Jagan Krishnan

The Role of Economic Trade-Offs in the Audit Opinion Decision: An Empirical Analysis

We extend existing audit opinion models by incorporating economic tradeoffs that arise in the auditors qualification (modification) decision. Prior qualification studies (e.g., Dopuch, Holthausen, and Leftwich [1987]; Bell and Tabor [1991]) do not investigate whether the opinion issued is influenced by particular trade-offs facing an auditor. On the one hand, the audit firm faces the risk of losing the client if it issues a qualification, and on the other, failing to qualify exposes the auditor to lawsuits and reputation loss. We model the auditors qualification decision as a two-stage model. We estimate a bivariate model that breaks down the probability of qualifying into two components: (1) the probability that the client deserves a qualified opinion based on the audit and (2) the probability that the auditor reports a qualified opinion, given the auditor considers that the client deserves such an opinion. We hypothesize that the second-stage decision to qualify or not is influenced by factors such as the auditors risk of litigation, the type (Big Six or not) of auditor, the extent of outsider ownership, the share of public debt in total debt, the relative importance of the client in the auditors portfolio, and the future growth rate of the client. Our results indicate that the auditors litigation risk, the extent of outsider ownership, the relative importance of the client in the auditors portfolio, and future growth are important factors in the audit opinion decision. Estimated mean and median probabilities indicate significantly higher values of reporting probabilities for qualified as compared to unqualified firms, suggesting that the second stage is an important component of the qualification decision.

Evidence on Auditor Risk-Management Strategies Before and After the Private Securities Litigation Reform Act of 1995

Abstract This study provides evidence that auditors adopted risk-management policies in the early 1990s in order to reduce their exposure to legal liability. Specifically, there is evidence that their clienteles became less risky and evidence of more conservative auditor reporting policies by non-Big Six auditors (but not by Big Six auditors). The auditors legal exposure was reduced under The Private Securities Litigation Reform Act of 1995, and there is evidence that risk-management policies were relaxed after 1994, resulting in riskier clienteles and less conservative reporting strategies for both Big Six and non-Big Six auditors. The study is important in documenting that alternative legal liability regimes can affect auditor incentives and behaviour.

The Simultaneous Relation between Auditor Switching and Audit Opinion: An Empirical Analysis

Previous studies examining the relation between the audit opinion and auditor switching assume a one-way causation, with the issuance of a qualified opinion triggering a switch. However, analytical studies dealing with auditor independence issues (e.g., Magee and Tseng, 1990; Dye, 1991; Teoh, 1992) suggest an opposite causation, in which the auditor is less likely to qualify the opinion for a client who may switch auditors. Some evidence of an opposite causation is provided by Krishnan (1994), who finds that auditors treat switchers more conservatively (relative to non-switchers) in issuing the audit opinion. The causation between switching and the audit opinion is clearly important for policy decisions regarding both opinion shopping and auditor independence. In this paper, we test the two-way causation hypothesis and find evidence in support of a two-way causation. Our simultaneity-adjusted estimates confirm previous findings of a positive effect of a qualified opinion on switching (Chow and Rice, 1982; Craswell, 1988; Citron and Taffier, 1992). However, we find in addition that auditors are more likely to issue qualified opinions to switchers. This finding does not support the analytical studies cited earlier.

Corporate Governance, Audit Firm Reputation, Auditor Switches, and Client Stock Price Reactions: The Andersen Experience

The financial scandal surrounding the collapse of Enron caused erosion in the reputation of its auditor, Arthur Andersen, leading to concerns about Andersens ability to continue in existence and ultimately to the firms demise. In this paper we investigate the role of corporate governance on the timing of the auditor switch by former Andersen clients. After controlling for factors associated with switching costs, we find clients with strong corporate governance were more likely to switch early. We also find that clients switching from Andersen experienced positive abnormal returns during the three-day window surrounding the announcement of the switch. We attribute this positive response to the reduction in uncertainty associated with the cost of finding a new auditor.

Shareholder Voting in Director Elections and Initial SOX Section 404 Reports

A primary channel for shareholders to express their dissatisfaction with the board is by withholding their votes in director elections. This study examines the relation between shareholders’ voting in director elections and initial Sarbanes-Oxley (SOX) Section 404 reports on internal control. We find that the presence of material weaknesses is associated with shareholder voting, but the effect varies between manager directors and audit committee directors. In the manager sample, shareholders react negatively to the existence of material weaknesses by withholding votes. Additional analysis of companies with material weaknesses reveals greater shareholder dissatisfaction when the number of material weaknesses is higher but less dissatisfaction when the company provided early warning disclosure of internal control problems during the fiscal year. By contrast, audit committee directors are not penalized for material weaknesses, but instead these directors are penalized for accounting restatements. Overall, the results provide new insights into the effects of internal control strength and restatements on shareholder voting for directors, and can potentially motivate directors to be more proactive in ensuring the quality of internal controls and the reliability of financial reporting.

Employee Satisfaction in Accounting Firms, Work-Life Balance, Turnover, and Audit Quality

The PCAOB’s audit-quality framework posits that superior inputs are essential for achieving high audit quality, and these inputs depend on the accounting firm’s ability to recruit and retain quality personnel. However, the link between these inputs and audit quality has gone largely unexplored due to a lack of data. We use employee-level reviews of accounting firm employers to examine some of these inputs, and test whether accounting firm’s internal characteristics explain employee satisfaction and audit quality. We provide descriptive evidence suggesting that “career opportunities,” “senior management,” and “culture and values” play a more important role in employees’ satisfaction than do “compensation and benefits” or “work-life balance.” While work-life balance is not among the most important factors that are associated with audit employees’ overall satisfaction, better work-life balance is nonetheless associated with higher audit quality. However, we do not find a significant association between audit-employees’ overall job satisfaction and audit quality.