Audit Quality and Disclosures of Less-Experienced Participating Audit Firms in PCAOB Filings Free

In many audits, particularly audits of clients with multinational operations, firms other than the firm signing the audit report (“lead auditor” or “principal auditor”) perform substantial portions of the audit. These other audit firms (“other auditors” or “participating auditors”) may perform a variety of functions, including auditing a client's subsidiary or assisting the lead audit firm with audit work on the issuer's operations in another country.¹ In our paper “Who Did the Audit? Audit Quality and Disclosures of Other Audit Participants in PCAOB Filings” (Dee, Lulseged, and Zhang 2015; hereafter, DLZ), we examine audit quality when disclosures made by audit firms in Public Company Accounting Oversight Board (PCAOB or Board) filings indicate that audit firms other than the firm signing the audit report have substantially participated in the audit. This paper summarizes the findings of DLZ and describes implications for practice and areas of future research.

Our study was conducted while the PCAOB was debating a requirement that audit firms publicly disclose the extent to which other auditors are involved in the audit. James Doty (2015), former PCAOB chair, states:

In its Release No. 2016-002 (PCAOB 2016, 5), the PCAOB notes that they have found deficiencies in some engagements involving the use of other auditors, “deficiencies that lead auditors did not identify or did not address.” They also state that “in audits selected by the PCAOB for inspection that involve other auditors, the other auditors audit on average between one-third and one-half of the total assets and total revenues of the company being audited” (PCAOB 2016, 7).² In sum, the Board argued that other auditors have significant participation in the audit of SEC issuers, the integration of these audits is far from seamless, and investors are not aware of the extent of participation of the other auditors. Thus, the PCAOB pressed for the requirement of principal audit firms to disclose the use of other auditors.

However, because the lead or principal audit firm bears the risk of litigation and damage to its reputation in the event of an audit failure, the firm has incentives to ensure the overall audit is of high quality regardless of the extent to which other audit firms participate. In addition, investors are aware of these incentives for the lead auditor to provide high quality, and therefore may be uninterested in learning of the involvement of audit firms other than the principal auditor. Thus, it is not clear whether investors will find disclosure of other audit participants useful.

These conflicting arguments—the concerns of regulators versus the lead audit firm's incentives for high quality—motivate our study (DLZ). In general, other audit participants are not identified in the auditor's report.³ However, in 2010, the PCAOB began requiring registered audit firms to publicly file “Form 2.”⁴ Firms must include on Form 2 a list of clients for which the firm acted as principal auditor. PCAOB-registered audit firms that do not act as principal auditor on any engagement are also required to file Form 2, and list the audits on which the firm “substantially participated,” along with the identity of the principal auditor. We use these Form 2 disclosures to identify the experimental issuers.

Disclosures about participating auditors on Form 2 are made only by audit firms that (1) played a “substantial role” in the audit of an issuer, and (2) did not issue audit reports of their own for SEC issuers.⁵ These participating auditors do not act as lead auditor on any issuer audits, yet they audit at least 20 percent of an issuer client for another firm that is acting as lead auditor. Thus, we emphasize that the participating auditors in our study are not representative of the universe of participating auditors. However, this setting—in which the participating auditors likely have limited experience in the audits of SEC issuers because they do not have issuer audit clients of their own—allows us a strong test of whether using participating auditors is associated with reduced audit quality. If the use of participating auditors leads to lower audit quality, such evidence is most likely found in the population we study—audit firms that do not have issuer clients of their own, yet are responsible for at least 20 percent of the audit. For ease of exposition, hereafter we use the phrase “LE participating auditors” to indicate this subset of less-experienced other auditors we examine. Figure 1 provides an example of Form 2 for Deloitte & Touche LLP, Deloitte's affiliate in Ireland.

Using these Form 2 disclosures filed by LE participating auditors, we identify client engagements on which these firms substantially participated. We first investigate whether investors view audits using LE participating auditors as being of lower quality. We find a negative stock market reaction when LE participating auditors first identify themselves and the issuer audits on which they participated on Form 2, indicating that investors discount the value of the client's stock when this news is disclosed. Moreover, in quarters subsequent to the disclosure, we find a reduction in the association between “unexpected earnings” and short-window (three-day) “abnormal stock returns” for these clients.⁶ This is consistent with the notion that investors perceive these issuers' quarterly earnings as less credible than they did before news of the LE participating auditors was revealed. In addition, we find that clients of auditors identified as using LE participating auditors have higher accruals (in absolute value) than are expected, which we interpret as an indication of lower earnings quality. However, we find no statistical difference in audit fees between our sample of clients using LE participating auditors and a control sample, which suggests that clients do not increase demands for higher audit quality to counteract the uncertainty in investor perceptions of audit quality.⁷

In 2017, after the time of our study, the PCAOB began requiring identification of other audit participants on a new PCAOB Form AP (PCAOB 2015). Lead auditors must now disclose on Form AP the identities and participation percentages of all audit firms providing at least 5 percent of the total audit hours on the engagement. Aggregated information must be reported about firms providing less than 5 percent of the total hours on the audit. The Form AP disclosures will allow academic research to explore a broader population of other auditors than we were able to do in DLZ. However, we believe our study is an important first step in understanding the consequences of using participating auditors to conduct a substantial portion of the audit.

The PCAOB's (2017) Auditing Standard (AS) 1205, Part of the Audit Performed by Other Auditors applies for audits of publicly traded companies that involve auditors other than the principal auditor.⁸ Under AS 1205.02 (PCAOB 2017), if a significant part of the audit is conducted by other auditors, the principal auditor “must decide whether his own participation is sufficient to enable him to serve as the principal auditor and to report as such on the financial statements.”

If the auditor determines his participation is sufficient to act as principal auditor, he then decides whether to refer to the other auditors in the audit report. An opinion that makes reference to the other auditors is commonly called a “shared responsibility opinion.” In such a case, the auditor should clearly indicate in the audit report the division of responsibility between the audit work completed by the principal auditor and the work completed by the other auditor or auditors. Shared responsibility opinions are relatively rare for publicly traded companies. Over the nine-year period from 2009 through 2017, Mao, Ettredge, and Stone (2019) find a total of 653 shared responsibility opinions filed with the SEC, or roughly 73 per year. The more common approach in audits of issuer companies is for the principal auditor not to make reference to the other auditor in the audit report. Additional procedures are required in this case, largely related to documentation that must be obtained from the other auditor.

Regardless of whether the principal auditor makes reference to the other auditor in the report, the principal auditor must inquire as to the “professional reputation and independence of the other auditor” (AS 1205.10, PCAOB 2017). The principal auditor must determine through communication with the other auditor that he understands the component being audited will be included in consolidated financial statements, and that there will be a review of intercompany transactions. Additionally, the principal auditor must make certain the other auditor is knowledgeable about PCAOB standards, Generally Accepted Accounting Principles, and SEC regulations (AS 1205.10.c, PCAOB 2017).

While it may seem obvious to accounting professionals that more than one audit firm would be involved in the audit of an issuer with multinational operations, investors do not necessarily have the same cognizance. Former chairman of the PCAOB Doty (2011) states:

Institutional and legal barriers largely prohibit principal audit firms from sending their U.S.-based employees to perform audits of client subsidiaries or component operations in foreign countries. Instead, firms must rely on outsourcing the work to auditors locally licensed in the applicable country. However, while global network firms advertise their seamless integration around the world, the structure of these networks is that each foreign affiliate of a global network firm is a separate legal entity organized in the foreign country. Because they bear the responsibility of the entire audit, and face litigation and reputation damage in the event of an audit failure, principal auditors have strong incentives to monitor the work of other auditors. However, they typically do not have access to the other auditors' full set of working papers and must instead rely on a more limited set of documentation to assess the work of the other audit firm (Downey and Bedard 2019).

Each country's affiliate of a global networked audit firm must be separately registered with the PCAOB if it is to conduct 20 percent or more of the audit of any issuer.⁹ Since 2010, the PCAOB has required registered audit firms to annually file Form 2 with the Board, and we gather data on LE participating auditors from these filings. The forms we examine are filed by the LE participating auditor—not the principal auditor. We match each issuer (experimental sample) to an issuer not having LE participating auditors (control sample), based on the issuer's principal auditor and percentage of foreign revenue. This matching allows us to isolate the effect of LE participating auditors on audit quality.

We identify 149 unique issuer clients using 65 unique LE participating auditors. In our sample, 98 percent of the experimental issuers have non-U.S. LE participating auditors, while only three issuers (2.0 percent) have U.S. LE participating auditors. For 89 percent of the experimental issuers, the LE participating auditor is a foreign affiliate of the principal auditor.

First, our primary analyses focus on investors' perceptions of audit quality. We examine the clients' stock price reaction over a short (three-day) window when news of LE participating auditors is revealed in the participating audit firm's Form 2 filing. We use statistical techniques that help isolate the effect of the news of LE audit participants from changes in stock prices unrelated to the news, such as overall market movements caused by unrelated economic events. Overall, we find that the stock prices for experimental issuers react negatively to the first-time news that less-experienced audit participants were involved in the audit. However, this negative reaction is only for the first issuance of Form 2—subsequent Form 2 filings by LE participating auditors mentioning their involvement in the audit of an issuer are not associated with stock market reaction. This supports our notion that the market reacts to the unexpected news of LE participating auditors being involved in the audit and that investors perceive audits involving LE participating auditors as being of lower quality or having higher quality uncertainty.

Second, we compare earnings response coefficients (ERCs) between the experimental and control samples in the pre- and post-disclosure quarters. ERCs are a measure of how responsive the stock price is to the issuer's unexpected earnings—that is, how much short-window stock returns are affected when the issuer's financial information is revealed in its Form 10-Q to differ from the market's expectations.¹⁰ We find that ERCs are significantly lower in the post-disclosure quarters only for the experimental issuers, not the control sample. The lower ERCs for the experimental issuers indicate that investors perceive the reported earnings less credibly due to greater uncertainty about the quality of the audit for the issuers disclosed as having LE participating auditors.

Third, we examine if issuers whose audits involve LE participating auditors have higher abnormal accruals. Abnormal accruals are “those that are higher or lower than expected” and are measured “using a well-established model for predicting expected accruals” (Causholli, Chambers, and Payne 2015).¹¹ We find that abnormal accruals are higher for the experimental issuers compared to the control issuers. This is an indication that the quality of earnings is lower for the issuers disclosed as having LE participating auditors.

Finally, we examine audit fees to see if issuers using LE participating auditors pay lower fees than other issuers. In analyses that control for other factors associated with audit fees, we find no difference in fees paid between the experimental and control issuers. The lack of significant differences in fees suggests that clients do not increase demands for higher audit quality to counteract the uncertainty in investor perceptions of audit quality. Alternatively, this could be because (1) cost savings for the principal auditor in using LE participating auditors are not passed through to the issuer, or (2) the difference in fees is not significant enough to be detected by our statistical tests.

Our study has implications for audit firms, their clients, and accounting researchers. First, the nature of audits of multinational corporations means that principal audit firms have little choice but to use other auditors; however, they can be better aware of the additional monitoring that may be necessary with less-experienced participating auditors. While the requirement to monitor participating auditors is not new, new required disclosures on Form AP about participating auditors will make the quality of their work more transparent. Second, clients should be aware of the potential market implications when less-experienced participating auditors perform substantial portions of the audit. Audit committees can request additional information from their principal auditors about the monitoring of less-experienced participating auditors. Finally, now that more data are available on issuer audits involving participating auditors, it is important for research to examine whether the findings in our study will continue to hold in a sample involving the wider population of participating auditors.