The Impact of Other Component Auditors on the Costs and Quality of Multinational Group Audits

The Impact of Other Component Auditors on the Costs and Quality of Multinational Group Audits Elizabeth Carson University of New South Wales Roger Simnett University of New South Wales Greg Trompeter University of Central Florida Ann Vanstraelen Maastricht University Draft: For presentation at University of Texas Preliminary draft: Please do not quote without permission of the authors. We thank Ashna Prasad, Dale Fu and Lin Liao for research assistance, and appreciate the comments of Ronen Gal-Or, Karla Johnstone and Per Christen Tronnes as well as participants at workshops at Boston College, Maastricht University, the University of Melbourne, the University of New South Wales and the European Accounting Association Annual Meeting and American Accounting Association Annual Meeting. We also acknowledge the financial support of the Australian Research Council. 1 The Impact of Other Component Auditors on the Costs and Quality of Multinational Group Audits Abstract Regulators have raised concerns about the quality of audits of financial statements of multinational companies. Of particular concern are engagements in which parts of the audit are not undertaken by the principal auditor but involve component auditors either affiliated or unaffiliated with the signing audit firm. Using unique disclosure requirements for Australian listed firms, we examine the incidence of such arrangements and their impact on audit fees and audit quality over the period 2008-2011 for a large sample of multinational companies. We find that relative to multinational group audits conducted solely by principal auditors, audit fees are lower when other auditors, either within or outside the network, are involved. Further we find that where other component auditors are engaged, audit fees are lower when the principal auditor’s network is involved relative to unaffiliated auditors. We find some differences in the magnitude of discretionary accruals and the propensity to issue going concern opinions for multinational group audits for specific combinations of auditors, in particular where affiliates of the global audit firm network are involved, suggesting that some concerns regarding audit quality may be warranted in relation to group audits. 2 1. Introduction Significant concerns have been raised by regulators about the quality of the auditing of multinational corporate groups (e.g., the Australian Securities and Investments Commission (ASIC), the United States Public Company Accounting Oversight Board (PCAOB), the International Forum of Independent Audit Regulators (IFIAR) and the European Commission (EC), all since 2010). Such audits generally involve corporate structures comprised of multiple components (e.g., subsidiaries and joint ventures) facing complex accounting issues and which are often geographically dispersed. Audits of such entities also commonly require the signing auditor to coordinate multiple other audit firms that are involved in providing audit evidence on individual components of the consolidated entity (referred to in this paper as ‘other component auditors’). This may involve coordination and evaluation of the work of other member firms within the audit network1 (e.g., PwC Australia signs the audit report, whilst PwC USA conducts audit work on the US subsidiary), other audit firms that are not members of the signing auditor’s network (e.g., PwC Australia signs the audit report, KPMG USA conducts audit work on the US subsidiary) or a combination of these situations. The difficulties in auditing such multinational groups have been highlighted by major multinational audit failures, such as Parmalat in Italy, Royal Ahold in The Netherlands (Knapp and Knapp 2007), and Satyam Corporation in India (SEC 2011), each of which have been associated with poor quality work undertaken by component auditors as part of the group audit. Currently, the identity and extent of involvement of other component auditors is not identified in the standard audit report of the International Auditing and Assurance Standards Board (IAASB) but it has been proposed that this be 1 “Network” is defined and used in Section 290 of the IFAC Code of Ethics for Professional Accountants (revised July 2006) as “a larger structure: (a) That is aimed at co-operation, and (b) That is clearly aimed at profit or cost sharing or shares common ownership, control or management, common quality control policies and procedures, common business strategy, the use of a common brandname, or a significant part of professional resources”. More detailed guidance on networks is provided in Section 290, paragraphs 16 to 26. 3 rectified (IAASB 2012)2. Concerns have been raised by the PCAOB (2010, 2011) with respect to such audits where other component auditors have been strategically selected for reasons of low price or low quality, both of which issues we consider in this research.3 For a group audit, the principal auditor must determine the extent to which other component auditors should be involved in the engagement. Under International Standards on Auditing (ISA), in particular ISA 600, if part of the group audit work is outsourced, the principal auditor remains ultimately responsible for the group audit opinion. Paragraph 11 of ISA 600 states that “the group engagement partner is responsible for the direction, supervision and performance of the group audit engagement in compliance with professional standards and applicable legal and regulatory requirements, and whether the auditor’s report that is issued is appropriate in the circumstances”. The group auditor therefore must be able to satisfy themselves that the use of other auditors means that the level of audit quality is not compromised. There are a number of ways in which this quality can be reached, which involves relying on the work of other component auditors to varying degrees. This can range from the group auditor putting themselves in a position, and undertaking sufficient quality checking, through supervision, direction and evaluation of quality control processes, to rely on the work of other component auditors, to not relying on their work at all, and effectively undertaking the work themselves, even if it means travel to potential far away destinations. 2 The proposed inclusion in the audit report in the IAASB Invitation to Comment on ISA 700 is “…At our request, other auditors performed procedures on the financial information of certain subsidiaries to obtain audit evidence in support of our audit opinion. The work of audit firms with which we are affiliated constituted approximately [percentage of audit measured by, for example, audit hours] of our audit and the work of other non-affiliated audit firms constituted approximately [percentage of audit measured by, for example, audit hours] of our audit…” 3 The PCAOB (2011) has proposed additional disclosures when auditing firms, other than the signing firm, are involved with an engagement. Specifically, the Board has proposed that such audits disclose the identity, location and extent of involvement (defined as percent of total audit hours) of all firms taking part in the audit engagement (potentially subjectto a minimum threshold). 4 Therefore the decision to involve other component auditors involves an economic trade-off for the auditor. On the one hand, if the decision is made to outsource part of a multinational group audit, arguably because it reduces costs, and the ability to assess the quality of service provided is limited, a principal agent problem arises with potential information asymmetry between the principal and the agent. In this case, the principal runs the risk of low performance, low audit quality and thus risk of litigation. On the other hand, if the auditor decides not to outsource, this may well result in a more costly and inefficient audit and the auditor runs the potential risk of client loss in the future if the client recognizes this and is able to negotiate a lower fee for the group audit with a competitor. The purpose of this study is to firstly document the prevalence and combinations of the involvement of other component auditors in multinational group audits, about which little is currently known4. Secondly, we examine the extent to which quality and fee differences (if any) arise when the signing auditor relies on other audit firms, either affiliated (part of the audit firm’s network), or unaffiliated (no relationship to the signing audit firm), to conduct portions of the audit engagement. As well as addressing an issue which regulators have identified as being of great concern, this paper contributes to a growing body of research studying factors associated with engagement-level audit quality. As explained by Francis (2011) there are multiple drivers of audit quality and research is required at all levels of analysis (i.e. audit inputs, audit process, accounting firms, audit industry, audit markets and institutions). We focus in this paper on a, to the best of our knowledge, unexplored engagement-specific factor, which is the group audit structure. Specifically, we examine whether the way in which the audit of a multinational group is structured (i.e. wholly audited by the principal auditor; partly audited within the network of the principal auditor; or parts of the multinational group 4 There is an emerging body of research evaluating the European experience of joint audits (for example, Francis et al, 2009). We distinguish joint audits (where two audit firms both sign the audit report and take joint responsibility for the assurance provided

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