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Preliminary draft: Please do not quote without permission of the authors.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.

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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.

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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).

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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 on the financial statements) from group audits where a single audit firm signs the audit report and takes responsibility for the audit of the group financial statements potentially relying on the work of other audit firms whose existence or role is not disclosed.

5 audited by unaffiliated auditors) affects the audit quality of the overall group audit. This paper also contributes to the extensive literature on audit fees (see Hay, Knechel and Wong, 2006 for a review) by considering whether differences in group audit structure can explain differences in audit fees, which to our knowledge has not been addressed before. This paper further highlights that a maintained assumption in the auditing research literature, that the audit firm which signs the audit opinion on these group financial statements has conducted the audit of all the entities within the group, is not correct.

This maintained assumption could lead to potentially erroneous conclusions as the quality of the financial statements has been assumed to be directly related to the identity of the firm signing the audit opinion.

More broadly, we contribute to the literature on multinational corporations (MNCs) which have become increasingly important. About half of worldwide GDP stems from foreign affiliates of multinational corporations and these organizations account for more than two-thirds of worldwide trade (UCTAD

2013). Given the growing economic importance of multinationals, it is therefore not surprising that financial reporting of these organizations has increasingly received attention from academics, regulators and standard-setters. For example, Dyreng et al. (2012) question “whether earnings management generally takes place in a firm’s foreign operations, far from headquarters and perhaps the scrutiny of auditors (emphasis added), or does it happen closer to home?” Interestingly, studies on financial reporting quality of multinationals investigate the group’s audited consolidated earnings figures but have largely ignored the role of a group auditor apart from some studies including a standard control for the type of auditor, Big 4 auditor or not. The impact of the group audit structure, however, has rarely been

6 considered.5 This is especially relevant in a setting where auditing standards hold the principal auditor ultimately responsible for the group audit opinion.

We take advantage of a unique disclosure rule that requires Australian listed companies to publicly disclose extensive audit fee information, including the audit fees paid to the principal (signing) audit firm, the audit fees paid to other member firms within the signing firm’s network, and any fees paid to

‘other’ auditors outside the network for audit work6. We use the level of discretionary accruals in the consolidated financial statements as our initial proxy for audit quality. The incidence of group audits in

Australia that are subject to ISA 600 is identified as high as the majority of companies listed on the

Australian Stock Exchange in 2008-2011 were found to be groups with multiple subsidiaries. We find that the use of multiple audit firms in the audit of such corporate groups in Australia is also a significant issue, evidenced by the fact that nearly half the multinational group audits are not conducted solely by the principal signing auditor, with at least part of each of these audits being conducted by unaffiliated audit firms or by members of the principal auditor’s network other than the principal auditor’s firm (or both). We find that multinational group audits conducted by a single national audit firm are more expensive relative to audits undertaken within the audit firm network or when unaffiliated auditors are

5 Harris et al. (2013) examine instances of voluntary disclosure of other component auditors in the U.S and their impact on audit quality. They found that companies with audit reports that voluntarily mention the work of a component auditor report higher abnormal accruals and are more likely to restate previously issued financial statements compared to a control group of firms that do not mention the work of a component auditor. However, there are two, closely related, distinguishing features between the US and the Australian environment. First, in the US, the only instance where the signing audit firm discloses the existence of a component auditor is when the signing firm is unwilling to accept responsibility for the work of the other auditor. This is typically the case when the signing firm does not review the work of the other auditor, but simply accepts the work at face value. (This distinction is particularly relevant for audits of companies with year ends prior to 15 December 2012. Subsequent to 15 December 2012, US rules require a somewhat greater level of coordination—but not necessarily supervision—of the component auditor.) Second, if the signing auditor is willing to accept responsibility for the work of the component auditor, then the signing auditor is not allowed to acknowledge the existence of a component auditor. Thus, for US audits conducted for year ends prior to 15 December 2012 that did not disclose the presence of another auditor, it is not possible to determine whether the audit was conducted solely by the signing auditor or if other component auditors took part. Relying on incomplete voluntary disclosures—where the signing auditor explicitly disclaims responsibility for the quality of the work done by the component auditor— creates a potential self-selection problem as well as a sample restriction problem, both of which are overcome by the disclosure requirement in Australia. 6 The Australian disclosure is much more comprehensive than that provided by SEC registrants which presently disclose two years of audit fee data in their DEF14a proxy statements, or Form 10-K filings, pursuant to SEC Release 33-8183 (January 28, 2003) with no categorisation by type of auditor.

7 involved. This is consistent with our expectation that audits outside the control of the signing audit firm will be for reasons of cost advantage but will carry higher agency and monitoring costs. Further, we find that audits undertaken using the principal auditor’s network are less expensive than those using unaffiliated auditors as these carry higher agency costs. With regard to audit quality, our results identify areas of concern regarding the quality of multinational group audits. Overall, given their high incidence and impact on audit fees, our evidence supports calls for greater disclosure of identity and responsibilities of other component auditors involved in multinational group audits.

The remainder of this paper is organized as follows. Section 2 provides the relevant background for this study. In Section 3, we develop our hypotheses. Section 4 describes the methodology and empirical models. In Section 5, we present the descriptive statistics and results of the main analyses, sensitivity analyses and robustness tests. Section 6 concludes and provides suggestions for future research.

2. Background Information

Although branded (and commonly thought of) as a single global entity, a global audit firm network

(hereafter, GAFN) is typically organized as an association of national partnerships that agree to affiliate and operate under a single global brand.7 In most countries, the authority to practice as an accounting firm is not granted to an international entity. Rather, that right is reserved for national firms in which local professionals have majority or full ownership. Consequently, GAFNs are typically organized as cooperatives or partnerships where membership is comprised of national firms where each member firm serves its geographic area and is subject to the laws and professional regulations of the country (or countries) in which it operates (Carson 2009). Whilst standards for accounting and auditing practices are increasingly driven by global standards, the enforcement of such standards is undertaken at the national

7 For example, in the US, global audit firm networks do not register with the PCAOB but individual member firms must register. Thus, each of the Big 4 firms has over 40 member firms registered with the PCAOB. A review of the PCAOB’s registry list reveals Ernst & Young firms from Ireland, China, France, Germany and approximately 50 other countries.

8 level. This presents a potential regulatory gap for audits of multinational groups conducted in multiple jurisdictions by multiple audit firms, whether or not they are members of the same global audit firm network.

Recently, the Public Company Accounting Oversight Board (PCAOB), the national auditor regulator in the United States, has released a practice alert identifying its concerns about the conduct of audits of multinational group financial statements, particularly when other component auditors are involved. In

July 2010, Staff Audit Practice Alert No. 6 (2010) was released noting the increasing prevalence of audit reports issued by registered public accounting firms of varying sizes located in the United States on financial statements by entities that have substantially all of their operations outside of the United

States.8 Specifically, the Alert: “…identified situations in which U.S. firms auditing companies with substantially all of their operations in another country appeared not to have appropriately executed their responsibilities with respect to the work of assistants engaged from outside of the firm.”9 Staff Audit

Practice Alert No. 6 (2010) notes that “the knowledge, skill and ability of personnel assigned significant engagement responsibilities should be commensurate with the auditor’s assessment of risk for the engagement, including the risk of material misstatement due to fraud. Ordinarily, higher risk requires the assignment of more experienced personnel or additional persons with specialized skills and knowledge”.

8 In a 27-month period ending March 31, 2010, the PCAOB report that at least 40 United States registered public accounting firms with fewer than five partners and fewer than ten professional staff issued audit reports on financial statements filed with the SEC by companies whose operations were substantially all in the China region. 9 For example, in one situation, a U.S. firm retained the services of a consulting firm that had personnel who could read, write, and speak the language of the area, in the China region, in which the issuer's operations were located. Those consultants planned the audit, communicated with the issuer's management, and travelled to the China region to complete a substantial portion of the audit. None of the U.S. firm's partners or employees travelled to the China region or planned, performed, supervised, or meaningfully reviewed the audit work. Procedures performed by the U.S. firm's engagement partner consisted primarily of reviewing certain work papers prepared by the consultants as well as issuer-prepared draft financial statements and lead schedules that had been translated into English. The PCAOB’s inspection staff concluded that the level of the firm's involvement in the audit work performed by the consultants was not sufficient for the firm to assert that an audit had been performed by the firm and that the audit provided a reasonable basis for the firm to have an opinion on the financial statements. Refer Staff Audit Practice Alert No. 6 (July 2010): http://pcaobus.org/Standards/QandA/2010-07- 12_APA_6.pdf.

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Both these Alerts suggest that there are potential concerns expressed by regulators with respect to the quality of multinational group audits due to their inherent riskiness as well as the risk associated with evaluating work conducted by another component auditor.

In a recent keynote address on the reliability, role and relevance of the audit, James Doty (2011), current chair of the PCAOB, stated, in relation to multinational audits:

“My first concern is investor and public awareness. I have been surprised to encounter many savvy business people and senior policy makers who are unaware of the fact that an audit report that is signed by a large U.S. firm may be based, in large part, on the work of affiliated firms that are completely separate legal entities in other countries. For many large, multi-national companies, a significant portion of the audit may be conducted abroad — even half of the total audit hours. In theory, when a networked firm signs the opinion, the audit is supposed to be seamless and of consistently high quality. In practice, that is often not the case. This gets to my second concern. Based on our inspections, I can say the challenges of managing a multi-national audit are great. As our international inspections program matures, we have begun to evaluate the various pieces of the audit performed by different registered firms in multiple jurisdictions. Our inspectors often see more than the principal auditor — or signing firm — does. In many cases principal auditors rely on high-level reports from subsidiary auditors. They often don't review the work papers of the other auditors. Our inspectors do. And they often find problems in that work.”

Chairman Doty’s observations are consistent with those expressed in Europe. A Green Paper from the

European Commission (October 2010) also outlines specific concerns with both the cost and quality of multinational audits. It states:

“Audits of large groups which operate in multiple jurisdictions are usually carried out by large global networks in view of the high level of resources such audits require. The Commission shares the concerns of a number of audit oversight bodies around the world which consider that the role of the group auditor needs to be reinforced. Arrangements need to be put in place to allow the group auditor to assume its role and responsibilities. Group auditors should have access to the reports and other documentation of all auditors reviewing sub-entities of the group. Group auditors should be involved in and have a clear overview of the complete audit process to be able to support and defend the group audit opinion.”

Global Audit Firm Networks and Multinational Group Audits

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However, the involvement of other component auditors in a group audit creates a principal agent problem. Specifically, the principal auditor runs a risk by accepting responsibility for work conducted by another auditor because there may be information asymmetry. Further, this information asymmetry is likely to be more severe when unaffiliated auditors are involved (as compared to engagements where the other component auditors are members of the signing firm’s GAFN). For example, different national practices, different standards or different interpretations of standards may create problems. Issues related to poor coordination and control could also lead to sub-standard auditing. It is especially these difficulties that have been observed by the regulators and that have led to concerns about the quality of multinational group audits.

In understanding this complex principal-agent relationship, it is helpful to consider who determines the appointment of the auditors for the different components of the multinational group. The terms of the engagement, including the use of other component auditors, their required access to component information and explanations from those charged with governance and management, and the expected fees should be agreed with the client and set out in the engagement letter (ISA 600.14). In certain situations management of a component of a multinational client will appoint an auditor for that component. This includes situations where components of a multinational group have a separate audit requirement, (for example, a listed overseas subsidiary), or sometimes, although not required, component management determines that there are advantages to the component’s financial statements being independently audited (Carey, Simnett and Tanewski 2000). In these situations the auditor of the consolidated entity has the ability to use the audit evidence on which the component’s audit opinion on the financial statements is based, outline additional testing for this auditor to undertake on the component (for example where an accounting method is used for the component, such as LIFO of inventory for a U.S. subsidiary, but which requires alternative accounting treatment for IFRS based

11 consolidated accounts), or may decide that the audit evidence collected by the other component auditor is unreliable or does not suit their putposes, and that other audit evidence needs to be collected (ISA

600.3).

In other situations it is the signing auditor who determines that there are components of a multinational group that require audit attention. For example, the auditor may identify that there are unaudited components of multinational group that are significant to the group10, and the auditor must determine how best to gather the required audit evidence for these components. This may involve greater work by the signing auditor, getting other parts of the GAFN to undertake additional audit work, or requesting additional audit work from unaffiliated auditors.11

The amount of work to be undertaken on the multinational group will depend on the materiality for the group financial statements as a whole when establising the overall audit strategy. This will be by definition greater that the materiality level of the individual components of the group. However, for components that are deemed significant due to their individual financial significance, the group auditor is expected to use the materiality level that is used by the component auditor (ISA 600.26). Also, if there are potential misstatements for which lesser amounts than the materiality level could be reasonably expected to affect the decision making of users taken on the basis of the group financial statements, the group auditor will need to apply a lower materiality level (ISA 600.21). However, in some of the first research undertaken on multinational group audits, Stewart and Kinney (2012) identify that the standards are silent about how these amounts should be determined and that methods

10A significant component is defined in ISA600.9(m) as “A component identified by the group engagement team (i) that is of individual financial significnace to the group, or (ii) that, due to its specific nature or circumstances, is likely to include significant risks of material misstatement of the group financial statements.” 11 There are incentives to align auditors from a network across a multinational group audit. Research shows takeovers commonly results in the aligning of auditors of acquirees to the auditors of acquirors over time (Anderson, Stokes and Zimmer 1993). Closer alignment of auditors across a multinational group audit are expected to result in lower co-ordination effort and monitoring costs (other components of a GAFN will be better known and there are commonly quality control reports available within a GAFN for different components of the network), and they also commonly strongly encourage the passing of business between different firms within the GAFN, and expect reciprocation.

12 being used in practice vary widely, lack theoretical support, and may either fail to meet the audit objective or do so at excessive cost. They therefore develop and outline a Bayesian group audit model that generalizes and extends the single-component audit risk model to aggregate assurance across multiple components.

A GAFN member commonly becomes the auditor of natural choice for multinational groups. Although the global network itself does not provide client services—that is done by the individual national firms - the network serves as a coordinating entity between member firms. Its role will typically include tasks such as promoting a global brand, developing a uniform audit methodology and coordinating peer review to ensure uniform application of risk and quality standards by member firms worldwide. In 2002, the Forum of Firms was established by BDO, Deloitte Touche Tohmatsu, Ernst & Young, Grant

Thornton, KPMG and PricewaterhouseCoopers as “an association of international networks of accounting firms that perform transnational audits of financial statements that are or may be used across national borders”. The members of the Forum of Firms, which stands at 24 members and two affiliates as at November 2013, have “committed to adhere to and promote the consistent application of high- quality audit practices worldwide” (Forum of Firms 2013). The Forum of Firms’ executive arm, the

Transnational Auditor Committee, is a committee of the International Federation of Accountants (IFAC) which allows the Forum of Firms and IFAC to work together with respect to standard setting, dialogue with the regulatory community and promotion of convergence to international standards.

To ensure quality, the GAFNs invest heavily in training, development of increasingly efficient and effective audit methods and the maintenance of well-staffed groups of technical experts worldwide.

Further, they expend great effort to ensure consistency across member firms. For example, when new audit methods are introduced, they are introduced worldwide to all of the GAFN member firms. Such effort should result in greater uniformity across member firms. To the extent that GAFN member firms

13 provide uniform quality audits, there should be no difference between the quality of work performed by members of the principal auditor and that performed by other members within the global audit firm network.

Our hypotheses developed in the next section investigate the impact of involvement of members of the principal auditor’s network and unaffiliated auditors (versus a group audit conducted solely by the principal auditor) on both the magnitude of discretionary accruals as a proxy for the quality of a group audit and audit fees. Australian data are unique to examine these issues since listed companies in

Australia are required to publicly disclose audit fees with categorization by type of auditor (i.e. fees paid to principal auditor, affiliated auditor and unaffiliated auditor), and their multinational group audits are subject to ISA 600. 12

3. Hypothesis Development

We build our hypotheses around the incentives and risks that principal auditors face when making decisions about the audit of multinational groups. It is often suggested in the literature that rational auditors are confronted with economic trade-offs in their decisions (e.g., Louwers, 1998). On the one hand, they face higher risk of litigation and loss of reputation in cases where they provide low audit quality. On the other hand, they face the risk of client loss if the client is dissatisfied by the quality of the audit work or where the audit fee is too high. Applied to our case of the multinational group audit, the auditor has to make a choice between whether or not to outsource part of the work over which they assume ultimate responsibility. If the auditor decides to outsource, arguably because it will result in

12 ISA 600 (IAASB 2007) superseded ISA 600 “Using the Work of Another Auditor” (IAASB 2002), but maintained the same assumption that the audit partner of the principal firm takes responsibility for the audit opinion expressed on the financial statements of the corporate group. The revised ISA 600 was operative for financial reporting periods commencing on or after 1 January 2010. The major difference between the two standards is that the current ISA600 has a much greater recognition of different types of audit firm networks, and more detailed prescription of the work required to be undertaken by the signing audit partner and his/her responsibilities in relation to work undertaken by network member firms and unaffiliated audit firms.

14 reduced costs compared with undertaking the work within the audit firm, a principal agent problem arises with potential information asymmetry between the principal and the agent, and the principal runs the risk of low performance, low audit quality and thus risk of litigation. If the auditor decides not to outsource, this is likely to result in a more costly audit and the auditor runs the risk of client loss as the client may be able to negotiate a lower fee with a competitor in the future. We develop our hypotheses around these two main issues: cost and quality.

Multinational Groups and Audit Costs

When considering the market for multi-national audit services, it is important to keep in mind that the principal auditor is, while maintaining required audit quality, seeking to minimize the costs to the client in order to offer the engagement at an attractive (i.e., competitive) fee. As outlined earlier, the audit fees are negotiated between signing auditor and client before the start of the engagement and are contained in the engagement letter. The audit fees for the multinational group will consist of the audit fees paid to the principal auditor, and amounts where the client contracts for and directly pays for the services of other component auditors (such as is the case for listed overseas entities). The principal auditor has a responsibility to ensure that there is sufficient appropriate evidence for the overall audit, and this involves collecting evidence on significant components, that may either require an audit or not. Thus the principal auditor may have to undertake further audit work on the work of other component auditors, plus also arrange for the collection of audit evidence of significant components of the multinational group that are unaudited. For components that are not significant, the principal auditor is expected to perform analytical procedures at a group level, and then follow up any risks of material misstatement

(ISA 600.28-.29). In addition, the principal auditor is expected to gather evidence that the consolidation process of the financial information from each of the components is appropriately undertaken (ISA

600.32-.37).

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The economically rational approach to achieve this is to select that combination of auditors (principal audit firm, other auditors affiliated with the GAFN, unaffiliated auditors) which is able to complete the multinational audit at the required quality and at the lowest cost. The relevant consideration is whether engagement costs will be saved by the choice of an other component auditor compared with if the principal auditor conducted the audit in its entirety. While it is always theoretically possible for a principal audit firm to audit a multinational group in its entirety, such an approach will usually incur additional costs. One obvious area for achieving lower costs when collecting audit evidence for an overseas component of a multinational group is engaging a local audit team in order to reduce the out- of-pocket expenditures related to international travel, and other costs incurred by paying for audit staff from the principal auditor. In addition, and perhaps more substantially, local auditors may be more efficient as they are likely better versed in local regulations such as tax, corporate and securities laws, saving time spent on the audit, and may know the local component, environment and management and the most efficient ways of gaining appropriate evidence better than staff from the principal auditor. The principal auditor will have incentives to secure the services of an other component auditor if the cost savings from the use of the other component auditor compared with the use of audit staff from the principal auditor are greater than the additional contracting and monitoring costs associated with hiring the other component auditor. It is expected that at least some of these realized cost savings will be passed on to the client in the form of reduced audit fees, in order to maintain the auditor-client relationship. In order to test this expectation we hypothesize the following:

H1: The cost of multinational group audits conducted wholly by principal auditors is higher than those involving other component auditors (networks or unaffiliated)

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There are two possible groups of ‘other component auditors’ which can be involved in the conduct of the audit, audit firms affiliated with the signing auditor as a member of their global audit firm network or alternatively unaffiliated auditors who have no relationship with the principal auditor. Using the global audit firm network is more efficient in time (through the use of common communications and standards/methodology) and also should involve reduced contracting and monitoring costs than would incurred by involved an unaffiliated auditor. Members of a global network are used to interacting with other members of the network on a regular basis. Global audit firm networks invest heavily in training, development of efficient and effective audit methods and the maintenance of well-staffed groups of technical experts worldwide. Further, they expend great effort to ensure consistency across member firms. For example, when new audit methods are introduced, they are introduced worldwide to all of the member firms of the network. Such effort should result in greater efficiency across member firms.

Member firms of GAFNs are also encouraged to share business across the network, and there is expected to be reciprocation between network member firms. These further build up knowledge of other parts of the network and reduce contracting and monitoring costs. Accordingly we test the following directional hypothesis:

H2: The cost of multinational group audits involving other members of the principal auditor’s network is lower than those involving unaffiliated auditors

Multinational Groups and Audit Quality

As outlined earlier, the major international standard-setting initiative responding to concerns about the quality of multinational corporate group audits is the revised ISA 600 (IAASB 2007). Applicable for financial periods commencing after 1 January 2010, ISA 600 requires that the audit partner of the

17 principal firm take responsibility for the audit opinion expressed on the financial statements of the corporate group regardless of whether that work was conducted by the principal network firm, affiliated members of the network firm or unaffiliated auditors. The expectation under ISA 600 is that the signing partner has put themselves in a position where they are satisfied that the consolidated accounts as a whole appropriately reflect the financial position and performance of the multinational group structure13.

Thus, it is incumbent for the signing partner to ensure that all aspects of an engagement are conducted at a similarly high level of quality. Large clients, particularly those with multinational operations, demand consistent auditing throughout the world. If global audit firms are effective at maintaining uniform audit quality throughout the network, and (as per ISA 600) they are effective at maintaining uniform audit quality when making use of unaffiliated firms, then equivalent or baseline audit quality should be achieved from all components.

The other component auditor also has incentives to achieve the required audit quality. For example, if the other component auditor is a small local firm that fails to produce audit evidence of the expected quality, or the principal auditor incurs too much in contracting, monitoring and reperformance, it is unlikely that the relationship will continue. It is recognized that this expectation is different to the concerns raised by regulators. However, while regulators have pointed to specific instances of reduced quality, there has been no testing as to whether this reduced quality is systematic across instances of the use of other component auditors. Given the legal and reputational incentives to maintain high quality audits, and to most appropriately test the concerns expressed by the regulators, the following hypothesis is stated in the null form:

13 This is in contrast to an option that is sometimes used in the current PCAOB standards in the U.S. where the responsibility for the opinion on a group audit can be shared (AU-C 600). While 2011 revisions to AU-C Section 600 more closely aligned the U.S requirement to the ISA 600requirements, AU-C 600 still permits the ability to “not assume responsibility for, and accordingly make reference to, the audit of a component auditor in the auditor’s report on the group financial statements” (para 08) (Lyubimov 2013).

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H3: The quality of multinational group audits conducted wholly by principal auditors is not different from audits involving other component auditors (networks or unaffiliated auditors).

4. Methodology

Using a sample of Australian listed companies with more than one foreign subsidiary (‘multinational group audits’) over the period 2008-2011, we examine differences in the costs and quality of multinational group audits across different group auditor combinations. Unlike other jurisdictions (for example, the United States), reporting guidelines in Australia require listed entities to disclose their audit fees as follows:

 The fee paid to the principal auditor (i.e. signing auditor).

 The fee paid to audit firms related to the principal auditor (i.e., affiliated firms that are

members of the principal auditor’s network).

 The fee paid to other auditors (i.e., unaffiliated firms that are not members of the

principal auditor’s network).

This reporting requirement allows for an assessment of the portion of the engagement that has been completed by the principal auditor, other members of the principal auditor’s network and unaffiliated auditors. This, in turn, presents an opportunity to test the impact on total audit costs (from the perspective of the client incurring such costs) where other component auditors are engaged to complete the multinational group audit as well as the impact of different combinations of auditors on the earnings quality of the group audit.

As ISA 600 does not cover the conduct of joint audits (that is, where more than one audit firm signs the audit opinion), instances of joint audits were removed from the population of listed companies to

19 identify our group audit sample. Consistent with the approach in the prior literature firms in the financial industry were also deleted. We eliminated observations with missing data, no foreign subsidiaries and firms with less than $1 million in total assets. This left us with 2,719 multinational group audit observations over the period 2008-2011 which fall into the following categories:

 All components audited by the principal auditor: 1,386 (51% of observations)

 Components audited by principal auditor and other members of the principal auditor’s

audit firm network only: 449 (17% of observations)

 Components audited by principal auditor and by unaffiliated auditors only: 706 (26% of

observations)

 Components audited by principal auditor, and by both members of its network and

unaffiliated auditors: 178 (6% of observations).14

The percentage of the total audit fee paid to the principal auditor for multinational group audits ranges from 13% to 100%. For the 49% of audits involving other component auditors, on average 27% of the total audit fee is paid to the network or unaffiliated firms respectively. For over 90% of these observations the proportion of the total audit fee paid to other component auditors exceeds 5% suggesting that the components we identify are material to the overall group audit.15

Empirical Models

Audit fee model

To test hypotheses 1 and 2, we employ an audit fee model. The model is derived from Craswell et al.

(1995), Ferguson et al. (2003) and Carson and Fargher (2007). The resulting OLS regression model is specified as follows (ignoring the company subscript):

14 These observations are categorised as both network and unaffiliated observations in the analyses. 15 We examine these observations in sensitivity analysis.

20

LAF = α + 1LTA + 2LSUB + 3CATA + 4QUICK + 5LEVERAGE + 6ROI + 7FOREIGN +

8 OPINION + 9 YE + 10 LOSS + 11BIGN + 12 LARGENONBIGN+13MINING + 14SUBGDP +

15SUBLITIG + 16SUBPROX + 17NETWORK(%) + 18UNAFFILIATED(%) +  (1)

Where the dependent variable and independent variables are as defined in Table 1. To test hypothesis 1, we examine audit fees of multinational group audits and compare principal only audits with those involving other component auditors included in the intercept. To test hypothesis 2, we examine a sub- sample of multinational group audits involving the network of the principal auditor and compare the fees to those charged by unaffiliated auditors which are included in the intercept.

INSERT TABLE 1

Audit Quality Measures

To test our hypothesis around the issue of audit quality we employ two proxies: firstly, discretionary accruals and secondly, going-concern issuance. For discretionary accruals we use the performance- adjusted cross-sectional modified Jones model (Jones, 1991; Dechow et al. 1995; Kothari et al. 2005) to measure discretionary accruals. Similar models have been widely used in the international auditing literature to measure audit quality across a range of countries (e.g. Kwon et al. 2007), across regions

(e.g. Europe: Van de Poel and Vanstraelen, 2011) and also within countries (e.g., Australia: Carey and

Simnett, 2006). We follow Kothari et al. (2005) and Ashbaugh et al. (2003) and use performance- adjusted discretionary accruals under the premise that extreme performance impacts the accruals-

21 generation process. Discretionary accruals are measured by the residual term ( ) by industry-year (by two-digit GIC sector code with a minimum of eight firm-years per sector16) using the following model:

ACCt = α0 + α1(∆Salest - ∆RECt) + α2PPEt + α3ROAt + εt (2) where:

ACC is the net profit after tax before extraordinary items less cash flows from operations; ∆Sales is the change in net sales revenue; ∆REC is the change in net receivables; PPE is net property, plant and equipment17 and; ROA is return on assets. All variables are scaled by average total assets (except ROA).

We also examine separately signed accruals as positive income-increasing accruals are likely to have different consequences to negative income-decreasing accruals for auditors.

The empirical model used to test our hypotheses is as follows:

ABSDAt = β0 + β1AGEt+ β2GROWTHt + β3INDGROWTHt + β4PERFORMt+ β5LTAt + β6LEVERAGEt +

β7LOSSt + β8PPEGROWTHt + β9MININGt + β10BIGNt + β11LARGENONBIGNt + β12SUBGDPt +

β13SUBLITIGt + β14SUBPROXt+ β15NETWORK(%)t + β16UNAFFILIATED(%)t + εt (3)

The dependent and independent variables are defined in Table 1.

We also use going-concern issuance as an additional test of audit quality. Hopwood et al. (1994) suggest that investigations of auditor reporting behavior with respect to decisions to issue a going concern opinion should be conducted on samples that have been partitioned into stressed and non-stressed categories because auditors’ decision processes are different for stressed and non-stressed companies.

Consistent with this, and in line with prior research, the sample is restricted to potentially financially

16 US studies typically impose a minimum of 20 firm-years per industry sector, but due to our more limited sample size, a 20 firm-year minimum per industry would be unduly restrictive. 17 We use Net Property, Plant and Equipment as we are unable to reliably calculate Gross Property, Plant and Equipment using Aspect Financials for this period.

22 distressed firms, defined as firms with a current year loss (e.g. DeFond et al. 2002; Geiger and Rama

2003; Carey and Simnett 2006). The financially distressed sample with sufficient financial and audit data exists consists of 1,657 observations. Following prior literature (e.g. Menon and Schwartz 1987;

Mutchler and Williams 1990; Bell and Tabor 1991; Hopwood et al. 1994; Carcello et al. 1995; Mutchler et al. 1997; Carcello and Neal 2000; Geiger and Raghunandan 2002; DeFond et al. 2002; Carey and

Simnett 2006; Carson et al. 2013), we will use the following logit model to test the hypotheses proposed.

The probability to observe a going concern modification is taken to be a function of the following variables:

Pr(Y=OPINION | x) =F(β0+ β1PBANK + β2LTA + β3LEVERAGE + β4∆LEV + β5CURRENT + β6WC +

β7QUICK + β8ROA + β9NEGEQ + β10BIGN + β11LARGENONBIGN + β12MINING + β13SUBGDP +

β14SUBLITIG + β15SUBPROX + β16NETWORK(%) + β17UNAFFILIATED(%) + ∑β Year Fixed

Effects + ∑β Industry Fixed Effects) (4)

Where:

F(x) =1/(1 + exp(−βx)) and the variables are defined in Table 1.

The choice of control variables is based on consideration of the prior literature and a deliberation of which factors may be correlated with the variables of interest and the auditor’s decision to issue a going concern modification or not. The explanatory variables have also been used in prior research (see

Dopuch et al. 1987; Mutchler et al. 1997; Reynolds and Francis 2000; DeFond et al. 2002; Carey and

Simnett 2006, Carson et al. 2013). PBANK, CURRENT, ROA are winsorised at 5%, ∆LEV and WC are winsorized at 1%.

The degree of financial distress is an important factor mentioned in the relevant auditing standards. The magnitude of financial distress is related to the probability of bankruptcy (Hopwood et al. 1994).

23

PBANK explicitly measures the probability of bankruptcy using the Zmijewski (1984) model.18 LEV and ∆LEV are included in the model because debt covenant violations are positively associated with the probability of issuing a going concern opinion (Mutchler et al. 1997; DeFond et al. 2002). Specifically,

LEV is included to capture the proximity to covenant violation as firms with high leverage are likely to be close to violations (Beneish and Press 1993). ∆LEV is included because an increase in leverage is likely to move firms closer to violation of debt covenants (Reynolds and Francis 2000; DeFond et al.

2002). Current year loss as an indicator variable is not included in the model because the sample- selection criterion is based on the firm incurring a loss in the current year. However, ROA is included because the more severe the current year loss, the more likely the firm is to receive a going concern modification. NEGEQ is included because firms with negative shareholders’ equity are more likely to be in financial distress and therefore also more likely to receive a going concern opinion (Ohlson 1980).

The models also include several factors that are likely to impact the probability of receiving a going concern opinion. SIZE (log of total assets in U.S. millions) is included because larger firms have more negotiating power when they are in financial difficulty and are therefore more likely to avoid bankruptcy and consequently less likely to receive a going concern opinion (Campbell 1996; Reynolds and Francis

2000; DeFond et al 2002). CURRENT, WC and QUICK are included in the model as liquidity measures that capture the availability of funds and the ability to quickly raise funds in relation to the firm’s short term obligations (DeFond et al. 2002). High liquidity suggests that firms are more likely to avoid bankruptcy and therefore less likely to receive a going concern opinion. The model also includes indicator variables for industry sectors (as defined by two-digit GICS codes) and for financial year.

Industry sector indicator variables are included to control for industry fixed effects associated with

18 The probability of bankruptcy using the Zmijewski model is calculated as: probability of bankruptcy = Φ[-4.803 - 3.599(return on assets) + 5.406(leverage) -0.100(current ratio)], where Φ is the cumulative distribution function of the standard/unit normal distribution

24 firms’ operation, as firms’ industry affiliation has been shown to be associated with auditors’ going concern judgments (Butterworth and Houghton 1995; Raghunandan and Rama 1999; Carey and Simnett

2006). Prior models based on similar variables prove to have acceptable explanatory power (see Menon and Schwartz 1987; DeFond et al. 2002; Carey and Simnett 2006).

5. Results

Table 2 presents the descriptive statistics for all the variables in the audit fee and discretionary accruals analyses conducted in the study for overall sample of multinational group audits and for our sub-samples of interest: principal only audits, networks, unaffiliated and a combination of networks and unaffiliated.

We winsorized AGE, CFO, LEVERAGE and ROI variables at the 1% and 99% levels (QUICK and

GROWTH are winsorized at the 5% levels due to extreme skewness). Over the period 2008-2011 for our sample of multinational group audits, the average absolute value of discretionary accruals are 16% of assets and the average multinational group reports losses and negative cash flows from operations. This is slightly higher than the absolute value normally identified in discretionary accruals studies, and is a reflection of the more complex nature of accounting faced in complex group structures and the time period over which the study is conducted includes the global financial crisis. As outlined earlier, the majority of multinational group audits are conducted wholly by the principal signing auditor (51%) and a further 17% are conducted within a single audit firm network. For these audits, 48% are audited by the

Big N and 37% by the large non-Big N firms. 32% of the multinational groups are from the mining industry. The average period since listing for a group is approximately 15 years. We tabulate but do not report the correlation matrix for our control variables and variables of interest. As expected, large correlations are observed between measures of firm size, number of subsidiaries, performance and audit fees.

25

INSERT TABLE 2

In Table 3 we present our analysis of audit cost hypotheses (Hypotheses 1 and 2). The descriptive statistics for the variables included in the audit fee model are reported in Table 2. Hypothesis 1 predicts that the cost of multinational group audits conducted wholly by principal auditors is higher than those involving other component auditors, irrespective of the type of other auditor. We find strong support for

Hypothesis 1 suggesting that as the extent of involvement of principal auditors increases in the multinational group audit, audit costs increase (p<0.001, two-tailed). This supports the view that principal auditors and clients select a combination of auditors (principal audit firm, other members of the

GAFN, other unaffiliated auditors) which is able to complete the multinational audit at a lower cost than the principal audit firm only. This also suggests that local auditors may be more efficient due to their knowledge of local regulations and laws and that the additional costs of monitoring of this work by the principal auditor are still lower than using staff of the principal auditor to complete the engagement.

INSERT TABLE 3

Hypothesis Two predicts that the cost of multinational group audits involving other members of the principal auditor’s network is lower than those involving unaffiliated auditors. In Column 2 of Table 3 we test this hypothesis on the sub-sample of multinational group auditors where other component auditors are involved. We find strong support for our proposition that total audit costs are lower when the principal auditor’s network is involved in the conduct of the audit (p<0.01, two-tailed). This supports the view that audit firm networks are more efficient at delivering audit services in a multi-location setting where members of the network have well developed modes and means of communication through the use of common protocols and audit methodology, resulting in reduced contracting and monitoring costs relative to those that would be incurred when an unaffiliated auditor is involved.

26

Regardless of the composition of the engagement team, and irrespective of any differences in cost ISA

600 requires that the signing partner accept full responsibility for all components of the engagement.

The assumption under ISA 600 is that the signing partner has put themselves in a position where they are satisfied that the consolidated accounts as a whole appropriately reflect the financial position and performance of the multinational group structure. Accordingly, Hypothesis 3 predicts that there will be no difference in audit quality associated with the combination of group auditors. We utilize two metrics of audit quality, firstly discretionary accruals and secondly, going-concern issuance.

In Table 4 we present our analyses of absolute discretionary accruals, income-increasing and income- decreasing accruals for multinational groups. We observe a strong positive association between the percentage involvement of networks in multinational group audits and higher levels of absolute value discretionary accruals (p<0.01, two-tailed). This implies that as the involvement of networks increases earnings quality is lower. We do not find an association between either income-increasing or income- decreasing accruals for network involvement in group audits. We also do not find an association between discretionary accruals and the role of unaffiliated auditors. This provides evidence to support that the objectives of ISA 600 are not being achieved in all combinations that use other component auditors, that is, there are differences in the earnings quality of multinational groups associated with the choice of auditors involved in the group audit. In particular, this suggests that the involvement of other member firms of the network is associated with lower audit quality. This may be related to a tendency for principal auditors to over rely on the work of member firms in their networks whereas professional scepticism is maintained where the work of unaffiliated auditors requires monitoring.

INSERT TABLE 4

27

In Table 5 we analyse absolute value discretionary accruals and signed discretionary accruals by type of audit firm (Big N, large non-Big N, small non-Big N) as additional analysis. We find that the significant positive association between extent of network involvement in multinational group audits and absolute value of discretionary accruals is confined to the Big N auditors. The statistical significance is due to an equal representation of income increasing and income decreasing discretionary accruals in the absolute value. The co-efficient for both the large non-Big N and small non-Big N sub-groups is larger for income increasing discretionary accruals, but smaller for income decreasing discretionary accruals. We do not find any association for unaffiliated auditor involvement, suggesting that audit quality is maintained at the same level as that provided by principal-only audits. INSERT TABLE 5

In our second test related to audit quality we consider a financially distressed sub-sample of loss-making multinational group audits. In Table 6, Column 1 we find that, for audits where an unaffiliated auditor is involved in the group audit, relative to principal only audits, that the audit opinion is more likely to be modified for reasons of going concern. This result is most strong where large non-Big 4 firms are the principal auditor. In Column B we find that where a Big N firm is the principal auditor and their network is involved in the audit, that the audit opinion is less likely to be modified for reasons of going concern.

This is consistent with our findings in relation to earnings quality in that for the Big N sample, higher absolute value accruals are permitted by signing auditors when the network is involved.

INSERT TABLE 6

Sensitivity Analyses and Robustness Tests

We re-perform our analyses using indicator rather than continuous variables for the involvement of networks and of unaffiliated auditors. Our results are qualitatively unchanged to those we reported. We also further refine our continuous variable to identify material involvement of networks and unaffiliated auditors and code all observations with less than 5% of the total audit fee as zero. Our results are similar

28 to those we report, with higher levels of significance in some cases. We further exclude the 178 observations where both networks and unaffiliated audit firms are involved in the multinational audit.

The direction and significance of our results are unchanged as a result of applying this sample restriction. Finally, as firms in the mining industry constitute a large proportion of the multinational group sample we re-perform our analyses excluding these firms. Again, the results are consistent with those reported with the exception of the going-concern model, where network involvement becomes significant at the 5% level in the overall sample, increases in significance in the Big N sample (p<0.01, two-tailed), is no longer significant in the small non-Big N sample whereas unaffiliated auditors are not significantly associated with the going-concern decision in the overall or in the sub-samples. This suggests that our findings in relation to reduced incidence of going-concern issuance is most strongly associated with Big N networks, supporting our results regarding over reliance within networks impacting audit quality.

6. Conclusions and Future Research

There is a regulatory gap with respect to audits of multinational corporate groups which operate across multiple jurisdictional boundaries and their auditors which conduct their audits either as principal auditors operating within a single country or as part of a global audit firm network operating across multiple countries. The oversight of these clients and their auditors is at a national level whilst much of the audit work is conducted across borders – to date, no research has addressed the consequences of this gap. A commonly expressed concern, especially by regulators, is that the audit quality of these multinational group audits is lower when they involve coordinating the work of other component auditors. This would mean that the requirements of international auditing standards, in particular ISA

600, are not being met, in that the group auditor has not satisfied themselves the level of audit quality has not been compromised in these situations. We find that there is some evidence to suggest that there

29 are differences in audit quality associated with type of auditor involvement which may indicate that the requirements of ISA 600 are not being met. We have some limited evidence to suggest that for Big N clients, the quality of audits that involve other network member firms is lower than the quality of engagements that are conducted entirely by the signing firm and those where an unaffiliated audit firm is involved. Our findings for clients of large non-Big N GAFNs suggests that audits involving other networked auditors have higher income-increasing discretionary accruals, whereas for clients of small non-Big N firms we find evidence of higher income-decreasing accruals where other (likely higher quality) auditors are involved.

We find that, after controlling for proxies for complexity, the audit fees for multinational clients where the audit is undertaken entirely by the principal audit firm are higher than those charged when other component auditors—either affiliated or unaffiliated—were responsible for conducting a portion of the engagement. This is consistent with the argument that in a competitive market, the use of another component auditor will be mainly driven by reasons related to cost. When combined with our findings on audit quality, this may be of concern to regulators.

Our findings also highlight that a maintained assumption in the auditing literature that the audit firm which signs the audit opinion on these group financial statements has conducted the audit of all the entities within the group is not correct. This maintained assumption could lead to potentially erroneous conclusions as the quality of the financial statements has been assumed to be directly related to the identity of the firm signing the audit opinion. Our approach is novel in that it explicitly takes into account the actual involvement of one or more audit firms in undertaking a group audit and examines the impact on audit costs and audit quality of taking this into consideration.

While our research has benefitted from the unique Australian disclosures regarding the amount of fees paid to other component auditors, our ability to comment further is limited by the fact that the exact

30 identity and extent of involvement of the other component auditors is not identified in the standard audit report. As we outlined earlier it has been proposed by the IAASB (2012) that this be rectified. In particular the IAASB has requested comment on the suggestion of including disclosure about the involvement of other component auditors in the group audit. The suggested wording for comment includes “…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…” Our research would support the inclusion of such disclosures as being important in understanding the overall quality of the financial information, although the requirements to disclose such information could possibly be better achieved as a footnote disclosure within the financial statements rather than in the audit report. This would have the advantage of not raising unfounded concerns or confusion about the quality of the audit, while providing necessary disclosures so that the structure by which the audit is undertaken can be better understood.

This study is subject to the following limitations. We acknowledge that discretionary accruals and going-concern issuance are only two possible aspects of audit quality that could be examined. We plan to examine other proxies for audit quality in future versions of this study. Further, it is not clear to what extent our results with regard to audit quality are attributable to the relatively strong Australian institutional setting in terms of for example investor protection, enforcement and public oversight. The inclusion of a control variable for quality of legal enforcement in the jurisdictions in which the subsidiaries operate provides some comfort on this issue. Similarly, Australia is a country with a relatively high cost of living which may magnify the difference in fees between group audits conducted solely by a principal auditor and audits involving component auditors outside Australia. Again, we

31 control for GDP based on the locations of the subsidiaries involved in the group audit. Hence, it seems warranted for future research, as data become available, to investigate whether the results also hold in other settings with a relatively low cost of living and with weaker institutions and enforcement to ensure audit quality. Finally, we note that some GAFN prescribe to make use of other member firms within that audit network unless not available or at the client's request. Future research could examine the economic consequences of these policies.

32

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Table 1 Variable Descriptions

ABSDA = absolute value of discretionary accruals scaled by average total assets; AGE = the number of years the client firm has been listed on the ASX; GROWTH = Total Assetst / Total Assetst-1; INDGROWTH = ∑ Total Assetsi,t / ∑ Total Assetsi,t-1 by two-digit GIC code; PPEGROWTH = Percentage change in gross property plant and equipment; PERFORM = operating cash flow scaled by total assets; LTA = natural log of total assets at year end ($ millions); LAF is natural log of sum of total audit fees paid to the principal auditor, network of the principal auditor and unaffiliated auditors ($ thousands); LSUB is the natural log of the number of subsidiaries; CATA is the ratio of current assets to total assets; QUICK is the ratio of current assets less inventories to current liabilities; LEVERAGE is the ratio of total liabilities to total assets; ROI is the ratio of earnings before interest and tax to total assets; FOREIGN is the proportion of subsidiaries that represent foreign operations; SUBGDP = country of each subsidiary multiplied by the yearly USD GDP per Capita, summed and scaled by the number of foreign subsidiaries; SUBLITIG = country of each subsidiary multiplied by the yearly Kaufmann Rule of Law Index, summed and scaled by the number of foreign subsidiaries; SUBPROX = country of each subsidiary multiplied by the distance in kilometers between location of subsidiary and Australia, summed and scaled by the number of foreign subsidiaries; NETWORK (%) is a continuous variable based on the audit fees charged by the network as a percentage of total group audit fees; UNAFFILIATED (%) is a continuous variable based on the audit fees charged by unaffiliated auditors as a percentage of total group audit fees; BIGN = indicator variable, 1 if the audit firm is a Big N auditor, 0 otherwise; LARGENONBIGN = indicator variable, 1 if audit firm is BDO, Bentleys, Crowe Horwath, Grant Thornton, HLB Mann, PKF, RSM, Stantons, WHK, 0 otherwise; MINING = indicator variable, 1 if client firm is in the mining industry, 0 otherwise; OPINION is an indicator variable with a value of one for a qualified or modified opinion; YE is an indicator variable with a value of one for non-June fiscal year end; LOSS is an indicator variable with a value of one for a loss in the current year; 2008, 2009, 2010 and 2011 are year indicator variables; GICS Sector variables are industry indicator variables.

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Table 2 Descriptive Statistics

Multinational Group Network + Principal Only Network Unaffiliated Audits Unaffiliated (n=1386) (n=449) (n=706) (n=2719) (n=178) Variables Mean/Median Mean/Median Mean/Median Mean/Median Mean/Median (S.D.) (S.D.) (S.D.) (S.D.) (S.D.) Panel A: Continuous Variables 0.16/0.10 0.18/0.12 0.12/0.08 0.15/0.09 0.12/0.06 ABSDA (0.19) (0.20) (0.15) (0.17) (0.17) 14.98/10 13.64/10 22.46/12 14.52/10 17.83/12 AGE (14.47) (13.72) (26.75) (15.19) (17.30) 1.27/1.05 1.31/1.05 1.14/1.04 1.29/1.05 1.21/1.06 GROWTH (0.71) (0.76) (0.49) (0.74) (0.56) 1.11/1.09 1.12/1.11 1.10/1.04 1.11/1.11 1.09/1.02 INDGROWTH (0.14) (0.14) (0.14) (0.14) (0.13) PPEGROWTH -0.11/0.03 -0.12/0.03 -0.02/0.03 -0.16/0 -0.01/0.08 (0.83) (0.89) (0.56) (0.90) (0.60) -0.08/-0.03 -0.13/-0.06 0.03/0.06 -0.10/-0.05 0.04/0.07 PERFORM (0.29) (0.32) (0.21) (0.27) (0.16) 3.89/3.53 3.33/3.09 5.43/5.12 3.54/3.29 5.89/5.89 LTA (2.09) (1.84) (2.13) (1.75) (1.97) 4.66/4.45 4.38/4.19 5.52/5.35 4.39/4.16 5.75/5.76 LAF (1.18) (1.03) (1.20) (1.02) (1.12) 2.06/1.95 1.75/1.61 2.76/2.64 1.93/1.79 3.31/3.37 LSUB (1.17) (0.94) (1.30) (1.09) (1.19) 0.44/0.41 0.45/0.41 0.41/0.38 0.46/0.43 0.42/0.41 CATA (0.26) (0.27) (0.23) (0.27) (0.21) 5.17/1.72 6.1/2.52 3.24/1.29 5.35/1.77 1.97/1.13 QUICK (7.55) (8.05) (5.84) (7.81) (3.20) 0.35/0.28 0.33/0.47 0.41/0.41 0.33/0.27 0.46/0.47 LEVERAGE (0.40) (0.45) (0.33) (0.33) (0.21) -0.22/-0.06 -0.30/-0.11 -0.04/0.06 -0.23/-0.08 -0.05/0.04 ROI (0.58) (0.64) (0.47) (0.50) (0.28) 0.52/0.50 0.47/0.43 0.53/0.50 0.61/0.63 0.56/0.60 FOREIGN (0.30) (0.30) (0.27) (0.48) (0.26) 38902/41943 40973/43738 39736/41325 34642/38189 37458/45199 SUBGDP (13476) (12774) (11568) (15393) (10970) 1.32/1.73 1.4/1.65 1.38/1.59 1.13/1.38 1.30/1.64 SUBLITIG (0.58) (0.53) (0.47) (0.72) (0.45) 4077/3444 3682/2998 4384/3473 4570/4030 4392/5422 SUBPROX (2496) (2822) (3185) (3059) (2334) 0.06/0 0.27/0.23 0.26/0.38 NETWORK (%) 0 0 (0.14) (0.18) (0.18) 0.08/0 0.27/0.24 0.11/0.16 UNAFFILIATED (%) 0 0 (0.15) (0.18) (0.12)

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Panel B: Categorical Variables Network + Variables Multinational Group Audits Principal Only Network Unaffiliated Unaffiliated Mean Mean Mean Mean Mean

BIGN 48% 42% 80% 29% 83% LARGENONBIGN 37% 39% 17% 51% 15% MINING 32% 34% 27% 36% 21% OPINION 24% 25% 15% 30% 11% YE 14% 11% 21% 14% 21% LOSS 61% 68% 42% 65% 36% PRINCIPAL 51% 100% 0% 0% 0% NETWORK 23% 0% 100% 0% 100% UNAFFILIATED 32% 0% 0% 100% 100% 2008 23% 25% 23% 23% 21% 2009 25% 25% 25% 24% 25% 2010 26% 24% 26% 28% 26% 2011 26% 26% 26% 25% 28% GICS_sector10 17% 19% 12% 16% 11% GICS_sector20 15% 12% 18% 14% 39% GICS_sector25 12% 11% 18% 10% 12% GICS_sector30 2% 1% 5% 0% 4% GICS_sector35 10% 10% 9% 11% 4% GICS_sector45 9% 9% 10% 9% 7% GICS_sector50 2% 2% 0% 2% 0% GICS_sector55 1% 2% 1% 2% 0%

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Table 3: Audit Fee Models

Multinational Network and Group Audits Unaffiliated (n=2719) (n=1155) 1.210*** 1.860*** Intercept (11.05) (13.38) 0.365*** 0.346*** LTA (42.67) (24.18) 0.237*** 0.257*** LSUB (17.25) (11.83) 0.342*** 0.377*** CATA (7.883) (5.037) -0.013*** -0.013*** QUICK (9.298) (5.534) 0.157*** 0.093** LEVERAGE (5.488) (1.974) -0.138*** -0.111*** ROI (7.099) (3.173) 0.488*** 0.399*** FOREIGN (9.291) (4.780) 0.147*** 0.171*** OPINION (6.010) (4.162) 0.040 0.001 YE (1.420) (0.020) -0.007 -0.012 LOSS (0.275) (0.307) 0.364*** 0.417*** BIGN (11.630) (7.856) 0.013 -0.022 LARGENONBIGN (0.432) (0.459) 0.054* 0.085* MINING (1.899) (1.884) 0.001 0.001 SUBGDP (0.586) (1.189)

0.048 -0.002 SUBLITIG (1.311) (0.029)

-0.001 -0.001 SUBPROX (0.654) (1.331)

0.659*** PRINCIPAL(%) (11.900) -0.192*** NETWORK(%) (2.241)

Year and Industry YES Fixed Effects YES Adj R2 85.2% 84.8%

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Table 4: Discretionary Accruals Models for Multinational Group Audits

Income- Income- Absolute increasing decreasing value discretionary discretionary discretionary accruals in accruals in

accruals absolute absolute value value Coefficient Coefficient Coefficient (t stat) (t stat) (t stat) 0.144*** 0.109*** 0.095*** Intercept (4.096) (3.619) (2.503) -0.001** -0.001 -0.001** AGE (2.298) (0.801) (2.561) -0.001 0.001 0.002 GROWTH (0.255) (0.132) (0.607) 0.029 0.024 0.015 INDGROWTH (1.269) (1.251) (0.593) -0.125*** -0.181*** 0.064*** PERFORM (7.974) (14.490) (3.849) -0.016*** -0.008*** -0.013*** LTA (10.960) (6.077) (9.594) 0.029*** -0.001 0.042*** LEVERAGE (3.949) (0.124) (6.688) -0.041*** -0.060*** 0.012** LOSS (6.061) (10.940) (2.034) -0.011*** -0.001 -0.009*** PPEGROWTH (3.140) (0.432) (2.958) -0.012* -0.014** -0.004 MINING (1.687) (2.288) (0.586) 0.010 -0.007 0.008 BIGN (1.462) (1.181) (1.194) 0.011* -0.001 0.011 LARGENONBIGN (1.707) (0.036) (1.627) 0.001 0.001 0.001 SUBGDP (0.954) (0.972) (1.587) -0.004 -0.006 -0.007 SUBLITIG (0.426) (0.676) (0.682) 0.001** 0.001** 0.001 SUBPROX (2.235) (2.349) (1.396) 0.044*** 0.022 0.024 NETWORK(%) (2.436) (1.557) (1.583) -0.013 -0.017 0.012 UNAFFILIATED(%) (0.869) (1.311) (0.723) Year and Industry Fixed Effects YES YES YES Adj R2 21.5% 39.6% 18.0% N 2,721 1,325 1,396

Variables are defined in Table 1. *** p<0.01, ** p<0.05, * p<0.10. All tests are two-tailed. Industry indicator variables are included but are not reported. All models are estimated using robust standard errors clustered by client and year (Petersen 2009).

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Table 5: Discretionary Accruals Models for Multinational Group Audits by Audit Firm Type

Big N Large Non-Big N Small Non-Big N Income- Income- Income- Income- Income- Income- Absolute increasing decreasing decreasing Absolute increasing decreasing Absolute increasing value discretiona discretiona discretiona value discretiona discretiona value discretiona discretiona ry ry ry accruals discretiona ry accruals ry accruals discretiona ry accruals ry accruals in accruals in in absolute ry accruals in absolute in absolute ry accruals in absolute accruals absolute absolute value (n=1008) value value (n=415) value (n=1298) value value (n=204) (n=536) (n=472) (n=211) (n=720) (n=578) 0.126** 0.127** 0.057 0.175*** 0.170*** 0.0275 0.017** 0.097 0.116 Intercept (2.568) (2.380) (1.282) (2.842) (3.464) (0.412) (2.029) (1.257) (1.197) -0.001** -0.001** -0.001 -0.001 -0.001 -0.001* 0.001 -0.001 -0.001 AGE (2.399) (2.327) (0.156) (1.562) (0.583) (1.840) (0.854) (0.598) (0.955) 0.005 0.006 0.001 -0.003 0.001 -0.003 -0.001 -0.004 0.005 GROWTH (0.692) (0.812) (0.235) (0.530) (0.176) (0.556) (0.094) (0.469) (0.600) 0.036 0.004 0.047 0.031 -0.017 0.083* 0.020 0.060 -0.042 INDGROWTH (1.191) (0.112) (1.589) (0.708) (0.504) (1.827) (0.363) (1.182) (0.631) -0.102*** 0.109*** -0.186*** -0.122*** -0.169*** 0.045* -0.190*** -0.221*** -0.001 PERFORM (4.277) (3.520) (9.194) (4.844) (8.326) (1.933) (4.281) (6.605) (0.007) -0.014*** -0.013*** -0.008*** -0.024*** -0.009*** -0.020*** -0.016*** -0.008* -0.009 LTA (7.900) (7.703) (4.415) (6.429) (3.283) (5.106) (2.701) (1.779) (1.585) 0.024*** 0.043*** -0.006*** 0.042*** 0.009* 0.054*** 0.032* -0.002 0.034*** LEVERAGE (3.104) (5.761) (2.605) (4.324) (1.828) (3.076) (1.784) (0.070) (3.402) -0.029*** 0.014* -0.051*** -0.050*** -0.062*** 0.014 -0.060*** -0.091*** 0.025 LOSS (3.458) (1.822) (6.790) (3.504) (6.290) (1.045) (3.804) (6.449) (1.332) -0.021*** -0.018*** -0.005 0.002 0.001 0.007 -0.024*** -0.001 -0.023*** PPEGROWTH (3.299) (3.653) (0.915) (0.383) (0.036) (1.506) (2.743) (0.041) (3.459) -0.025** -0.016 -0.017* -0.009 -0.016 0.001 0.008 -0.005 0.014 MINING (2.265) (1.552) (1.735) (0.776) (1.636) (0.069) (0.415) (0.263) (0.661) 0.001 0.001 0.001 0.001 0.001 0.001 -0.001 -0.001 0.001* SUBGDP (0.765) (0.397) (1.059) (1.178) (0.753) (1.117) (1.001) (0.585) (1.689) -0.008 -0.001 -0.006 -0.013 -0.006 -0.009 0.016 -0.002 -0.020 SUBLITIG (0.383) (0.070) (0.419) (0.712) (0.423) (0.473) (0.836) (0.083) (1.137) 0.001* 0.001 0.001 0.001* 0.001** 0.001 -0.001 -0.001 -0.001 SUBPROX (1.767) (1.266) (1.480) (1.828) (1.966) (1.096) (0.892) (0.326) (0.904) 0.036* 0.022 0.029 0.081 0.044 0.011 0.041 0.032 -0.010 NETWORK(%) (1.707) (1.297) (1.623) (1.489) (1.404) (0.172) (0.910) (0.536) (0.271) UNAFFILIATED -0.026 -0.031 0.005 0.001 -0.015 0.026 -0.005 -0.021 0.053 (%) (1.011) (1.101) (0.192) (0.062) (0.802) (1.040) (0.181) (0.705) (1.629) Year and Industry YES YES YES YES YES YES YES YES YES Fixed Effects Adj R2 22.2% 22.6% 41.1% 16.5% 33.5% 10.9% 29.1% 42.6% 27.0%

Variables are defined in Table 1. *** p<0.01, ** p<0.05, * p<0.10. All tests are two-tailed. Industry indicator variables are included but are not reported. All models are estimated using robust standard errors clustered by client and year (Petersen 2009).

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Table 6: Going Concern Models

Financially Financially Financially Financially Distressed MNE Distressed MNE Distressed MNE Distressed MNE Group Large Non- Group Small Non- Group Sample Group Big N Sample Big N Sample Big N Sample (n=1657) (n=609) (n=760) (n=288) Coefficient Coefficient Coefficient Coefficient (t stat) (t stat) (t stat) (t stat) 0.866** 0.794 0.887 0.924 Intercept (2.034) (0.985) (1.550) (0.747) 2.105*** 4.998*** 0.753 -0.125 PBANK (3.180) (4.281) (0.809) (0.062) -0.386*** -0.331*** -0.516*** -0.140 LTA (6.570) (3.355) (5.354) (0.864) 0.362 -0.414 0.838 -0.056 LEVERAGE (0.826) (0.618) (1.215) (0.044) -0.644 0.598 -1.255* -0.337 ∆LEVERAGE (1.445) (0.755) (1.800) (0.355) 0.012 -0.038 0.014 0.013 CURRENT (0.648) (0.638) (0.578) (0.340) -3.019*** -3.232*** -2.799*** -4.000*** WC (8.917) (4.700) (5.839) (4.244) -0.056* -0.018 -0.061 -0.053 QUICK (1.937) (0.218) (1.612) (0.864) -0.697*** -0.800*** -0.659*** -0.634* ROA (4.668) (2.746) (3.210) (1.782) -0.268 0.240 -0.622 0.595 NEGEQ (0.493) (0.220) (0.773) (0.402) -0.039 N.A. N.A N.A. BIG4 (0.199) -0.003 N.A. N.A N.A LARGENONBIGN (0.199) 0.098 0.301 -0.076 0.182 MINING (0.549) (0.809) (0.316) (0.392) 0.001 -0.001 0.001 0.001 SUBGDP (0.141) (1.210) (0.413) (0.905) -0.311 0.368 -0.371 -1.270* SUBLITIG (1.323) (0.822) (1.060) (1.958) 0.001* 0.001 0.001** -0.001 SUBPROX (1.821) (1.324) (2.022) (0.525) -0.878 -2.076** 1.260 -4.566** NETWORK(%) (1.505) (2.285) (1.300) (2.545) UNAFFILIATED 0.653* 0.260 1.149** 0.149 (%) (1.780) (0.305) (2.384) (0.158) Year and Industry YES YES YES YES Fixed Effects 26.6% 31.6% 26.2% 30.1% Pseudo r2

Variables are defined in Table 1. *** p<0.01, ** p<0.05, * p<0.10. All tests are two-tailed. Industry indicator variables are included but are not reported. All models are estimated using robust standard errors clustered by client and year (Petersen 2009).

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