Brian FitzgeraldThomas OmerTexas A&M University

Anne ThompsonThe University of Illinois

Audit Partner and Audit Firm Rotation and the Assessment of Internal Control Deficiencies

Overview

Research questionMotivationHypothesesResearch designEmpirical results Conclusions and contributions

Research Question

What are the effects of audit firm changes and audit partner rotation on the reporting of internal control deficiencies?

MotivationImplications for understanding the costs and benefits of audit

firm and audit partner changes– Financial reporting misstatements and low accrual quality

are associated with internal control weaknesses– Control risk assessment is important for planning substantive

audit procedures– Lack of client specific knowledge may lead to over- or

under-reliance on internal controls (i.e. ineffective or inefficient audit program)

– Auditors’ choices about whether and how to report control deficiencies can influence stakeholders’ decision-making

The Not-for-Profit Sector SettingThe U.S. federal government relies on internal control

attestation to monitor federal award recipients– Focus on controls supports compliance with laws and regulations– Helps to ensure appropriate administration of federal awards

NFPs have financial incentives to invest in internal controls– Federal agencies and private donors decrease funding following

disclosure of internal control deficiencies

Two unique features of this setting:– A-133 audit reports disclose material weaknesses, significant

deficiencies, and exceptions in the controls and substantive testing– Audit partner is observable

Hypotheses

Audit Firm Changes (H1)

Control deficiencies may be reported more frequently following audit firm changes due to initial year audit procedures– Professional standards require auditors to invest in gaining client-

specific knowledge in the initial year, including the control environment

– Prior studies document higher audit hours in the first year of an engagement

Predecessor auditors may not have reported known control deficiencies in prior years

– Escalation of commitment may influence auditors’ assessments of the severity of detected internal control deficiencies

Audit Firm Changes (H1) (cont)

Control deficiencies may be reported less frequently following audit firm changes if a high degree of client-specific knowledge is needed to evaluate controls effectively– Auditors may place greater reliance on management representations

due to lack of client specific knowledge– Prior studies commonly document lower accrual quality in the early

years of the auditor-client relationship

H1: Audit firms are no more likely to report internal control deficiencies in the initial year of audit firm tenure

Audit Partner Rotation (H2)

Partners may develop relationships with their clients over time that potentially compromise auditor independence

Audit partner rotation may result in an increase in reported control deficiencies

– Partner rotation may bring a “fresh look” to the engagement– Partners increase planned procedures in their initial year on an

engagement

Audit Partner Rotation (H2) (cont)

Control deficiencies may not be reported more frequently following audit partner rotation– Client-specific knowledge is carried forward in work papers– Other client personnel are not required to rotate– Survey evidence indicates that U.S. audit partners need two years

to gain client-specific knowledge

H2: Audit partners are no more likely to report internal control deficiencies in the initial year of audit partner tenure on a continuing client.

Audit Partner Tenure (H3)

No clear prediction for how control deficiency reporting varies with audit partner tenure– Audit partners have incentives to protect their reputational capital– Audit partners may be susceptible to cognitive biases over

successive audits– Studies on audit partner tenure from other securities markets

(Australia, Taiwan) provide mixed evidence on the relation between audit partner tenure and audit quality

H3: Audit partners are no more likely to report control deficiencies on clients with longer partner tenure.

Research Design

The Not-for-Profit Sector

As a component of the U.S. economy, the NFP sector:– Contributes 5% of GDP– Employs 10% of the U.S. workforce– GAO estimates $235 billion in federal awards reached the NFP

sector in 2006– NFPs benefit from $50 billion annually in foregone federal tax

payments

Growth of NFP sector has attracted Congressional scrutiny– NFPs can exploit their tax-exempt status to earn economic rents at

the expense of for-profit counterparts

OMB Section A-133 Audit Reports

Federal award recipients submit audited financial statements and A-133 audit reports if federal expenditures exceed $500,000 during the year ($300,000 prior to 2004)

A-133 audit reports disclose material weaknesses and reportable conditions (significant deficiencies) over:

– Internal control over financial reporting– Compliance with major program requirements

Reports also include audit findings and questioned costs (i.e. exceptions identified in the control and substantive testing over major programs)

Sample SelectionFinancial statement data from IRS Form 990 information return for NFPs reporting at least $30 million in assets (2000-2007)

Audit opinions from the Federal Audit Clearinghouse for NFPs expending at least $500,000 in federal awards during the year (1997 onward)

Intersection of SOI and A-133 files (2000-2007) 22,936

Less: entities missing 3+ years of data -3,809

Less: missing audit partner information -236

Less: observations missing prior year data -3,227

Final Sample (2001-2007) 15,664

Industry Distribution

Arts Museums, PBS, Carnegie Hall 2%Education Colleges and universities 38%Environmental Audubon Society, World Wildlife Fund 1%Healthcare Hospitals, American Cancer Society 23%Human Services Red Cross, YMCA, Goodwill Industries 27%Int'l Org Hunger relief, vaccination programs 2%Public Benefit Regional development, research laboratories,

student loan servicing7%

Sample Statistics

Average NFP Largest NFP

Assets $246 million $60.03 billion Harvard University

Revenues $128 million $29.7 billion Kaiser Foundation Health Plan

Federal Expenditures $28.4 million $2.3 billion Johns Hopkins University

Employees 1,166 69,374 Kaiser Foundation Health Plan

Dependent Variables

Estimate logistic regressions where the dependent variable equals one if the audit report indicates:– Financial statement reportable condition (FS_RC)– Financial statement material weakness (FS_MW)

– An audit finding or questioned cost (FINDORQ)– Major program reportable condition (MP_RC)– Major program material weakness (MP_MW)

Independent Variables

H1: CHANGEFIRM equals one if the client changed auditors from year t-1 to year t

H2: CHANGEPARTNER equals one if the audit partner changed from year t-1 to year t and CHANGEFIRM=0

H3: LONGTENURE equals one if audit partner tenure in year t exceeds 5 years

Regression model

Control deficiency = CHANGEFIRM + CHANGEPARTNER + LONGTENURE + Controls + Year + Industry + IMR

Control Variables:• Prior Year Report Modifications (GC and control deficiency)• Complexity, Size, Growth, Leverage, Performance, Acct Fees,

Employees, Lobbying, Risk• Auditor (BigN, Second Tier, Specialist, Other PCAOB/non PCAOB

registered firm)

Selection Model

Public companies are more likely to change auditors following an adverse internal control opinion

Follow Tate (2007) in modeling for audit firm changes in the NFP sector – Changes in contributions, revenues, expenses, liabilities,

compensation, and accounting fees– Augment with outcome variables, auditor’s client base, and

Andersen client, industry, year, and state indicator variables

ROC = 0.786, Pseudo R-Square = 0.243

Empirical Results

Frequency of control deficiencies

Reported control deficiencies by audit partner tenure

Multivariate tests of H1-H3

FS Control Deficiencies by Audit Firm TierBig N Sec Tier Specialist Other

PCAOBOther non-PCAOB

Reportable Condition

CHANGEFIRM Positive*** Positive*** Positive*** Positive* ns

CHANGEPARTNER ns ns ns ns ns

LONGTENURE ns ns ns ns ns

Obs 5,138 2,879 1,180 1,834 4,628

Material Weakness

CHANGEFIRM Positive*** Positive*** ns Positive** ns

CHANGEPARTNER ns ns ns ns ns

LONGTENURE Positive** ns ns ns ns

Obs 5,138 2,879 1,010 1,796 4,628

Control deficiency reporting surrounding auditor tier changes

H2 Additional Tests: Change Partner

Insignificant coefficient on CHANGEPARTNER:– Audit partners may have previous experience on the client, and so

do not bring “fresh eyes” to the engagement

– Audit partners require 2 years experience to gain familiarity with the client, so effects, if any, may arise in year 2

Prior Client Familiarity

Second year of audit partner tenure

H1 Additional Test: Change Firm

Is the positive significant coefficient on CHANGEFIRM:

– Due to the application of new audit methodology and initial year audit procedures?

– Or did the predecessor auditor fail to report known deficiencies in prior years

Control deficiency reporting preceding audit firm and partner changes

Control deficiency reporting preceding audit firm and partner changes (Big N/Second Tier)

Sensitivity Tests

Results are consistent :– Controlling for prior audit partner tenure– Controlling for or excluding former Andersen partners and clients– In annual cross sectional regressions– Examining only “first time” control deficiencies

Summary of Findings

Auditors are more likely to report all categories of control deficiencies in the initial year of the auditor-client relationship

No differences in reported control deficiencies in years of audit partner changes

Long audit partner tenure is associated with higher likelihood of reported findings and questioned costs

Conclusions and Contributions

Contributions to the literature on the costs and benefits of audit firm changes and audit partner rotation:– New audit firms’ investment in understanding controls appears to

lead to an increase in reported control deficiencies– May provide an explanation for why accrual quality improves with

audit firm tenure– No evidence supporting the notion that audit partner rotation

immediately provides a “fresh look”– Partner tenure exceeding 5 years may lead to higher audit quality

Thank you

FS Reportable Conditions by Audit Firm Tier

FS Material Weaknesses by Audit Firm Tier