The Impact of Group Audit Arrangements on Audit Pricing and Audit Quality Elizabeth Carson University of New South Wales Roger Simnett University of New South Wales Greg Trompeter University of Central Florida Ann Vanstraelen Maastricht University Please do not quote without permission of the authors.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, Bill Kinney 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, University of Texas, University of Western Australia 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 Group Audit Arrangements on Audit Pricing and Audit Quality Abstract Regulators have raised concerns about audits of financial statements of groups. Of particular concern are engagements in which parts of the audit are not undertaken by the principal auditor but involve the use of other component auditors. These component auditors may be either affiliated or unaffiliated with the principal audit firm signing the audit report. Using unique disclosure requirements for Australian listed firms, we examine the incidence of such arrangements and their impact on audit fees and audit quality. We find that relative to group audits conducted solely by principal auditors, audit fees are higher when other auditors, either within or outside the network, are involved. Further we find that where other component auditors are engaged, audit fees are higher when the principal auditor’s network is involved relative to unaffiliated auditors. Using a range of proxies, we find some evidence of differences in audit quality related to group audit arrangements. 2 1. Introduction Significant concerns have been raised by regulators about the quality of the auditing of 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 other audit firms that are involved in providing audit evidence on individual components of the consolidated entity (‘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) or the use of 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). The difficulties in auditing such groups have been highlighted by major international 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 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 report of the International Auditing and Assurance Standards Board (IAASB) but it has been proposed that this be 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 reason of low price.3 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 group is structured (i.e. wholly audited by the principal auditor; partly audited within the network of the principal auditor; or parts of the group 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 previously addressed. 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 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 subject to a minimum threshold). 4 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. 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 work4. 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 30% of 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 group audits conducted wholly by the principal auditor are cheaper relative to audits undertaken within the audit firm network or when unaffiliated auditors are involved. Further, we find that audits undertaken using the auditor’s network are more expensive than those using unaffiliated auditors. In relation to audit quality, we find differences across our proxies for audit quality (discretionary accruals and going concern issuance) between types of group audit arrangements. Overall, given their high incidence and impact on audit fees and quality, our evidence is supportive of calls for greater disclosure of identity and responsibilities of other component auditors involved in group audits. 4 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. 5 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 For a group audit, the principal auditor must determine the extent to which other component auditors should be involved in the engagement. This is considered as part of accepting a group audit engagement. Under International Standards on Auditing (ISA), in particular ISA 600, if part of the group audit work is undertaken by other component auditors (whether related to the principal auditor or not), 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”.