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How do auditors respond to accounting restatements? Evidence on audit staff allocation

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Abstract

We examine how auditors respond to accounting restatements using audit input data from Japan. We find that audit fees, the number of Certified Public Accountant (CPA) licensed staff, and the number of signing partners are higher for firms in the restatement year than in the year prior to the restatement. Our results also reveal that the increase in audit fees and the higher numbers of CPA-licensed staff and signing partners persist after the restatement year. The results are robust after excluding dismissal of auditors subsequent to the occurrence of restatements. We further find that client firms are not able to gain a fee discount but will be audited by greater numbers of partners if they switch auditors after the restatement. We also obtain consistent results using propensity score matching. Overall, our findings suggest that audit firms increase audit inputs (i.e., higher fees and more experienced staff with a CPA license) in response to their own mistakes (i.e., accounting restatements). Taken together, the results suggest that the increased audit fees may reflect the increase in the risks, but not the risks alone.

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Data Availability

The data used in this paper are from publicly available sources as referenced.

Notes

  1. The CPA Act of Japan requires at least one signing partner for assurance services (CPA Act 34–10-4 and CPA Act 34–10-5). However, in practice, audit firms usually assign two or more signing partners to each audit engagement.

  2. We use the terms “auditor” and “audit firm” interchangeably throughout this paper.

  3. GAO uses the term “financial restatement” in its reports. We use “accounting restatement” or “restatement” interchangeably throughout this paper.

  4. According to the Standard Audit Fee Schedule set by the JICPA, audit fees consist of basic fees and working fees. The basic fees are JPY9.95 million for firms listed in the First Section of the TSE, JPY6.85 million for firms listed in the Second Section and JPY5.75 million for all other firms. Working fees are JPY2.48 million per leading auditor. If auditors spend more than 25 days auditing a firm, the additional working fees are JPY0.089 million per day multiplied by the number of leading and supporting auditors.

  5. Each auditor has their own charge rate according to their rank (e.g., partner, manager, senior and junior) in the audit firm.

  6. Since the establishment of the time charge method in 2004, several studies (e.g., Yazawa 2009; Fukukawa 2011; Yazawa 2012) in Japan, including those by the JICPA itself, have attempted to examine how audit fees are determined under the new pricing scheme. The JICPA has also conducted several studies that attempt to reveal how auditors estimate audit time under the time charge method. The study reports and a follow-up revision (kansajikan no mistumori ni kansuru kenkyu hokoku) were released in September 2006 and June 2008, respectively. For details, see https://jicpa.or.jp/specialized_field/post_518.html and https://jicpa.or.jp/specialized_field/18_12.html, respectively (in Japanese).

  7. US Securities and Exchange Commission (Release No. 34–77,787; File No. PCAOB-2016–01), “Public Company Accounting Oversight Board; Order Granting Approval of Proposed Rules to Require Disclosure of Certain Audit Participants on a New PCAOB Form and Related Amendments to Auditing Standards,” May 9, 2016. (https://www.sec.gov/rules/pcaob/2016/34-77787.pdf).

  8. Press release for sanctions on the signing partners in the recent Toshiba scandal available at the following URL: https://www.fsa.go.jp/news/27/sonota/20151222-4.html.

  9. All annual filings dated March 31, 2009 and later are prepared in accordance with JSOX.

  10. Operated by the Financial Services Agency of the Government of Japan.

  11. Some files contain duplicate information. For example, if a firm restates its net income in 2015 for an accounting mistake in 2012, this affects the net income in 2012 and 2013. Firms are required to submit restatement filings for each fiscal year from 2012 to 2015 to the regulatory authorities (i.e., four files for the two years’ of restatements will be retrieved from the EDINET).

  12. Audit staff information became available in the annual reports beginning on March 31, 2005.

  13. Before January 1, 2006, those passing the CPA exam in Japan gained the status of CPA candidate (kaikeishiho). After three years of practical training, CPA candidates were eligible for the final exam, and after passing, were granted a CPA license. However, from January 1, 2006, there was no granting of CPA candidate status. Instead, those passing the CPA exam are “people who have passed the CPA exam,” and after two years of practical training, are granted a CPA license. For more details about the CPA exam system in Japan, see Ch. 4 of the 2004 annual reports of the Certified Public Accountants and Auditing Oversight Board, Japan (http://www.fsa.go.jp/cpaaob/shinsakai/reports/16/honpen/).

  14. Skinner (2008), Kato et al. (2009) and Kato et al. (2017) employ the same data source.

  15. The Cabinet Office of the Government of Japan only requires firms to disclose audit staff-related information in an easily comprehensible way (Cabinet Office Ordinance on the Disclosure of Corporate Affair, Cabinet Office Ordinance No. 34 of March 31, 2005). Without a uniform disclosure format, the audit staff disclosures in the annual reports vary from the exact numbers of auditing staff to “the firm is audited by multiple staff.”.

  16. In the regression, the amounts of audit fees (in millions of JPY) are in natural logarithms. Therefore, the coefficient for PreREST 0.1672 indicates that the audit fees in the year of restatement represent 118.20% of the audit fees in the year prior to the year of restatement, i.e., 18.20% (exp[0.1672]).

  17. The coefficient for REST is 0.1444, thus exp(0.1444) = 1.1553 or 115.53%, indicating an increase of 15.53% from the year prior to the restatement year.

  18. Because LnStaff, LnLiStaff, and LnPartner are discrete values of the number of audit staff, we re-estimate the model using Poisson regression. The results are similar to those using ordinary least squares. We find that audit firms are more likely to allocate more licensed staff and signing partners in the restatement year, and that the increased number of audit staff persists at least for a year in the post-restatement years.

  19. As in our treatments of restatements, we compare: (a) the differences between the year prior to a misstatement and the misstatement year, and (b) the misstatement year and the year after a misstatement. Therefore, there will be 27 observations in the regression analysis (i.e., nine each for the year prior to the misstatement, the misstatement year, and the year after restatement).

  20. We perform a t-test to check the differences of variables for propensity score matched firms and our sample firms, and find no significant difference.

  21. Since the number of member of the board of director will never be zero; when REST interacts with BoardSize, REST and PostREST will lose economic meaning. Hence, we measure BoardSize as the deviation from the corresponding industry-year mean.

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Acknowledgements

We are grateful for the insightful comments and guidance from Professor Cheng-Few Lee (editor) and the anonymous reviewer. We also thank Roberta Barra, Jeff Zeyun Chen, Chris Hogan, Ling Lei Lisic, Shivaram Rajgopal, Aki Yamauchi, and conference participants at the 8th Conference of the World Accounting Frontiers Series (WAFS 2019) at the University of Macau and the Hawaii Accounting Research Conference 2020 (HARC 2020) for constructive comments and suggestions. Chien-min Kevin Pan acknowledges financial support from the Ministry of Science and Technology of Taiwan for [MOST105-2410-H-004-049-]. The editing assistance by Richard Subber is gratefully acknowledged. All remaining errors are our own.

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  1. Department of Accounting, National Chengchi University, ZhiNan Rd, NO. 64 Sec. 2 Wenshan District, Taipei City, 11605, Taiwan

    Wuchun Chi & Chien-min Kevin Pan

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Appendix

Appendix

Variable Definitions

Variable

Definition

LnAFee

Audit fee, in natural logarithms;

LnStaff

Number of auditing staff, in natural logarithms;

LnLiStaff

Number of staff with a CPA license, in natural logarithms;

LnPartner

Number of signing partners, in natural logarithms;

REST

An indicator variable set equal to 1 if the financial statement is restated in the corresponding fiscal year, 0 otherwise;

PostREST

An indicator variable set equal to 1 if the fiscal year is one year after restatement year, 0 otherwise;

MISS

An indicator variable set equal to 1 if the financial statement is misstated in the corresponding fiscal year, 0 otherwise;

PostMISS

An indicator variable set equal to 1 if the fiscal year is one year after misstatement year, 0 otherwise;

LnAsset

Natural logarithm of total assets;

Leverage

Total liabilities over total assets;

ROA

Net income over lagged total assets;

OverseaSales

Overseas sales over total sales;

LnSeg

Natural logarithm of the number of operating segments plus 1;

LnSub

Natural logarithm of the number of subsidiary companies plus 1;

DailyReturn

Firm-level standard deviation of daily stock returns;

LnFirmAge

Firm age, measured as the financial statement reporting date minus firm establishment date, in natural logarithms;

BigN

An indicator variable that equals 1 if the firm’s auditor is a Big-N auditor, 0 otherwise;

JSOX

An indicator variable that equals 1 if the firm’s annual report is filed in accordance with JSOX requirements, 0 otherwise;

Ln(ReLags)

Audit report lags, measured as the days between fiscal year-end date and the audit report date, in natural logarithms;

BoardSize

Number of members on the board of directors, in natural logarithms

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Chi, W., Pan, Cm.K. How do auditors respond to accounting restatements? Evidence on audit staff allocation. Rev Quant Finan Acc 58, 847–879 (2022). https://doi.org/10.1007/s11156-021-01011-1

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