Kenneth L. Bills University of Oklahoma May 2012

1. The Effects of Significant Changes in Auditor Clientele and Auditor-Client Mismatches on Audit Quality Kenneth L. Bills University of Oklahoma May 2012

2. Presentation Overview • Research Topic • Regulatory Concerns • Hypothesis Development • Methodology and Results

3. Research Topic Strained Capacity at Local Audit Offices Excess Capacity at Local Audit Office Audit Quality Portfolio Management Decisions Audit Firm Size

4. Research Topic Auditor-Client Mismatches Audit Quality

5. Regulators’ Concerns Mandatory Audit Firm Rotation Arguments For • ↑ Auditor Independence • ↑Audit Firm Competition • Fresh Viewpoint • Concern about what New Audit Firm will Find Arguments Against • Forced Switch from Most Experienced Audit Firm • Company-Specific Knowledge is a GOOD Thing • Cost to Companies is Burdensome

6. Additional Potential Concerns • Increased Frequency of Auditor Changes May • Disrupt Audit Firms’ Operations • Interfere with their Ability to Focus on Perform High Quality Audits • Audit Firms May Not Have the Capacity to Assign Appropriately Qualified Personnel to New Engagements • Rotation Requirement May Limit a Company’s Choice of Auditor

7. Mandatory Audit Firm Rotation Volatility in Audit Firms’ Clientele Portfolios Strained or Excess Audit Firm Capacity Audit Quality

8. Mandatory Audit Firm Rotation Mandating Auditor Changes & Limiting a Company’s Choice in Audit Firm Auditor-Client “Mismatches” Audit Quality

9. Regulators’ Concerns Contingency Planning for Significant Changes in Audit Firm Capacity in a Geographic Area 2008 Technical Committee Report International Association of Securities and Exchange Commissions (IOSCO)

10. Strained and Excess Capacity • Causes • External Shocks to the Audit Market • Changes in Capacity Inputs • Changes in Capacity Outputs

11. Strained and Excess Capacity Significant Changes in Local Audit Office Clientele

12. Steps to Reduce Strained or Excess Capacity • Hiring/Firing Employees • Hiring/Firing Clients • Use of Built in Cushion • Use of Flexible Capacity (Overtime, Outsourcing) • Transferring Employees (Larger Audit Firms) • May Be Insufficient for Extreme Changes in Clientele

13. Hypothesis Development

14. Hypotheses – Audit Quality • Production Economics Literature • Maintaining Delivery Dependability and Quality is More Difficult in Tightly Constrained Systems • Lovelock (1984) and Sridharan (1998)

15. Proper Judgment Hypotheses – Audit Quality • Reduce Risk • Proper Judgment • Poor Judgment • Proper Judgment • Proper Judgment • Relationship Concerns

16. Hypotheses – Audit Quality H1: Companies audited by local audit offices with strained (excess) capacity will have audit quality similar to companies audited by local audit offices without strained (excess) capacity.

17. Hypotheses – Audit Quality • Discretionary Accruals Model • Modified Jones Model (Dechow et al. 1995) • Kothari et al. (2005) Performance Matched • Absolute Value • A Broad Measure of Audit Quality

18. Hypothesis – Audit Firm Size • Reputational Concerns • “More to Lose” (DeAngelo 1981) • National Office • Established Client-Acceptance Procedures • Established Audit Performance Standards • Ability to Transfer Personnel • Greater Flexibility to Reduce Excess and Strained Capacity

19. Hypothesis – Audit Firm Size H2: The effects of strained (excess) capacity on audit quality will be smaller forBig 4 and second-tier audit firms than for other firms.

20. Hypotheses – Portfolio Management Decisions • Strained Capacity • Ability to Discriminate Among Clients ↑ • Select “Most Preferred” Clients • Excess Capacity • Need to Fill Capacity • Client Acceptance Criteria May be Loosened

21. Hypotheses – Portfolio Management Decisions • Shu (2000) and Landsman et al. (2009) • Mismatches Occur when Large Audit Firms Align with Clients Typically Served by Smaller Audit Firms and Vice Versa • Mismatches Are Not Preferred H3: Auditor-client mismatches are less (more) likely to occur when an audit firm has strained (excess) capacity.

22. Hypotheses – Mismatches and Audit Quality • Mandatory Auditor Rotation may Increase the Occurrence of Mismatches • Especially where there are Few or No Viable Alternatives • Large Audit Firms Correlated with Higher Audit Quality • Francis et al. (1999), Becker et al. (1998) , etc. • Correlation Goes Away when Matched Sample Design is Used • Lawrence et al. 2011 TAR

23. Hypotheses – Mismatches and Audit Quality H4a: Auditor-client mismatches where clients expected to be served by large audit firms are served by small audit firms have lower audit quality than where no mismatches are present. H4b: Auditor-client mismatches where clients expected to be served by small audit firms are served by large audit firms have higher audit quality than where no mismatches are present.

25. Methodology- H1 • Estimate the Following Model Under Two Specifications ERRORit = μ0 + μ1STRAINft + μ2EXCESSft + μ3LATit + μ4Zit + μ5ΔZit + μ6AFEESit+ μ7NFEESit+ μ8GDPit+ μ9ΔGDPit+ μjYearit+ εit • Null Hypotheses: μ1 =0 , μ2 = 0 +/- +/-

26. Methodology- H2 • Add to Each of the Models • Add an Interaction of LGAUDITOR with Each Variable of Interest • Test Significance • LGAUDITOR*STRAIN & LGAUDITOR*EXCESS

27. Results of Going-Concern Opinion Error Test

28. Methodology- H1 • Estimate the Following Model ABSPDAit= β0 + β1STRAINft + β2EXCESSft + β3LTAit + β4CFOit + β5LEVit+ β6MKTBKit+ βjYeart + εit • Null Hypotheses: β1 = 0 , β2 = 0 +/- +/-

29. Results of Discretionary Accruals Test

30. December and Non-December Year End

31. Methodology- H3 • Sample Restricted to First Year Audit Engagements • Estimate the Following Model Under Two Specifications MISMATCH(1 or 2)ft= σ0 + σ1STRAINft + σ2EXCESSft + σ3AFEESit + σ4NFEESit + σ5GDPit + σ6ΔGDPit + σ7HERFft + σkYeart + εit • Hypotheses = σ1 < 0 , σ2 > 0 - +

32. Results of Mismatch Test

33. Methodology- H4 • Estimate the Following Model ABSPDAit= λ0 + λ1MISMATCH1ft + λ2MISMATCH2ft + λ3LTAit + λ 4CFOit + λ5LEVit+ λ5MKTBKit+ λjYeart + εit • Hypotheses = λ1 = 0 , λ2 = 0 + -

34. Results of Discretionary Accruals-Mismatch Test

35. Conclusion • Audit Quality may be Negatively Affected by Strained and Excess Capacity • The Negative Effect of Strained Capacity is Less for Larger Audit Firms

36. Conclusions Continued… • Large Audit Offices with Strained Capacity are Less Likely to Accept New Clients that are Mismatches • Small Audit Firms with Strained Capacity are More Likely to Accept New Clients that are Mismatches • Mismatches may increase or decrease audit quality, depending on the size of the audit firm providing the audit.

37. Thank You for Your Comments