Industry-Specific Knowledge Transfer in Audit Firms: Evidence from Audit Firm Mergers in China

Using a difference-in-differences approach, we examine the effect of industry-specific knowledge transfer on audit performance after a merger of two Chinese audit firms with different levels of expertise in an industry. For clients in an industry audited by both merging audit firms, those audited by the audit firm less specialized in that industry belong to the treatment group, while all other clients belong to the control group. We find an economically-significant improvement in audit quality (as reflected in a reduction in financial misstatements) for the treatment group relative to the control group in the same merged audit firm. We show that the treatment effect is not driven by changes in auditor incentives or personnel movement and is more pronounced when we expect stronger communication between the less and more specialized auditors after the merger. We caution that our findings are specific to China and may not generalize to other countries.

Auditors' Responses to Classification Shifting: Evidence from U.S. Firms

This study examines how auditors react to clients' engagement in classification shifting which refers to the intentional misallocation of line items within the income statement. We find that classification shifting is positively associated with audit fees, audit report lags, the issuance of a modified audit opinion, and auditor resignations. Additional analyses show that auditors' responses to multiple-year classification shifting are similar to our main findings. We further find that classification shifting is associated with a higher likelihood of financial misstatements in the classification shifting year, and future announcements of financial restatements. We also find that the probability of future restatements is even higher when audit clients engage in both classification shifting and real earnings management. Overall, our results imply that auditors become more cautious in response to audit clients' classification shifting behavior.

Misstatements and Internal Control over Operations and Compliance

This study examines whether the effectiveness of internal control over operations and compliance is associated with the likelihood of financial misstatements. Using a unique dataset from Taiwan, we find that the more deficiencies a company has in internal control over compliance, the greater the likelihood that the company’s financial statements will be restated in the future; indeed, severe misstatements are more likely for firms with more internal control deficiencies in compliance. However, we do not find a similar impact involving internal control over operations. As the literature contains little about internal control over operations and compliance, our study contributes by shedding light on the importance of control activities in operations and compliance in regard to the quality of financial reporting.

Profitability, Market Incentive and Audit Quality of Financial Misstatements: Evidence from Malaysian Public Listed Companies (PLCs)

The purpose of this study is to examine whether there is mean difference in profitability (Profit), market incentive (EPrice) and audit quality (AudQ) variables between restatement and non-restatement firms in Malaysia. The sample comprises of 285 public listed companies on the Main Board of Bursa Malaysia for the years between 2005 and 2013. A descriptive statistics analysis is performed to differentiate the characteristics of restatement and non- restatement firms. The study finds significant difference between restatement and non-restatement firms in the profitability and market incentive variables. The results show that restatement firms reported higher profit than non- restatement firms in the year prior to the restatement year. And, restatement firms have higher earnings-to-price ratio (proxy for market incentive) relative to the non-restatement firms that are matched by total assets, but lower than non-restatement firms which not matched by total assets. This indicates that restatement firms are able to maintain high growth expectations embedded in the firm’s share price. The study finds no significant difference in audit quality between misstatement and non-misstatement firms. The comparable audit fees between restatement and non-restatement firms indicate that the external auditors of restatement firms failed to appropriately assess the audit risk of these firms.

CFO Outside Directorship and Financial Misstatements

SYNOPSIS I study an important accounting consequence—financial misstatements—of CFO outside board membership. I find that firms with CFOs holding outside directorships have a lower likelihood of misstatements. These results likely reflect the benefits accruing to CFOs' home firms in terms of improved financial reporting quality. These findings are based on several methods that control for unobserved factors that may affect both incidence of CFO outside directorships and a firm's financial misstatements. I also provide some preliminary insights into CFO and home firm characteristics that determine CFO outside board directorships. My findings are consistent with the inter-organizational embeddedness perspective, suggesting that inter-firm networks provide sources for counseling and learning opportunities, which executives can use to improve their home firms' performance. JEL Classifications: M41.

Financial Statement Footnote Readability and Corporate Audit Outcomes

SUMMARY We examine whether the readability of financial statement footnotes in the annual report is informative about audit engagement risk. Using various readability measures, we predict and find that firms with less readable footnotes have longer audit report lag, incur higher audit fees, and are more likely to receive a first time modified going concern opinion. We also show that readability of footnotes is associated with a higher likelihood of financial misstatements and future accounting-related litigation. Our results are robust to several measures of readability used in prior literature, as well as different specifications and design choices, revealing that financial statement footnote readability provides incremental information about audit engagement risk that affects auditor-client contracting. Data Availability: Data are obtained from public sources identified in the paper.