Measuring audit quality

Abstract

We document 45 specific allegations related to audit deficiencies based on GAAS, as detailed in 141 AAERs and 153 securities class action lawsuits over the violation years 1978–2016. Next, we use these allegations to validate popular proxies of audit quality. Of all the audit quality proxies, we find that restatements consistently predict all of the top six most cited audit deficiencies. The ratio of audit fees to total fees and the presence of a city specialist auditor predict five of the most cited deficiencies. Overall, our results suggest that the predictive power of audit quality proxies depends on (i) the settings that researchers are interested in and (ii) the specific audit deficiencies hypothesized to matter in the investigated setting. For instance, future studies related to auditor independence might consider using restatements and the ratio of audit fees to total fees as proxies of audit quality.

Appendices

Appendix 1

Table 12 Variable definitions

Appendix 2

Table 13 Top 10 cited audit deficiencies

Appendix 3: Detailed examples of specific audit deficiency allegations

1.1 App C1: Most frequently cited deficiencies

In this section, we briefly discuss the 10 most frequent categories of audit deficiencies: (1) 200 instances of failure to gather sufficient competent audit evidence (violation of the fieldwork standard, row E2 in Table 2); (2) 177 cases of failure to exercise due professional care (violation of the general GAAS standard, row C3); (3) 156 instances of failure to express an appropriate audit opinion (violation of the reporting standard, row G5); (4) 126 instances of inadequate planning and supervision (violation of the audit planning standard, row D1); (5) 122 cases of lack of independence from the client (violation of the general GAAS standards, row C2); (6) 106 instances of failure to obtain an understanding of internal control (violation of the fieldwork standard, row F2); (7) 93 cases of insufficient level of professional skepticism (violation of general GAAS standard, row C4); (8) 91 cases of failure to faithfully state whether the financial statements are presented in accordance with GAAP (violation of the reporting standard, row G3); (9) 70 cases of failure to evaluate the adequacy of disclosure (violation of the reporting standard, row G6); and (10) 67 cases of inadequate consideration of fraud risks (violation of the audit planning standard, row D3). These instances are reviewed in detail in the following subsections.

1.2 App C2: Failure to gather sufficient competent audit evidence

Several cases in this category accuse the auditor of relying on management representations without verifying the underlying evidence, or it is claimed that the auditor did not even obtain management representation before signing off on the audit report. An example is the lawsuit filed by lawyers of Worldcom’s shareholders against Arthur Andersen, which states: “Andersen failed to obtain sufficient evidence in connection with WorldCom’s elimination or reduction of expenses through write-offs of reserves. Instead, Andersen relied largely on management’s representations. As a result, during 1999 and 2000, approximately $1.2 billion of those reserves were written off directly to income without any conceptual basis under GAAP. Andersen failed to discover that the adjustments were unsupported by documentation. In particular, Andersen failed to determine whether nonreporting-system journal entries (i.e., those entries that come from sources other than WorldCom’s revenue, expense, cash receipts, cash disbursement and payroll accounting and reporting systems) were valid. Either Andersen failed to review WorldCom’s general ledgers or failed to ask to see any post-closing journal entries, or recklessly disregarded such journal entries made without support. For example, while discussing management’s aggressive accounting practices, Andersen documented the following note in its work papers: ‘Manual Journal Entries How deep are we going? Surprise w[ith] look [at] journal entries.’ Andersen failed to examine the nature of these manual journal entries.” (In re Worldcom, Inc. Securities Litigation, U.S. District Court, Southern District of New York, Dec. 2, 2003, p. 224.)

1.3 App C3: Failure to exercise due professional care

Most of the allegations in this category are about inadequate audit procedures, despite knowledge of potential risks associated with the client. For example, the SEC states: “PwC and Hirsch (the audit partner) identified a number of risk factors associated with the preparation of SmarTalk’s financial statements. Despite PwC’s and Hirsch’s awareness of numerous risks and other information that could materially impact the financial statements, PwC and Hirsch failed to perform sufficient audit procedures to assess properly whether SmarTalk’s accounting for and charges against its restructuring reserves was in conformity with GAAP. As a result, SmarTalk improperly established a non-GAAP restructuring reserve and, as described above, misused it to materially inflate earnings before one-time charges at year-end 1997” (AAER 1787 2003).

The SEC alleges in relation to Gemstar’s audit: “KPMG did not have in place a policy that required consultation with the Department of Professional Practice regarding all significant issues that had come to the attention of the engagement.” The agency goes on to assert: “With respect to the AOL revenue, Wong, Palbaum, Hori, (the partners) and KPMG unreasonably failed to exercise professional care and skepticism in reviewing the AOL IPG agreement and in testing Gemstar’s representations regarding the purpose of the upfront nonrefundable fee” (AAER 2125 2004).

1.4 App C4: Failure to express an appropriate audit opinion

Allegations in this category mainly relate to the auditor issuing an unqualified opinion, despite alleged knowledge of the fraudulent accounting policies or schemes used. For instance, the lawsuit against Seitel Securities (In re Seitel, Inc. Securities Litigation, U.S. District Court, Southern District of Texas, Dec. 6, 2002, p. 58) states: “E&Y’s published audit opinion, which represented that Seitel’s 2000 financial statements were presented in conformity with GAAP, was materially false and misleading because E&Y knew or was reckless in not knowing that Seitel’s 2000 financial statements violated the principles of fair reporting and GAAP.” Similarly, in the case against Andersen related to Global Crossing (In re Global Crossing LTD. Securities Litigation, Second Amended Complaint, U.S. District Court, Southern District of New York, March 22, 2004, p. 331), the lawyers point to “Andersen’s failure to qualify, modify or disclaim issuing its audit opinions on Global Crossing’s 1998, 1999, and 2000 financial statements, or Asia Global Crossing’s 2000 financial statements, when it knew or deliberately turned a blind eye to numerous facts that showed that those financial statements were materially false and misleading.”

1.5 App C5: Inadequate planning and supervision

As the title suggests, this category relates to deficient audit plans. In its AAER no. 1452, the SEC alleges: “For the fiscal 1994 and 1995 audits conducted by Wilkinson, there is a complete lack of documentation of any planning and no written audit programs. For the fiscal 1996 to 1998 audits conducted by Boettger and reviewed by Wilkinson (partner), audit planning documents and checklists were often incomplete, undated and unsigned. Supervision of the audits was inadequate and included little partner involvement. For the fiscal 1998 audit, a staff accountant conducted the audit at Madera’s Miami headquarters while his supervisor, an audit manager, remained at Harlan & Boettger’s San Diego office. Boettger permitted the audit manager to supervise the audit by telephone” (AAER 1452 2001).

In the case against Nicor, the lawyers allege: “Nicor’s switch to the PBR plan was a new audit area that presented Andersen with a high degree of audit risk and it needed to focus on this area with an audit strategy characterized by, among other things, heightened professional skepticism and expanded audit procedures designed to obtain more persuasive evidence that Nicor’s financial statements were not materially misstated. Such procedures would include careful investigation of the third-party contracts Nicor was relying upon to justify the LIFO decrements, the substantial December 1999 ‘sales’ which inflated earnings in 2000, and the impossibly high volume of infield transfers in 2000” (In re Nicor, Inc. Securities Litigation, U.S. District Court, Northern District of Illinois, February 14, 2003, p. 80).

1.6 App C6: Lack of independence

These allegations relate to the absence of an independent attitude of the auditor in dealing with the client. For instance in the Global Crossing case, the lawyers allege: “because of significant non-audit related fees paid by Global Crossing and the hiring of Andersen’s former senior partner in charge of the Telecommunications Practice in the Firm and lead partner on the Global Crossing engagement as the Senior Vice President of Finance at Global Crossing in May 2000, Andersen lacked the requisite independence when Andersen audited the Company’s financial statements” (In re Global Crossing LTD. Securities Litigation, Second Amended Complaint, U.S. District Court, Southern District of New York, March 22, 2004, p. 331). Similarly in the matter of AaiPharma, the lawyers allege: “E&Y participated in the wrongdoing alleged herein in order to retain AaiPharma as a client and to protect the fees it received from AaiPharma. E&Y enjoyed a lucrative, long-standing business relationship with AaiPharma’s senior management for which it received $4.7 million dollars in fees for auditing, consulting, tax and due diligence services for 2002–2003. These fees were particularly important to the partners in E&Y’s Raleigh office as their incomes were dependent on the continued business from AaiPharma” (In re AaiPharma Inc. Securities Litigation, U.S. District Court, Eastern District of North Carolina, February 11, 2005, p. 101).

1.7 App C7: Failure to obtain an understanding of internal control

These allegations typically deal with the auditor’s negligence in appreciating the deficient internal control systems of the firm, which potentially led to the alleged accounting fraud. For instance, the lawsuit against Cellstar states: “Although KPMG Peat Marwick was retained by the Company to address deficient internal control problems at the same time that it was auditing the Company’s financial statements for the year ended November 30, 1995, KPMG Peat Marwick recklessly failed to enhance the scope of its audit so as to uncover Defendants’ fraudulent scheme” (State of Wisconsin Investment Board, et al. v. Goldfield, et al., U.S. District Court, Northern District of Texas, p. 23). Similarly, in the matter of Informix, the lawyers allege: “Informix had weak internal controls. E&Y knew that Informix’s tiny internal audit department performed no procedures to ensure revenue was recognized properly but primarily audited customer accounts as to license use. Informix’s weak internal controls made it possible for the defendants to recognize revenue on shipments made after quarter end” (In re Informix, Corp. Securities Litigation, U.S. District Court, Northern District of California, April 6, 1998, p. 42).

1.8 App C8: Insufficient level of professional skepticism

Exercise of professional skepticism requires auditors to demonstrate a questioning mind and to critically assess audit evidence. In the Worldcom case, the lawyers allege: “Specific examples of failing to exercise due professional skepticism include: (i) given the poor state of the telecommunications industry in 2000 and 2001, Andersen failed to use professional skepticism in evaluating WorldCom’s ability to continue to meet aggressive revenue growth targets and maintain a 42% line cost expense-to-revenue ratio; and (ii) during 2000, WorldCom employees reported to Andersen audit team that WorldCom’s European operation reversed $33.6M in line costs accruals after the close of the first quarter of 2000 and as a result they were under-accrued. This top-side entry was directed by WorldCom’s U.S. management, and the U.K. employees did not have supporting documentation for it. Andersen failed to request and receive supporting documentation for this reduction and failed to exercise due professional care in evaluating the accrual” (In re Worldcom, Inc. Securities Litigation, U.S. District Court, Southern District of New York, December 2, 2003, p. 224).

A lawsuit against Hollinger Inc. likewise alleges: “KPMG was required to exercise professional skepticism, an attitude that includes a questioning mind, including an increased recognition of the need to corroborate management representations and explanations concerning mutual matters. Here, KPMG completely failed in its duties by issuing ‘clean’ or unqualified opinions in connection with its deficient audits and reviews of Hollinger’s financial statements” (In re Hollinger International, Inc, Securities Litigation, U.S. District Court, Northern District of Illinois, p. 151).

1.9 App C9: Failure to faithfully state whether financial statements are in accordance with GAAP

In a lawsuit against Microstrategy, the lawyers allege: “PWC violated GAAS Standard of Reporting No. 1 which requires the audit report to state whether the financial statements are presented in accordance with GAAP. PWC’s audit reports falsely represented that MicroStrategy’s fiscal 1997, 1998 and 1999 financial statements were presented in accordance with GAAP when they were not for the reasons stated herein” (In re MicroStrategy Inc. Securities Litigation, U.S. District Court, Eastern District of Virginia, p. 33). In AAER no. 2238, the SEC alleges: “the respondents did not heed sufficiently indications that Just for Feet may have been improperly recognizing income through the acquisition of vendor display booths and failed to consider that this would mean that the financial statements did not conform to GAAP” (AAER 2238 2005b).

1.10 App C10: Failure to evaluate the adequacy of disclosure

GAAS requires the auditor to determine whether informative disclosures are reasonably adequate, and if not, the auditor must state so in their report (PCAOB AU 431 1980). Allegations in this category pertain to the auditor’s failure to assess whether the client should have disclosed material information in its financial statements. For instance, in the case of KPMG and Xerox, the SEC in its AAER no. 2234 stated: “KPMG also failed to assess adequately (or require Xerox to assess) the need to disclose in the MD&A or financial statements the nature of and the impacts from these accounting actions, which materially deviated from the company’s historical accounting and financial reporting and accelerated $2.8 billion of equipment revenues and $659 million in pre-tax earnings that otherwise would not have been recorded under GAAP” (AAER 2234 2005a).

In the case of PWC and Arthrocare, the class action lawyers allege: “ArthroCare’s financial statement disclosures were inadequate and, therefore, PwC violated GAAS by not modifying its previously issued unqualified audit opinions for the inadequacy of the information disclosed. The inadequate disclosures involved basic fundamental concepts such as revenue recognition, acquisition accounting and impairment analysis” (In re Arthrocare Corp. Securities Litigation, U.S. District Court, Western District of Texas, December 18, 2009, p. 275).

1.11 App C11: Inadequate consideration of fraud risks

In the matter of Hanover, lawyers allege: “under AU §316, consideration of fraud in a financial statement audit, PWC was required to consider and plan for factors that indicated Hanover may be dealing with entities that were not independent. The risk factors under AU §316.17 included: (i) significant, unusual, or highly complex transactions, especially those close to year end, that pose difficult ‘substance over form’ questions; (ii) overly complex organizational structure involving numerous or unusual legal entities, managerial lines of authority, or contractual arrangements without apparent business purpose; (iii) difficulty in determining the organization or individual(s) that control(s) the entity; and (iv) unusually rapid growth or profitability, especially compared with that of other companies in the same industry” (Pirelli Armstrong Tire Corporation Retiree Medical Benefits Trust, et al. v. Hanover Compressor Company, et al., U.S. District Court, Southern District of Texas, October 4, 2004, p. 37).

Similarly, in SEC’s AAER 2815, the SEC alleges: “Putnam received indications of possible fraud at Ebix including earnings management, high involvement in accounting decisions by non-financial management, commitments made to analysts, the expectation of possible equity funding, the desire to maintain a high stock price, Ebix’s very aggressive accounting policies, and possible opinion shopping by Ebix among accounting firms, among others. In particular, Putnam became aware that Ebix’s management had taken an extremely aggressive approach to recognizing revenue from the company’s software sales” (AAER 2815 2008).

Appendix 4

Table 14 Correlation matrix