Audit Quality: Association between published reporting errors and audit firm characteristics

251 Pages·2014·44.872 MB·English

by  Jonas Tritschler (auth.)

Audit Quality
Jonas Tritschler
Audit Quality
Association between published
reporting errors and audit fi rm
characteristics
Foreword by Univ.-Prof. Dr. Rudolf Steckel
and Univ.-Prof. Dr. David Manry
Jonas Tritschler
Innsbruck, Austria
PhD Th esis University of Innsbruck, 2013
ISBN 978-3-658-04173-1 ISBN 978-3-658-04174-8 (eBook)
DOI 10.1007/978-3-658-04174-8
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Foreword
We are delighted to present Jonas Tritschler's dissertation on Audit Quality.
Auditing remains a very active research area in financial economics and account
ing. Much of the research focuses on audit quality, materiality, error rates, audit
partner tenure, and auditor experience. Although there has been a convergence of
thought among regulators and enforcement agencies on characteristics of audit
quality, there is no widely-held operational definition of audit quality in the re
search literature. Moreover, most audit research on German firms has not made
use of actua\ audit errors reported in the German Federal Gazette.
Arising from the author's experience as a practicing CPA in a "Big Four"
audit firm, this book is quite different from other research in this field, as it con
fronts the subject of audit quality from a pragmatic perspective. The approach
the author adopts is based on the very origius of quality considerations, and does
not rely on the seemingly-ubiquitous earnings management approach.
In the 1940s, manufactoring quality was usually measured by the number of
defects per thousand uuits of finished products. The researcher uses a similar
approach to measure audit quality at the audit firm level. Since 2005, public
interest entities have been required to publish their material reporting errors in
the German Federal Gazette. Actual published audit failures, the remaiuing ma
terial misstatements identified in audited financial statements by regulatory
authorities, thus comprise the data points used in this research to measure audit
quality.
Auditing is a people business, with human resources as production factors.
Quantified audit input factors, such as competence and experience, provide vari
ables to explain performance differences in audit service quality. Favorable input
factors, associated with low auditor failure rates (the number of absolute report
ing errors divided by the auditor's number of clients in the public market), sug
gest cauaa\ity.
In essence, this is a study that focuses on the audit quality of German audit
firms and the uuique aspects of the German regulatory framework. It includes a
wealth of institutional detail on German enforcement authority (FREP) examina
tion triggers, as well as on how these fit into EU secorities markets oversight.
International accounting standards are converging over time. Much contem
porary research covers similarities and differences among developed nations.
VI Foreword
Given the scarcity of empirical research into auditors of Gennan public compa
nies and their regulatory environment, the focus and encyclopedic detail of this
book mark it as authoritative, innovative, and significant.
Last but not least, we believe that a periodic disclosure of audit quality
would increase audit quality over time. Thus, research on the development of a
transparent audit quality measure at the audit firm level in Germany (or even
world-wide) would be an important first step towards creating competition in
both audit fees and audit quality. This in torn could lead to a win-win situstion
for capital markets, regulators, and economies in general.
Because of the somewhat unusual but interesting and very relevant content,
we are confident that this research work will appeal to a wide selection of acade
mic and professional readers. Stodents, researchers, practitioners, and regulators
will find this book useful for further stody and additioual research.
Innsbruck Univ.-Prof. Dr. Rudolf Sleekel
New Orleans Univ.-Prof. Dr. David Manry
Acknowledgements
First of all, I want to thank my doctoral advisors, Rudolf Steckel, University of
Innsbruck and David Manry, University of New Orleans. Rudolf Steckelliked
my research idea from the very beginniug, which kept me motivated throughout
a long aud challenging period of time. His continuous guidance, valuable advice,
and constant encouragement made it possible to finish my dissertation within
three years of research.
I am very proud and grateful for having David Manry as my advisor. I will
not forget the stimulating discussion when we first met in New Orleans (he al
most missed his Wednesday-3pm-Iecture because of our lively discussion!). His
ideas and his advices helped much to concretize my research model, and his de
dicated review aud feedback encouraged me to continue as a researcher and to
develop further models on audit quality measurements.
I am also very grateful to a former colleague at work and a friend, Josef
McGnigan, who critically reviewed and commented on my pre-draft version (be
fore handing it in to my advisors). His excellent comments helped a lot to im
prove the quality of my research paper. I am sure that he could become an excep
tioual researcher in accounting and auditing if ouly he wanted. It is a pity that he
did not choose a research career!
Further thanks go to Ellen Palli, who manages the Austrian-Stodent-Pro
gram. The program, in connection with Waiter Lane (by the way, I liked his lec
tures in economics very much!), bnilt the transatlantic bridge from Innsbruck to
New Orleans, which helped me to get in touch with David Manry.
I say also thanks to RudolfSteckel's research team in the Department of Ac
counting, Auditing and Taxation, especially to Julia Baldauf and Marcel Steller,
for allowing me the opportunity to present and discuss my research idea - even
though it was quite vague and half-baked in the beginniug.
Last but not least, I would like to thank Irene Thaler, who organized and
scheduled most of the meetings with Rudolf Steckel and who managed the admi
nistrative hurdles such as the formal research proposal acceptance at the regis
trar's office (bureaucracy sometimes can be even as challenging as research
work itselfl).
I owe all of you my sincere and deepest gratitode - thank you very much indeed!
Innsbruck Jonas TritschIer
Table of Contents
Foreword .............................................................................................................. V
Acknowledgements ............................................................................................ vn
xv
List of Figures ....................................................................................................
List of Tables ................................................................................................... XIX
Abbreviations ................................................................................................... XXI
List of Symbols ..............................................................................................X XIII
1 Introduction ............................................................................. 1
1.1 Problem Statement ................................................................................ I
1.2 Research Objective ............................................................................... 3
1.3 Research Data and Methodology .......................................................... 4
1.4 Basic Assumptions and Hypothesis ...................................................... 5
1.5 Outline of this Study ............................................................................. 6
2 Literature Review and Current Issues .................................. 7
2.1 Agency Theory and Audit Services ...................................................... 7
2.2 Definitions of Audit Quality ............................................................... 10
2.2.1 Two Main Schools ofThoughls ............................................... 10
2.2.1.1 DeAngelo's Definition of Audit Quality .................. 10
2.2.1.2 Level of Compliance with Standards ....................... 10
2.2.1.3 Financial Reporting Quality and Compliance
with Auditing Standards ........................................... 11
2.2.1.4 Francis Framework on Audit Quality Research ....... 13
2.2.2 Regulatory Definitions and Frameworks on Audit Quality ..... 14
2.2.2.1 Directive of the European Union ............................. 14
2.2.2.2 PCAOB's Definition of Audit Quality ..................... 14
2.2.2.3 Internatioual Standard on Quality Control
(ISQC 1) ................................................................... 15
2.2.2.4 IAASB Framework on Audit Quality ...................... 18
2.2.2.5 UK Financial Reporting Council's Framework
on Audit Quality ...................................................... 24
x
Table ofContcnts
2.2.2.6 Overview of Important Institutions Concerned
with Audit Quality ................................................... 24
2.3 Determinants of Audit Quality ............................................................ 25
2.3.1 Overview ................................................................................. 25
2.3.2 Independence ........................................................................... 27
2.3.2.1 Prerequisite for Professional Judgment .................... 27
2.3.2.2 Threats tu Independence .......................................... 30
2.3.3 Audit Firm Size ....................................................................... 40
2.3.4 Audit Fees ................................................................................ 41
2.3.5 Provision of Non-Audit Services ............................................. 48
2.3.6 Audit Tenure ............................................................................ 50
2.3.7 Legal Liability ......................................................................... 53
2.3.8 Accounting and Audit Knowledge .......................................... 54
2.3.9 Client, Industry and Audit Experience ..................................... 58
2.3.10 Audit Effort and Resource Mix ............................................... 59
2.3.11 Audit Methodology and Tools ................................................. 60
2.4 Criticism on Selected on Audit Quality Measures .............................. 61
2.4.1 EamingsManagement ............................................................. 61
2.4.2 Restatements ............................................................................ 65
2.4.3 Going-Concern Reportiog ....................................................... 66
2.5 Conclusion and Knowledge Gap ......................................................... 67
3 Audit Quality Measure Based on Reporting Errors .......... 69
3.1 Overall Audit Objectives and Audit Failures ...................................... 69
3.1.1 Overall Objectives of the Auditor ............................................ 69
3.1.2 Material Misstatements ............................................................ 70
3.1.2.1 Misstatements in Financial Statements .................... 70
3.1.2.2 Materiality ................................................................ 71
3.1.2.2.1 Concepts ofMateriality. ........................................... 71
3.1.2.2.2 Quantitative Considerations ofMateriality .............. 76
3.1.2.2.3 Qualitative Considerations ofMateriality ................ 77
3.1.2.3 Audit Risk and MateriaIity. ...................................... 79
3.1.2.4 Consequences ........................................................... 80
3.1.3 Audit Failures .......................................................................... 80
3.1.3.1 Definitions ............................................................... 80
3.1.3.2 Indicators of Audit Failures ..................................... 83
3.1.3.2.1 Siguificant Audit Engagement Deficiencies ............ 83
Table ofContcnts XI
3.1.3.2.2 Restatements ............................................................ 86
3.1.3.2.3 Litigations ................................................................ 89
3.1.3.2.4 Accountiog Enforcement Releases .......................... 90
3.2 Accountiog Enforcement in Germany ................................................. 91
3.2.1 Legal Basis... ............................................................................ 91
3.2.2 Examination Triggers .............................................................. 93
3.2.2.1 Examination with Cause (Concrete Indicators) ........ 94
3.2.2.2 Examination on Request by BaFin (Certain
Indicators) ................................................................ 94
3.2.2.3 Examination by Random Sampling
(no Indicators) .......................................................... 95
3.2.3 Enforcement Process .............................................................. 101
3.2.3.1 Examination Commencement ................................ 101
3.2.3.2 Examination Process .............................................. 103
3.2.3.3 Process for Publication ........................................... 104
3.2.3.4 Materiality in the Enforcement Process ................. 106
3.2.4 Summary of Enforcement Results ......................................... 108
3.2.4.1 Error Rate Trend .................................................... 108
3.2.4.2 Error Categories ..................................................... 109
3.2.4.3 Causes ofHigb Error Rates .................................... III
3.2.5 Evaluation of the Enforcement Methodology ........................ 112
3.2.5.1 Evaluation Criteria ................................................. 112
3.2.5.2 Evaluation by Criteria ............................................ 116
3.2.5.2.1 Objectivity. ............................................................. 116
3.2.5.2.2 Reliability ............................................................... 119
3.2.5.2.3 Validity .................................................................. 121
3.2.5.2.4 Transparency .......................................................... 122
3.2.5.2.5 Adequacy ............................................................... 122
3.2.5.2.6 Reflexivity .............................................................. 123
3.2.5.2.7 Discussion of Limitations ...................................... 124
3.2.5.2.8 Triangulation .......................................................... 125
3.2.5.2.9 Evaluation Summary .............................................. 125
3.3 Published Reporting Errors as Audit Quality Indicator .................... 128
3.3.1 Audit Failure Rates Definitions ............................................. 128
3.3.1.1 Auditors' Absolute Failure Frequency ................... 128
3.3.1.2 Auditors' Relative Failure Frequency .................... 129
3.3.2 Data Description .................................................................... 130
3.3 .2.1 Data Basis .............................................................. 130