Asad Kausar

Regulating Audit beyond the Crisis: A Critical Discussion of the EU Green Paper

With the European Commission making global leadership claims in the field of audit regulation, the content of its 2010 Green Paper on ‘Audit Policy: Lessons from the Crisis’ warrants careful scrutiny. Important issues raised in the Green Paper include regulatory oversight, competition in the audit market, the dangers of having very few firms with the capacity to audit global transnational corporations, professional judgement, innovative audit practices and, last but not least, social responsibility. This article analyses the principal perspectives and assumptions underpinning the construction of the Green Paper. The aims are threefold: to enhance understanding of the contemporary regulatory mindset of the European Commission, contribute to policy debate and inspire future research.

The Demand for Audit in Private Firms: Recent Large-Sample Evidence from the UK

Abstract Although theory suggests that companies would rationally select into audit even if it were not a legal requirement, many countries impose mandatory audits. This is arguably due to an audit having elements of a public good, which may result in not enough audits being purchased without regulatory intervention. The mandatory nature of public company audit has created problems for researchers wishing to investigate the demand for voluntary audit. Recent events in the UK, however, have provided such an environment. In the UK, private companies must publicly file financial statements and, until recently, they had also to be audited. However, this requirement has now been relaxed for many private companies. We are therefore able to examine the determinants of voluntary audit in a large sample of companies for which we have financial statement data. We analyse a sample of 6274 recently exempt companies, following them for three years post-exemption. We use agency theory and prior evidence to generate our hypotheses and examine them using a more comprehensive set of explanatory variables than has previously been available in the literature. Our results indicate that companies are more likely to purchase voluntary audits if they have greater agency costs, are riskier, wish to raise capital, purchase non-audit services from their auditor, and exhibited greater demand for audit assurance in the mandatory audit regime. We also document a trend away from audit over time. Overall, our results strongly support the idea that companies choose to be audited when it is in their interests to do so.

The impact of voluntary audit on credit ratings: evidence from UK private firms

After a long period of universal mandatory audit, the UK reduced the regulatory burden of private firms by introducing size-based audit exemption in 1994; the size thresholds have subsequently been progressively increased. Both accounting bodies and credit-rating agencies (CRAs) have expressed reservations about this policy, arguing it could diminish user confidence in reported accounting numbers, and lead to a reduction in financial statement quality and credit ratings. Prior research, however, suggests that the managers of small UK companies do not perceive there to be an association between financial statement audit and firm credit score. To provide evidence of any effect on user confidence of making audit optional, we examine the credit scores and financial reporting quality of a large sample of UK private firms which qualified for audit exemption after major threshold changes in 2004. We find that, even though they report lower average profits, companies which retain a voluntary audit enjoy significantly higher credit scores than those which opt out of audit. The results of both conservatism and accruals-based tests indicate that opting out of audit is associated with less conservative financial reporting, consistent with the concerns of the accounting bodies and the CRAs, and providing an explanation for why opt-out firms report higher profits but receive lower credit scores. This study contributes to an important policy debate by providing large sample evidence that the audit does confer benefits to private firms in terms of financial reporting quality, assurance and the credit scores generated from the financial reports.

Legal Regimes and Investor Response to the Auditor’s Going-Concern Opinion:

This article examines how legal regime may affect the market’s reaction to the auditor’s going-concern (GC) opinion. We hypothesize that, ceteris paribus, investors in a creditor-friendly bankruptcy regime (the United Kingdom) will react more adversely to a first-time GC opinion indicating increased risk of loss associated with bankruptcy than do investors in a debtor-friendly bankruptcy regime (the United States). Our empirical results are consistent with this expectation. These findings are strengthened by additional analysis of the impact of the recent convergence in bankruptcy regime between the United States and United Kingdom on the market reaction to GC opinions in the United States. Our findings demonstrate a specific situation where the auditing standards and institutional factors interact, with their joint impact affecting the market’s reaction to the GC opinion.

Why the Going-Concern Anomaly: Gambling in the Market?

This paper investigates why the market fails to incorporate the adverse information conveyed by the going-concern (GC) opinion in a timely manner. Our main conjecture is that the lottery-like features of GC stocks attract a predominantly retail clientele who use those stocks to gamble in the market. Such trading behavior leads to the underreaction to the GC event and significant downward drift in prices over the following year. Using a sample of first time GC firms from 1993 to 2007 we show that GC stocks have extreme lottery-type characteristics. We further demonstrate that retail investors have a proclivity to be net-buyers of these stocks around the GC event, and such contrarian behavior is directly related to the lottery-like nature of GC firms. Using individual investor-level trading, socioeconomic, and demographic data we confirm that retail investors who are known to have a greater propensity to gamble are more likely to trade GC stocks. We rule out several alternative explanations for our findings, and conclude that gambling-motivated trading behavior of retail investors is the most likely driver of the anomalous short-term market reaction and the associated longer-term market response following the release of going-concern audit opinion.

Estimation Risk and Auditor Conservatism

Estimation risk occurs when individuals form beliefs about parameters that are unknown. We examine how auditors respond to the estimation risk that arises when they form beliefs about the likelihood of client bankruptcy. We argue that auditors are likely to become more conservative when facing higher estimation risk because they are risk-averse. We find that estimation risk is of first-order importance in explaining auditor behavior. In particular, auditors are more likely to issue going-concern opinions, are more likely to resign, and charge higher audit fees when the standard errors surrounding the point estimates of bankruptcy are larger. To our knowledge, this is the first study to quantify estimation risk using the variance-covariance matrix of coefficient estimates taken from a statistical prediction model.

Overconfidence and Corporate Tax Policy

Using a sample of firms experiencing exogenous CEO departures, we investigate whether firms with overconfident CEOs avoid more tax. We find robust evidence of a positive relation between proxies for corporate tax avoidance and CEO overconfidence. Because our empirical tests use a panel of firm-years with exogenous CEO departures and include controls for stationary firm effects as well as observable firm characteristics, we can better isolate the role of an idiosyncratic personality trait (i.e., overconfidence) on corporate tax outcomes, thus adding to the literatures on overconfidence, managerial effects, and tax avoidance.

The Usefulness of Negative Aggregate Earnings Changes in Predicting Future Gross Domestic Product Growth

Konchitchki and Patatoukas (2014) (hereafter KP 2014) show that aggregate accounting earnings growth predicts future nominal Gross Domestic Product (GDP) growth and that professional macro forecasters do not fully incorporate the information contained in aggregate accounting earnings. Based on results from prior literature, which find that accounting earnings reflect bad economic news in a timelier manner than good news, we condition KP’s GDP growth forecast model on the sign of earnings changes. We show that negative changes in aggregate earnings predict future GDP growth up to three quarters ahead while positive changes in earnings do not. Furthermore, we show that professional macro forecasters underreact to the information contained in negative changes in aggregate earnings about future GDP growth. In additional analyses we find evidence suggesting the incremental usefulness of negative earnings changes is driven by accounting conservatism rather than other drivers of asymmetric timeliness in earnings.

Testing Behavioral Finance Models of Market Under- and Overreaction: Do They Really Work?

We test the predictions of the three main behavioral finance theories of market under- and overreaction using out-of-sample data conditional on the nature of the news using the going-concern audit opinion (bad news event) and its withdrawal (good news event). We find strong support for the Daniel, Hirshleifer and Subrahmanyam (1998) model for our bad news as well as the good news case suggesting that market underreaction to going-concern opinions is a consequence of prior market overreaction resulting from incorrect classification of going-concern firms by investors into trending regimes. In contrast, we find no support for the Barberis, Shleifer and Vishny (1998) or Hong and Stein (1999) models in our event-study setting in either the bad or good news cases. Our results have a number of implications relating to the value of such theoretical behavioral finance models in practice. We also highlight the central role of the limits-to-arbitrage assumption when testing such behavioral finance theories.