Jere R. Francis Curators’ Professor and KPMG Distinguished Research Professor, University of Missouri francis@missouri

1. Jere R. FrancisCurators’ Professor and KPMG Distinguished Research Professor, University of Missourifrancis@missouri.edu Doctoral Consortium “Researching Audit Quality” For literature review, see “What do we know about audit quality?” British Accounting Review 36 (2004), pp. 345-368.

2. Challenges in Audit Quality Research • Quality (competence/independence) can’t be directly observed • The exception is “proven” ex-post audit failures (very rare) • Auditor choice is endogenous (selection problem) • i.e., is audit quality the result of good audits or do “good” companies simply choose “better” quality auditors • endogeneity/selection is perhaps the biggest challenge • Three broad proxies for audit quality • Auditor characteristics • firm size (big/small), brand name (B4), industry expertise, litigation and sanctions – these measures are correlated • locale/unit of analysis (global, country, city/office, partner/team) • Engagement-specific characteristics • audit/nonaudit fees (client influence), auditor alumni, tenure • Financial statement characteristics (audit outcomes) • Is audit quality=auditor conservatism, and is this a good thing?

3. Genres of Research(complementary) • Experiments • experimental economics • audit judgment research • Archival/empirical • audit markets research • Qualitative research • field studies • socio-historical studies • Modeling-Analytical studies • Mathematics, economics, logic, simulations, etc.

4. Units of Analysis • Audit testing & evidence-gathering procedures • Auditor judgments about testing/evidence • individual auditors • auditors work in teams • Accounting firms • auditors work in firms • Publicly observable audit outcomes • audit firms issue audit reports • firms-clients jointly produce audited financial statements • Audit markets • firms operate/compete in audit markets • Regulatory institutions • auditors, firms and markets are subject to regulations

5. Audit Testing Procedures • Purpose • Understanding, evaluating and improving the quality of audit testing and evidence-gathering procedures • Historical examples • Effectiveness of accounts receivable confirmations • Caster (AJPT 1990) [archival working papers] • Development of dollar-unit statistical sampling • more efficient and effective than classical sampling • Current examples • How do risk assessments affect other audit testing procedures? • Mock and Wright (AJPT 1999) [archival working papers] • How effective is the new business risk audit methodology? • University of Illinois/KPMG case research program

6. Auditor Judgments • Descriptive “lens” models (1970s) • What information cues affect auditor decision-making? • Heuristics and biases (1970s-80s) • Are auditors different than other decision-makers? • Memory and cognition (1990s) • What do auditors know, and why? • Some current examples • How does “justification” affect performance quality? • How does “accountability” affect judgment? • Do groups outperform individuals in brainstorming fraud risk? • new SAS fraud requirement for U.S. auditors

7. Accounting Firms(mostly a black box) • Understanding the structure/administration of firms • How centralized/decentralized are firms? • how much autonomy for local offices/partners? • a central issue in Andersen’s Enron audit • begs question, what’s the appropriate unit of analysis? • How do partners share profits? • large v. small pools, awarding of partnership units • incentive effects? SOX eliminated NAS-based compensation (cross-selling) • Do firm reputations (audit quality) vary across offices? Across countries? • if so, why, and what are the consequences?

8. Observable Audit Outcomes • Audit reports issued by accounting firms • limited opportunities as only 10% are GC reports • Audited financial statements • jointly produced by auditors-clients • Examples of research questions: • do audit firm characteristics (size, reputation, locale, etc.) affect observable audit outcomes? • what factors affect modified audit reports? • are modified audit reports informative? • what are the discretionary/judgmental elements of F/S’s most affected by (differential) auditing?

9. Audit Industry & Markets (IO) • Why is the industry dominated by large firms? • scale economies (Banker et al. JAE 2003) • Are there barriers to entry in auditing? • Are audit markets competitive, or monopolistic? • Are there positive spillovers in the joint production of audits and other services? • Is there demand for (supply of) differential audit quality, and why? • agency, signaling, insurance, and litigation stories, • If so, how are differential audits priced, and are audit outcomes (e.g., earnings quality) different?

10. Regulatory Institutions • How do professional bodies & regulatory institutions affect audits and accounting firms? • Examples of research questions: • How do regulator (SEC) sanctions affect firms? • Wilson & Grimlund (AJPT 1990) • How do other regulations/institutions affect audits/firms? • e.g. SOX, and role of audit committees • How do legal liability regimes affect audits/firms? • changes in the U.S. (Lee and Mande AJPT 2003) • cross-county studies of alternative regimes • How would a ban on nonaudit services affect audits? • many current studies on nonaudit services/auditor independence • How have mergers/consolidations affected audits/industry?

11. Good Research Questions • What is the study’s research question? • Should be clearly stated on first page (title, 1st sentence?) • Introductions should be 2-3 pages max (simple overview) • Who cares, and why? • Answers a fundamental “core question” in the field • e.g., is there differential auditor reputation/audit quality and how does it affect earnings quality? • Investigates important public policy issues, e.g., auditor rotation, nonaudit services and auditor independence • Examines “hot topic” e.g. Sarbanes-Oxley (competition) • Research design/methodological issues (least interesting) • Recognize the limitation of any single study • auditor differentiation (pricing), then evidence on outcomes (reporting and accruals conservatism)

12. Data Innovation in Empirical Audit Research • Key driver is doing what you enjoy, and finding the right data • Novel data sources • Use new data to answer “old” questions better or to answer “new” questions that could not previously be investigated • public data – new U.S. audit fee data • risky because of competition • private data collection • risky because costly and outcome is unknown • Novel use of existing data sources (most studies) • Creatively uses existing data in new ways • link financial statements (abnormal accruals) with auditor characteristics • Becker et al. (CAR 1998), Francis et al. (AJPT 1999) • city-level unit of analysis • Francis et al. (ABACUS 1999), Reynolds &Francis (JAE 2000)