Group audits and earnings informativeness

AuthorAshna Prasad,Alexey Lyubimov,Johannes Impink
Date01 July 2020
Published date01 July 2020
DOIhttp://doi.org/10.1111/ijau.12191
ORIGINAL ARTICLE
Group audits and earnings informativeness
Johannes Impink
1
| Alexey Lyubimov
2
| Ashna Prasad
3
1
Warrington College of Business
Administration, Fisher School of Accounting,
University of Florida, Gainesville, Florida, USA
2
John Molson School of Business, Concordia
University, Montreal, Quebec, Canada
3
Monash Business School, Monash University,
Melbourne, Australia
Correspondence
Ashna Prasad, Monash University, Monash
Business School, 20 Chancellors Walk,
Clayton, VIC 3800, Australia.
Email: ashna.prasad@monash.edu
The Public Company Accounting Oversight Board (PCAOB) has cited investors as the
main stakeholder group requesting greater disclosure about the involvement of audi-
tors other than the group auditor. This study investigates the following: 1) whether
(any) differences in investor perceived earnings quality of group audits are associated
with the component auditor belonging to the same network as the group auditor
and; 2) whether this association is affected by the location of the client. We find that
earnings informativeness is lower for group audits conducted by audit firms related
by a global network. However, this finding is pertinent only to non-US-domiciled
companies. We also find that since the escalation of PCAOB scrutiny, the earnings
informativeness of non-U.S. companies has increased.
KEYWORDS
component auditors, earnings informativeness, group audits, PCAOB
1|INTRODUCTION
The Public Company Accounting Oversight Board (PCAOB) has esti-
mated that 55% of Securities Exchange Commission (SEC) issuers
have multinational operations and that 80% of Fortune 500 compa-
nies require multinational audits (PCAOB, 2016, p. 7). Owing to the
geographical dispersion of these companies' operations, audits of
their consolidated financial statements require several audit firms to
work together on the same group audit engagement (Downey &
Bedard, 2019a; Hanes, 2013). The auditor in charge of the group
audit engagement is referred to as the group auditor(also the prin-
cipal auditor). The audit committee may also engage a third-party
audit firm or a component auditor, to perform audit procedures on
financial information related to a component, for example, an audit
of a subsidiary.
1
Frequently, the group and the component auditors
belong to the same global audit firm network (Sunderland &
Trompeter, 2017).
The PCAOB has expressed significant concerns about the quality
of group audits (e.g., Doty, 2011a; Doty, 2012b). These concerns are
related to difficulties in supervising and coordinating multifirm audits,
as well as differences in business practices and culture across coun-
tries where component audits are conducted (PCAOB, 2016). In
considering the transparency of group audit arrangements that
involve different audit firms, the PCAOB cited investors as the lead-
ing stakeholder group requesting greater disclosure about the
involvement of auditors other than the group auditor (Anderson,
Gaynor, Hackenbrack, Lisic, & Wu, 2014; PCAOB, 2013). We con-
sider two intertwined elements that are likely to affect investors' per-
ceptions of earnings quality (earnings informativeness) of group
audits: network membership of audit firms and the location of the cli-
ent. The first research objective is to assess the effect of the group
and the component auditor belonging to the same network on SEC
issuers' earnings informativeness (network effecthereon). More
specifically, we investigate whether there are differences in earnings
informativeness when investors can reasonably believe that primarily
a group auditor and component auditor from the same network of
audit firms (same-networkhereon) compared with when these
auditors are not from the same network (non-networkhereon) con-
ducted a group audit.
A group audit requires significant coordination and quality-control
procedures between different audit firms working together on differ-
ent components of a single (commonly multinational) entity
(Downey & Westermann, 2019). On the one hand, a same-network
group audit allows for consistent application of audit procedures and
quality standards, ensuring that the component auditor's work is of
the quality that would be acceptable by the group auditor. On the
other hand, the PCAOB has raised concerns about the quality of
1
A component is an entity or business activity for which group or component management
prepares financial information that should be included in the group financial statements
(IAASB, 2007). In the context of this study, auditoris synonymous with audit firm.
Received: 30 January 2019 Revised: 14 February 2020 Accepted: 15 February 2020
DOI: 10.1111/ijau.12191
Int J Audit. 2020;24:245267. wileyonlinelibrary.com/journal/ijau ©2020 John Wiley & Sons Ltd 245
group audits of geographically dispersed multinational entities, which
can be exacerbated in networks. The former PCAOB chair stated that
often principal auditors rely on high-level reports from subsidiary
auditors,but they frequently don't review the work papers of the
other auditors,yet when the inspectors do, they often find problems
in that work(Doty, 2011a). Further, the former PCAOB chair stated,
in theory, when a networked firm signs the opinion, the audit is sup-
posed to be seamless, and of consistently high quality, in practice, that
may not be the case(Doty, 2011a). There is also a possibility that the
group auditor is likely to be supervising and reviewing nonnetwork
component auditor's work with greater diligence. Consequently, the
group auditor may over-rely on work completed by a same-network
component auditor. Thus, it is an empirical question whether the pub-
lic knowing that network member firms are working together affects
investor perceptions of the resulting earnings quality.
In considering the importance of the network effect, we acknowl-
edge the strong prior evidence in the literature relating to the varia-
tion in financial reporting quality in different legal regimes (e.g., Lang,
Raedy, & Wilson, 2006). Thus, our second research objective is to
investigate whether the network effect is different when the client is
domiciled in different legal jurisdictions. We consider this by dis-
tinguishing between companies domiciled in the United States and
outside the United States.
Consistent with Dee, Lulseged, and Tianming (2015), we use
Form 2 filings by PCAOB-registered audit firms to identify group
audit participants.
2
We adopt a cumulative abnormal returns model
(Dee et al., 2015; Francis & Ke, 2006; Ghosh, Kallapur, & Moon,
2009) and use short-window returns around quarterly earnings
announcements to examine our research objectives. Using 1,250
firm-quarter observations for audits completed over the period
20102015, we find that the market perceived the earnings of com-
panies audited by same-network component auditors to be of lower
quality compared to companies audited by nonnetwork component
auditors. However, this result is observed only for companies domi-
ciled outside the United States. These results are robust to using
restricted subsamples.
Several events in the period 20112012 indicate an increased
regulatory scrutiny of multinational group audits. These events include
the PCAOB chair's public remarks on group audit quality; the subse-
quent proposal to identify component auditors that participated in an
audit using Form AP; and an update to the U.S. group auditing stan-
dard for private companies to significantly increase the involvement
of the group auditor in component audits. In our additional analyses,
we examine whether this increased regulatory scrutiny led to any
changes in market perception. We find that the scrutiny is associated
with an increase in earnings informativeness of group audits. This
improvement was noted only for group audits conducted of non-U.S.-
headquartered companies.
This study makes the following contributions to audit regulation
and practice. Regulators have expressed serious concerns about the
quality of group audits, and have identified investors as the leading
stakeholder group interested in component auditor disclosures. How-
ever, investors' perceptions of earnings quality in the context of multi-
national group audits is mostly unexplored in research (Sunderland &
Trompeter, 2017). This study provides empirical evidence that the
market recognizes the concerns raised by the regulators regarding
group audits. More specifically, by comparing same-network and non-
network group audits, we provide evidence that investors also per-
ceive network membership as an important factor impacting earnings
quality. Our findings also show that the location of the client is a vital
characteristic in understanding the association between investor per-
ceived earnings quality and network membership of the group and
component auditors. This study also informs audit regulators such as
the PCAOB that the market recognizes an increased level of regula-
tory scrutiny as an attempt to improve the quality of group audits.
The findings are useful to audit firms engaging in group audits
because they demonstrate that the market cares about the quality of
the group audit process when more than one audit firm is involved in
the audit. By providing empirical evidence using a panel of multifirm
group audits, we also add to the limited literature on group audits and
answer the call from Sunderland and Trompeter (2017) for more
research in this area.
The remainder of the article is organized as follows. The following
section presents a brief background on audit firm networks, the
importance of these networks in conducting multinational group
audits, and applicable group audit standards, as well as a review of the
relevant literature. This section is followed by the development of the
hypothesis and research question. We subsequently outline our
research design and present the results of the main and additional
analyses before drawing our conclusions.
2|BACKGROUND AND RELEVANT
LITERATURE
2.1 |Who Does the Multinational Group Audits?
The rise of multinational companies and their demand for audits of
foreign operations has been a significant factor in the increased inter-
nationalization of audit firms (Klaassen & Buisman, 2000). This has led
to significant jurisdictional crossovers by audit firms in the context of
group audits, whereby several audit firms from around the world work
together on different components of the audit of the same client
(Krishnan, Krishnan, & Song, 2017). Multinational audits are described
as an audit involving several affiliates of a global auditing network or
other unrelated auditors in various countries(Ferguson & Sharp,
2017). Moreover, audits have gone from being executed by a single
firm out of a local office near your company [to] being executed by a
series of globally affiliated network firms, under a single brand, with
offices around the world(Doty, 2012a). Audit firm networks can
offer an integrated intra-network audit service to their multinational
2
Unlike Dee et al. (2015), a strength of our article is that we are only examining engagements
that use component auditors, and thus, we do not have the problem of drawing conclusions
based on a comparison of group audits and nongroup audits. We thank an anonymous
reviewer for this insight.
246 IMPINK ET AL.

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT