Surrogates for audit quality

According to DeAngelo (1981b), audit quality is the auditor’s perceived ability to detect misstatements and to report them141_{. While the ability to detect misstatements depends on the}

auditor’s competence and level of effort, the decision to report them is conditional on his independence. Since both the procedures performed by the auditor and the specific client-auditor dynamic cannot be observed from the outside, measuring audit quality has proven to be a challenge142. In an attempt to develop a framework for studying audit quality, Francis (2004) proposes to visualise audit quality as a continuum, where the lower and upper extremities imply a very low or a very high level of audit quality143. He then describes the lowest point of this continuum as characterised by the presence of audit failures, which occur when the auditor does not comply with the applicable standards and fails to issue the appropriate audit opinion144. While

138 _{DeAngelo (1981b), pp. 187-192.}

139 _{E.g. Ostrowski/Söder (1999), p. 558; Chung/Kallapur (2003), p. 932.} 140 _{Recital 7 EU-reg.}

141 _{DeAngelo (1981b), p. 186. This definition provided by DeAngelo is commonly used in auditing literature, see e.g.}

Fiallo/Hecker (2019a), p. 226.

142 _{DeAngelo (1981b), p. 186. Similar considerations are made e.g. by Fiallo/Hecker (2019a), p. 226.} 143 _{Francis (2004), p. 346; Francis (2011), p.129.}

85 the definition provided by DeAngelo (1981b) appears abstract, the definition of Francis (2004) allows at least for a concretisation of the concept of low audit quality145.

Figure 3.1: Definition of audit failure

As shown in Figure 3.1, an audit failure takes place when an auditor issues a qualified or adverse opinion even though the financial statements are free from material errors (false positive), and most notably when he issues an unmodified opinion in the presence of material errors (false negative). In this context, the presence of accounting errors in audited financial statements and the lack of a qualified or adverse opinion might be interpreted as an audit failure and be used as an indicator of low audit quality146. There is, however, a caveat. As shown in Figure 3.1, there is an area where, despite the presence of errors and of an unmodified opinion, we cannot speak of audit failures. Due to the inherent limitations of the audit procedures and the residual audit risk, the auditor can only attest with reasonable assurance that financial statements are free from material errors147. As argued by Knechel (2009), audit risk can be reduced to an “appropriate” level, but perfect assurance cannot be attained, which is why errors may go undetected148_{. It follows that the presence of accounting}

145 _{Knechel/Krishnan/Pevzner/Schefchik/Velury (2013), pp. 387-388; Knechel (2009), pp. 5-6.} 146 _{Tritschler (2013), p. 4.}

147 _{ISA 240.5. See here also the discussion in Fiallo/Hecker (2019a), p. 227.} 148 _{Knechel (2009), pp. 6-7.}

86 errors in financial statements where the auditor issued an unmodified opinion does not univocally define an audit failure. However, an audit failure (false negative) requires the presence of errors and of an unmodified opinion, which means that enforcement findings and audit quality should be strongly negatively correlated149.

Notwithstanding their limitations, enforcement findings might be a better surrogate for audit quality than other popular proxies such as auditor’s modified/going concern opinions or discretionary accruals150. Sharma/Sidhu (2001) argue that interpreting modified opinions as signals for independence and unmodified opinions as a lack thereof is misleading, unless it was possible to determine which opinion would have been appropriate151. Due to the evident difficulties for researchers to determine the appropriate opinion, some studies prefer using, as a surrogate for audit quality, the probability of issuing a GCO to companies in financial distress, or which have later filed for bankruptcy152_{. However, GCOs also have limitations. The auditor’s decision to issue a}

GCO relies on estimates and predictions, which might be undermined by the occurrence of unforeseeable events (e.g. global crisis)153. It follows that failing to issue a GCO to a company in financial difficulties does not necessarily imply a lack of independence. Especially when, as argued by Ewert (2004), the auditor does not expect any future economic benefit from the client (e.g. in case of bankruptcy)154.

Another popular proxy for audit quality is discretionary accruals. Accruals are the difference between earnings and operating cash-flow155. Accruals might arise from normal business activities. However, they might also reflect earnings management conducted by managers. The accounting

149 _{It should be noted that the presence of errors in audited financial statements is not equal to the existence of}

enforcement findings. Rather, financial statements subject to an enforcement announcement are a subset of the population of financial statements with errors. As to why this occurs, see the discussion in Fiallo/Hecker (2019a), pp. 226-227. Also, Fiallo/Hecker (2019a) argue that this consideration does not contradict the use of enforcement findings to proxy for low audit quality, but it rather indicates that the lack of enforcement findings is not equal to the lack of errors.

150 _{A recent review of auditing research has shown that modified or going concern opinions and discretionary accruals,}

are the most used proxies for audit quality. See Simnett/Carson/Vanstraelen (2016), p. 14. Examples of studies using going concern opinions are Blay/Geiger (2013) and Ratzinger-Sakel, (2013). Examples of studies using discretionary accruals are Lopatta/Kaspereit/Canitz/Maas (2015), Krauß/Zülch (2013), Krauß/Pronobis/Zülch (2015), Molls (2013), Quick/Sattler (2011b), Sattler (2011) and Tebben (2011). For an extensive list of proxies for audit quality, see e.g. Gros/Worret (2014).

151 _{Sharma/Sidhu (2001), p. 597.} 152 _{E.g. Ratzinger-Sakel (2013), p. 130.} 153 _{Tritschler (2013), p. 66.}

154 _{Ewert (2004), p. 257. A similar consideration is made by Blay/Geiger (2013), p. 583.} 155 _{E.g. Wagenhofer/Ewert (2015), p. 280.}

87 literature has therefore produced different models, which try to discriminate between normal accruals, which are compatible with the company’s performance, industry, and other economic characteristics, and discretionary accruals, which result from the arbitrary decisions of managers156. Since one of the auditor’s tasks is to restrict earnings management practices, discretionary accruals can be indirectly used to measure audit quality157. This approach, although widely used in prior auditing studies158, is often criticised, as it has a few drawbacks. First, earnings management is essentially a measure of accounting quality and only an indirect measure of audit quality159. Second, earnings management does not always imply the presence of accounting errors. In fact, earnings management can be practised within the scope of GAAP, in which case the auditor would have no reason to issue a modified opinion160. Third, the level of “normal” accruals is usually estimated using a cross-sectional approach, where companies are clustered by sector and year. Jackson (2018) states that “econometrically speaking, discretionary accruals are simply deviations from industry averages”, while attributing this difference entirely to earnings management is an overconfident assumption161_{. In fact, discretionary accruals are very sensitive to the estimation}

sample and to the characteristics of peer firms (e.g. the presence of earnings management in the estimation sample), which might increase the risk of incorrectly classifying accruals, thus leading to measurement errors162.

In conclusion, each surrogate has its limitations163. In this paper, I choose to use the existence of enforcement findings as a proxy for audit quality, as the presence of errors in audited financial statement should be a good indicator of low audit quality164. Additionally, the fact that enforcement findings are established by an independent institution, it allows to minimise measurement errors165.

156 _{Ronen/Yaari (2008), p. 372.} 157 _{Gros/Worret (2014), p. 348.}

158 _{E.g. Quick/Sattler (2011b), p. 320; Krauß/Zülch (2013), p. 311; Sattler (2011), p. 210.} 159 _{Quick/Schmidt/Simons (2016), p. 197.}

160 _{Quick/Schmidt/Simons (2016), p. 196; Gros/Worret (2014), p. 348.} 161 _{Jackson (2018), pp. 137-138.}

162 _{Jackson (2018), pp. 140-144, conducts an experiment where he intentionally “adds” earnings management to one}

of the companies in the estimation sample. He is able to show that, since discretionary accruals are estimated within the group, the modification in the fundamentals of one company leads to different values of discretionary accruals for all the companies in the group.

163 _{For an extensive analysis, see also DeFond/Zhang (2014), pp. 283-289.}

164 _{A similar assumption has been made by e.g. Frey/Möller/Weinzierl (2016), p. 563 and Gros (2016), pp. 219-220.} 165 _{Hoehn/Strohmenger (2013), p. 10; DeFond/Zhang (2014), p. 284; Dechow/Ge/Schrand (2010), p. 371.}

Dechow/Ge/Schrand (2010), p. 371, caution that although using enforcement releases leads to less type I errors (classifying financial statements as erroneous when they are not), it might introduce a selection bias. The bias arises

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