Audit Firm Tenure, Non-Audit Services and Internal Assessments of Audit Quality

1. Audit Firm Tenure, Non-Audit Services and Internal Assessments of Audit Quality T. Bell, M. Causholli and W.R. Knechel

2. The Issues that Will Not Go Away … • Auditor tenure and non-audit services • Accounting firm commercial self-interest. • Regulatory obsession: • PCAOB and GAO report • EU Green Paper and related proposals • PCAOB Concept Release (2011) and Public Meeting on Firm Independence and Rotation (2012) • Academic attention and (debatable) audit quality proxies.

3. The Arguments • Conflicted expertise? • Improves auditor knowledge (spillovers, learning). • Reduces audit costs and improves efficiency. • Natural reaction to increasing complexity (globalization, IT change, financial complexity). • Needed due to integration of control and governance. • Uninformed independence? • Economic bonds and incentives increasingly complex. • Creates inappropriate incentives. • Undermines independence.

4. Summary of Some Key Results • Audit quality is significantly lower in year one but not later. • Lowballing occurs in year one but this is when the intensity of auditor effort is highest.  Hard work cannot completely compensate for lack of familiarity. • Some types of NAS are associated with higher audit quality, especially MAS. • NO evidence of any loss of audit quality from NAS in general.

5. Academic Research: Tenure • Association of tenure and audit quality: • Evidence of decline in early year(s) of an engagement (Johnson et al. 2002, Myers et al. 2003). • Association may not be linear (Davis et al. 2009, Brooks et al. 2012). • Would results be different in mandatory setting? • Actual or proxy settings (Cahan and Zhang 2006, Blouin et al. 2007, Cameran et al. 2009). • On balance: Short tenure can have negative consequences for audit quality, but in some cases so does very long tenure • Few clear benefits to mandatory rotation.

6. Academic Research: Tenure • Most prior research suggests that financial reporting quality is lower when auditor tenure is short (see Myers et al. 2003). • But what is causing this association? • Deficiencies in audit process? • Economic bonding? • Lack of knowledge? • Poor proxies? H1: Audit firm tenure is associated with the internally assessed quality of the audit process.

7. Academic Research: Non-audit Services • Association between NAS and audit quality: • Some evidence of a problem (Frankel et al. 2002) • But majority of later evidence is to the contrary (Habib 2009) • Types of NAS may matter: • Tax vs. MAS vs. other (Kinney et al. 2004) • Recurring vs nonrecurring (Paterson and Valencia 2011) H2: Different types of non-audit services are differentially associated with internally assessed audit quality.

8. Our Data • Data come from internal assessments of the quality of US-based audits in a Big 4 firm. • Data was collected form late spring to early fall of 2003 and pertain to audits before SOX (FYE = 2002 or 2003). • Firm personnel knew that PCAOB inspections were on the horizon. • Final sample = 265 engagements in 4 industries • Consumer & industrial products; financial services; information, communication and entertainment; health care. • Includes high number of former AA clients

9. Audit Quality Measures • A review team assessed 55 individual audit activities: • Audit planning (analytical procedures, fraud risk assessment) • Internal controls (testing of controls; understanding of processes) • Substantive testing (tests of details; inventory observations, rev, recognition) • Wrap up (subsequent events, GCOs, related party) • For each activity the team judged whether audit performance was satisfactory or deficient. • Data included number of deficiencies (Range: 0 to 14).

10. Audit Quality Measures • At conclusion review team made 4 composite assessments • The sufficiency of evidence obtained to support the audit opinion • The appropriateness of the accounting principles • The appropriateness and completeness of presentations and disclosures embodied in the financial statement • The appropriateness of the auditor opinion • The review team also made and documented a final composite assessment of the overall audit qualityfor the engagement

11. Audit Quality Measures • Rating of overall audit quality • Rating = 1: Unqualified Satisfactory (N= 112; 42%) • Rating = 2: Satisfactory with comments (N=133; 50%) • Rating = 3: Needs improvement (N=18; 7%) • Rating = 4:Unsatisfactory (N=2; 1%) • Primary Analysis: AQ = 1 if rating = 1 (Unqualified Satisfactory); 0 otherwise

12. Audit Deficiencies

13. “Satisfactory with Comments” • Alternative analysis: Some audits rated “Satisfactory with comments” have only minor issues and are comparable to “satisfactory”. • No engagements rated 3 or 4 had fewer than 2 deficiencies. • Secondary Analysis: AQREV = 1 forengagements receiving “Unqualified Satisfactory” (RATING=1) plus the subset of engagements receiving “Satisfactory with Comments” (RATING=2) that had less than 2 deficiencies .

14. Audit Quality by Industry

15. Test Variables: Tenure • Dummy FIRST = 1 for first year clients; 0 otherwise • Supplementary analyses: • Continuous tenure • Non-linear (alternative cut-offs, tenure squared etc)

16. Test Variables: NAS • Classify NAS by type: • Tax services (TAX) • Management Advisory Services (MAS) • Services relating to new securities offerings (OFFER) • Services relating to M&A activities (MA) • Other (OTHER) • Scale fees by the square root of total assets: • TAXFEESQRT • MASFEESQRT • OFFRFEESQRT • OTHFEESQRT (includes MA + OTHER)

17. Empirical Specification AQ/AQREV= a0 + a1(LAST) +a2(PUB) + a3(ROMM) + a4(LEV) + a5(FIRST) + a6(TAXFEESQRT) + a7(MASFEESQRT) + a8(OFFRFEESQRT) + a9(OTHFEESQRT) + u where LAST = natural log of total assets. LEV = long-term debt divided by total assets. ROMM = 1 if the assessed risk of material misstatement at the overall financial statement level is moderate or high, 0 otherwise. PUB = 1 if the client is publicly-listed, 0 otherwise.

18. Tenure Results: Table 4, Panel A

19. Tenure Results: Table 4, Panel B

20. Tenure Results: Table 5, Panel A

21. Tenure Results: Table 5, Panel B

22. Tenure: Additional Analyses • Add dummy LONG = 1 if tenure ≥9 years • LONG is not significant • Use TENURE and TENURE squared • TENURE w/o including the square term is positive and marginally significant • TENSQ not significant •  no evidence of a non-linear relationship • Define SHORT as tenure ≤ 3 • Not significant • Exclude AA clients • FIRST no longer significant (power?)

23. Additional Analysis: Lowballing/Effort • Audit intensity = labor hours by ranks divided by assets • Audit Fees = f(FIRST, controls) (Bell et al. 2008) • Audit intensity = f(FIRST, controls) • Results: Evidence of lowballing, but audit intensity is higher for first year engagements • Interpretation: • Competitive pressures lead to low initial fees. • Increased intensity suggests auditors lack knowledge of the client in the initial year and will obtain this knowledge in spite of lowballing (Schelleman and Knechel, 2010). • Initial audits still likely to be lower quality.

24. NAS Results: Table 4, Panel A

25. NAS Results: Table 4, Panel B

26. NAS Results: Table 5, Panel A

27. NAS Results: Table 5, Panel B

28. NAS: Additional Analyses • Consider total NAS fees • No significant results • Use dummy variables for each type of NAS • Results are qualitatively similar to primary results • Exclude AA clients • Results are qualitatively similar to primary results

29. Conclusions • First year audits are more likely to be of lower audit quality, but the lower audit quality does not extend beyond the first year. • Evidence that the lower quality in first year audits is due to lack of client specific knowledge. • Some types of NAS provide benefits to audit quality • Regulatory implications: • Provides little support for mandatory rotation, which may increase costs and reduce audit effectiveness. • Regarding NAS, our results suggest a more nuanced approach rather than outright prohibition