Brian Fitzgerald Thomas Omer Texas A&M University Anne Thompson The University of Illinois

1. Audit Partner and Audit Firm Rotation and the Assessment of Internal Control Deficiencies Brian Fitzgerald Thomas Omer Texas A&M University Anne Thompson The University of Illinois

2. Overview Research question Motivation Hypotheses Research design Empirical results Conclusions and contributions

3. Research Question What are the effects of audit firm changes and audit partner rotation on the reporting of internal control deficiencies?

4. Motivation Implications for understanding the costs and benefits of audit firm and audit partner changes • Financial reporting misstatements and low accrual quality are associated with internal control weaknesses • Control risk assessment is important for planning substantive audit procedures • Lack of client specific knowledge may lead to over- or under-reliance on internal controls (i.e. ineffective or inefficient audit program) • Auditors’ choices about whether and how to report control deficiencies can influence stakeholders’ decision-making

5. The Not-for-Profit Sector Setting The U.S. federal government relies on internal control attestation to monitor federal award recipients • Focus on controls supports compliance with laws and regulations • Helps to ensure appropriate administration of federal awards NFPs have financial incentives to invest in internal controls • Federal agencies and private donors decrease funding following disclosure of internal control deficiencies Two unique features of this setting: • A-133 audit reports disclose material weaknesses, significant deficiencies, and exceptions in the controls and substantive testing • Audit partner is observable

6. Hypotheses

7. Audit Firm Changes (H1) Control deficiencies may be reported more frequently following audit firm changes due to initial year audit procedures • Professional standards require auditors to invest in gaining client-specific knowledge in the initial year, including the control environment • Prior studies document higher audit hours in the first year of an engagement Predecessor auditors may not have reported known control deficiencies in prior years • Escalation of commitment may influence auditors’ assessments of the severity of detected internal control deficiencies

8. Audit Firm Changes (H1) (cont) Control deficiencies may be reported less frequently following audit firm changes if a high degree of client-specific knowledge is needed to evaluate controls effectively • Auditors may place greater reliance on management representations due to lack of client specific knowledge • Prior studies commonly document lower accrual quality in the early years of the auditor-client relationship H1: Audit firms are no more likely to report internal control deficiencies in the initial year of audit firm tenure

9. Audit Partner Rotation (H2) Partners may develop relationships with their clients over time that potentially compromise auditor independence Audit partner rotation may result in an increase in reported control deficiencies • Partner rotation may bring a “fresh look” to the engagement • Partners increase planned procedures in their initial year on an engagement

10. Audit Partner Rotation (H2) (cont) Control deficiencies may not be reported more frequently following audit partner rotation • Client-specific knowledge is carried forward in work papers • Other client personnel are not required to rotate • Survey evidence indicates that U.S. audit partners need two years to gain client-specific knowledge H2: Audit partners are no more likely to report internal control deficiencies in the initial year of audit partner tenure on a continuing client.

11. Audit Partner Tenure (H3) No clear prediction for how control deficiency reporting varies with audit partner tenure • Audit partners have incentives to protect their reputational capital • Audit partners may be susceptible to cognitive biases over successive audits • Studies on audit partner tenure from other securities markets (Australia, Taiwan) provide mixed evidence on the relation between audit partner tenure and audit quality H3: Audit partners are no more likely to report control deficiencies on clients with longer partner tenure.

12. Research Design

13. The Not-for-Profit Sector As a component of the U.S. economy, the NFP sector: • Contributes 5% of GDP • Employs 10% of the U.S. workforce • GAO estimates $235 billion in federal awards reached the NFP sector in 2006 • NFPs benefit from $50 billion annually in foregone federal tax payments Growth of NFP sector has attracted Congressional scrutiny • NFPs can exploit their tax-exempt status to earn economic rents at the expense of for-profit counterparts

14. OMB Section A-133 Audit Reports Federal award recipients submit audited financial statements and A-133 audit reports if federal expenditures exceed $500,000 during the year ($300,000 prior to 2004) A-133 audit reports disclose material weaknesses and reportable conditions (significant deficiencies) over: • Internal control over financial reporting • Compliance with major program requirements Reports also include audit findings and questioned costs (i.e. exceptions identified in the control and substantive testing over major programs)

15. Sample Selection Financial statement data from IRS Form 990 information return for NFPs reporting at least $30 million in assets (2000-2007) Audit opinions from the Federal Audit Clearinghouse for NFPs expending at least $500,000 in federal awards during the year (1997 onward)

16. Industry Distribution

17. Sample Statistics

18. Dependent Variables Estimate logistic regressions where the dependent variable equals one if the audit report indicates: • Financial statement reportable condition (FS_RC) • Financial statement material weakness (FS_MW) • An audit finding or questioned cost (FINDORQ) • Major program reportable condition (MP_RC) • Major program material weakness (MP_MW)

19. Independent Variables H1: CHANGEFIRM equals one if the client changed auditors from year t-1 to year t H2: CHANGEPARTNER equals one if the audit partner changed from year t-1 to year t and CHANGEFIRM=0 H3: LONGTENURE equals one if audit partner tenure in year t exceeds 5 years

20. Regression model Control deficiency = CHANGEFIRM + CHANGEPARTNER + LONGTENURE + Controls + Year + Industry + IMR Control Variables: • Prior Year Report Modifications (GC and control deficiency) • Complexity, Size, Growth, Leverage, Performance, Acct Fees, Employees, Lobbying, Risk • Auditor (BigN, Second Tier, Specialist, Other PCAOB/non PCAOB registered firm)

21. Selection Model Public companies are more likely to change auditors following an adverse internal control opinion Follow Tate (2007) in modeling for audit firm changes in the NFP sector • Changes in contributions, revenues, expenses, liabilities, compensation, and accounting fees • Augment with outcome variables, auditor’s client base, and Andersen client, industry, year, and state indicator variables ROC = 0.786, Pseudo R-Square = 0.243

22. Empirical Results

23. Frequency of control deficiencies

24. Reported control deficiencies by audit partner tenure

27. Multivariate tests of H1-H3

28. FS Control Deficiencies by Audit Firm Tier

29. Control deficiency reporting surrounding auditor tier changes

30. H2 Additional Tests: Change Partner Insignificant coefficient on CHANGEPARTNER: • Audit partners may have previous experience on the client, and so do not bring “fresh eyes” to the engagement • Audit partners require 2 years experience to gain familiarity with the client, so effects, if any, may arise in year 2

31. Prior Client Familiarity

32. Second year of audit partner tenure

33. H1 Additional Test: Change Firm Is the positive significant coefficient on CHANGEFIRM: • Due to the application of new audit methodology and initial year audit procedures? • Or did the predecessor auditor fail to report known deficiencies in prior years

34. Control deficiency reporting preceding audit firm and partner changes

35. Control deficiency reporting preceding audit firm and partner changes (Big N/Second Tier)

36. Sensitivity Tests Results are consistent : • Controlling for prior audit partner tenure • Controlling for or excluding former Andersen partners and clients • In annual cross sectional regressions • Examining only “first time” control deficiencies

37. Summary of Findings Auditors are more likely to report all categories of control deficiencies in the initial year of the auditor-client relationship No differences in reported control deficiencies in years of audit partner changes Long audit partner tenure is associated with higher likelihood of reported findings and questioned costs

38. Conclusions and Contributions Contributions to the literature on the costs and benefits of audit firm changes and audit partner rotation: • New audit firms’ investment in understanding controls appears to lead to an increase in reported control deficiencies • May provide an explanation for why accrual quality improves with audit firm tenure • No evidence supporting the notion that audit partner rotation immediately provides a “fresh look” • Partner tenure exceeding 5 years may lead to higher audit quality

39. Thank you

42. FS Reportable Conditions by Audit Firm Tier

43. FS Material Weaknesses by Audit Firm Tier