest Information and Learning Company. All rights reserved. This m icroform 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, Ml 48106-1346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Committee’s Page. This page is not to be hand-written except for the signatures Committee’s Page. This page is not to be hand-written except for the A dissertation entitled STUDIES ON AUDIT QUALITY submitted to the Graduate School of the University of Wisconsin-Madison in partial fulfillment of the requirements for the degree of Doctor of Philosophy by Joel E. Pike Date of Final Ora! Examination: June 12,2003 M o nth & Y ear D eg re e to b e a w ard e d : December May August 2003 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Approval Signatures of Dissertation Committee Signature, Dean of Graduate School Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. For my wife Nadine Mercil and my father Gilmour J. Pike Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Acknowledgements I would like to thank my dissertation advisor, Ella Mae Matsumura, for her support and guidance over the last six years. I also want to express my deep gratitude to my co-chair, Brian Mayhew, for his generous sharing of his time and expertise. I hope that I can be to others in the future the colleagues they have been to me. I would also like to thank the remaining members of my dissertation committee, Mark Covaleski, John Eichenseher, and Robert B. M iller for their time and suggestions. Several other members of the accounting community at the University of Wisconsin - Madison also deserve special mention. Terry Warfield has been particularly generous with his time and willingness to offer help and suggestions. Kathy Hurtt has also offered insightful comments on sections of this dissertation. My fellow Ph.D. students have also profoundly affected me, making this time one of intellectual exploration and joy. I would like to especially recognize Changling Chen and Helen Brown for their helpful comments and shared interests, and Qiang Cheng for his sense of humor and inspiration. In addition, I would like to thank Matt Magilke for many stimulating discussions, the University of Wisconsin - Madison Department of Accounting and the School of Business for their financial support, and my wife Nadine for her support and her hours of assistance with data collection. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. i i i Table of Contents Acknowledgments ii Figures and Tables viii Chapter 1 Introduction 1 1. Independence and Audit Quality 1 2. The Demand for Auditing, Independence, and Quality 3 3. Levels of Analysis, Methodological Issues in Prior Literature, and Proposed Resolutions 4 3.1 Levels of Analysis 4 3.2 Methodological Issues in the Prior Literature and Proposed Resolutions 6 3.2.1 Archival Studies 6 3.2.2. Analytical Models 8 3.2.3 Experimental Studies 10 4. Summary of Remaining Chapters 11 Chapter 2 Reputation in Auditing 13 1. Introduction 13 2. Theories of Reputation 16 2.1 Reputation Formation and Depletion 18 Chapter 3 Reliable Reputation Formation 21 1. Hypotheses 21 2. Experiment 24 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2.1 Game Description and Player Choices 2.2 Experimental Design 2.3 Subject Pool 3. Results 3.1 Reputation Formation; Sensitivity to Cost and Expected Life 4. Discussion and Conclusions Chapter 4 The Value of a Reputation for Audit Quality: Experimental Evidence from Buying and Selling Reputations 1. Buying and Selling Reputations 2. Hypotheses Development 3. Experiment 3.1 Game Description and Player Choices 3.2 Experimental Design 3.2.1 Treatments: Buying and Selling Reputations 3.2.2 Subject Pool 4. Results 4.1 Buying and Selling Reputations 4.1.1 Competent Auditors Buying Preferences 4.1.2 Competent Auditors Selling Preferences 4.1.3 Inept Auditors Selling Preferences 4.1.4 Other Analysis - Purchase Price Effects 4.1.1a Effects on Buyer-Seller Combination 4.1.1b Effects of Treatments on Purchase Prices Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. V 4.2 Summary 57 5. Discussion and Conclusions 57 Chapter 5 Audit Quality and the Provision of Non-Audit Services: Evidence from the Property-Casualty Insurance Industry: Overview 66 1. Introduction 66 2. Review of Prior Research and Industry Background 68 2.1 Audit Quality 68 2.2 Non-Audit Services and Independence 70 2.3 Insurance Industry Background and Accounting 72 2.4 Loss Reserves and Managerial Incentives 76 Chapter 6 Audit Quality and the Provision of Non-Audit Services: Evidence from the Property-Casualty Insurance Industry: Replication 79 1. Introduction 79 2. Hypotheses Development 79 3. Research Methodology and Results 81 3.1 Sample Selection 81 3.2 Sample Descriptive Statistics 85 3.3 Model Development 85 3.4 Multivariate Analysis 86 4. Conclusion 99 Chapter 7 Audit Quality and the Provision of Non-Audit Services: Evidence from the Property-Casualty Insurance Industry: Industry Specialization 101 1. Industry Specialization 101 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 8 Appendix Appendix 2. Hypotheses Development 102 3. Research Methodology and Results 105 3.1 Sample Selection 105 3.2 Sample Descriptive Statistics 105 3.3 Model Development 105 3.4 Multivariate Analysis 106 4. Conclusion 114 Conclusion 116 1. Summary and Contribution 116 2. Future Research 119 A. Parameter Definitions, Updating, Value, and Cost Constraint Functions and an Excerpt from Mailath and Samuelson (2001) 121 B Experimental Materials 126 1. Instructions for Baseline Short Expected Life 126 2. Instructions for Baseline Long Expected Life 131 3. Instructions for Treatment 1 136 4. Instructions for Treatment 2 143 5. Instructions for Treatment 3 150 6. Instructions for Treatment 4 157 7. Quiz for Baseline Sessions 164 8. Quiz for Treatment Sessions 165 9. Post Experiment Questionnaire 166 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 10. Background Information Request Form Appendix C Example of Loss Reserve Reporting and Development References Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. [...]... Level Industry Specialization by Auditors Industry Concentration in Actuarial Services Industry Concentration in Actuarial Services Provided by Outside Consultants 4 5 7 9 25 27 38 102 103 104 TABLES Table 3-1 Table 3-2 Table 3-3 Table 3-4 Table 3-5 Table 4-1 Table 4-2 Table 4-3 Table 4-4 Table 4-5 Table 4-6 Table 6-1 Table 6-2 Table 6-3 Sixteen High Quality Outcomes and Four Low Quality Outcomes 29 Demographics...v iii Figures and Tables FIGURES Figure 1-1 Figure 1-2 Figure 1-3 Figure 1-4 Figure 3-1 Figure 3-2 Figure 3-3 Figure 7-1 Figure 7-2 Figure 7-3 Demand for Auditing Role of Information Asymmetry in Perceived Auditor Independence and Quality Characteristics and Relationships to Independence and Quality Three Player Multi-Period Game Example Period t Timeline and Player Moves Screenshot... signaling by audit firms and the incentives for investing in forming a reputation for high quality audits Investing in a reputation for high quality could also be considered as one method of trying to signal both a commitment to providing high quality audits and to using high effort in performing the audit It is the formation of a reputation and the relation of a proxy for audit quality with firms considered... resulting measure of precision used as a proxy for audit quality The presence or absence of quality, and the relationship with audit firm type, size, and incentives is explored The study specifically tests the audit firm level variables for the provision of non -audit services, audit firm size, and audit fee links to audit quality in panel A of Figure 1-3 Chapter 6 replicates prior studies and extends them... Assets on Industry Specialist Auditor Type, Actuary Type and Control Variables Reproduced with permission of the copyright owner Further reproduction prohibited without permission 92 9 5-9 7 10 9-1 12 1 Chapter 1 Introduction 1 Independence and Audit Quality Concern over the independence of auditors and the quality of audits has grown in recent years The SEC, the AICPA, academic researchers and practitioners... quality by extending the “look-back” period to include seven years of ex post realization In addition, Chapter 7 looks at the contribution of industry specialization to increased audit quality Chapter 8 concludes with a short discussion and offers suggestions for future research Reproduced with permission of the copyright owner Further reproduction prohibited without permission Chapter 2 Reputation... experimental studies based on these models have produced conflicting evidence on reputation formation Experiments conducted by DeJong et al (1985), Dopuch and King (1991) and King (1996) found inconsistent reputation formation Reputations formed in some markets, but in other markets with the same parameters and institutional rules, reputations did not form 8 Perfect information requires that for each decision... observations of quality or the lack of quality makes them even more important This dissertation extends prior literature on the conditions and characteristics that affect the likelihood of high -quality audit outcomes by using two complementary methodologies: 1) experimental economics to test a new analytical model of reputation formation and transfer and 2) archival data analysis to directly examine audit quality. .. e | » [Conflict o v e r N o n -A m b ig uo u s Is su e [Conflict o v e r A m b ig u o u s ls s u ~ [Prior C onflicts H istory Figure 1-3 Reproduced with permission of the copyright owner Further reproduction prohibited without permission ] 8 measure of audit quality 3.2.2 Analytical Models Antle (1982, 1984) develops analytical models based on game theory that demonstrate equilibrium conditions for... a multi-period dynamic programming model with one client and many auditors to examine both the audit pricing decision in a multi-period setting and conditions that may lead to impaired independence They define independence as reporting contrary to the auditors’ belief about what GAAP reporting requires, in a setting where auditors may disagree about GAAP They find that economically rational auditors . 1-1 Figure 1-2 Figure 1-3 Figure 1-4 Figure 3-1 Figure 3-2 Figure 3-3 Figure 7-1 Figure 7-2 Figure 7-3 TABLES Table 3-1 Table 3-2 Table 3-3 Table 3-4 Table 3-5 Table 4-1 Table 4-2 . permission of the copyright owner. Further reproduction prohibited without permission. V 4.2 Summary 57 5. Discussion and Conclusions 57 Chapter 5 Audit Quality and the Provision of Non -Audit Services: Evidence. Table 4-3 Table 4-4 Table 4-5 Table 4-6 Table 6-1 Table 6-2 Table 6-3 Figures and Tables Demand for Auditing 4 Role of Information Asymmetry in Perceived Auditor Independence and Quality