California State University, Dominguez Hills. Youngkyun Park ... Keywords: PCAOB inspection reports; audit deficiency; shareholder ratification; corporate ...
ACCOUNTING AND THE PUBLIC INTEREST Vol. 17, No. 1 2017 pp. 107–129
American Accounting Association DOI: 10.2308/apin-51802
PCAOB Inspection Reports and Shareholder Ratification of the Auditor Myungsoo Son California State University, Fullerton Hakjoon Song California State University, Dominguez Hills Youngkyun Park University of Idaho ABSTRACT: We examine the effect of unfavorable PCAOB inspection reports, which contain audit deficiencies related to GAAS and/or GAAP violations, on shareholder voting for the auditor ratification. We further investigate whether shareholders likely vote against ratification for the auditors receiving deficiency reports in a weak corporate governance environment. Overall, we do not find evidence that shareholders vote against auditor ratifications when their auditors receive unfavorable inspection reports. However, we find some evidence that shareholders cast their votes against the ratifications of auditors receiving unfavorable inspection reports when the corporate governance is weak, as proxied by CEO duality and a low level of board diligence. Our results suggest that shareholders seem not to incorporate inspection reports as a potential proxy for auditor quality in their vote decisions on auditor ratification. Keywords: PCAOB inspection reports; audit deficiency; shareholder ratification; corporate governance. Data Availability: Data are available from public sources identified in the paper.
INTRODUCTION
T
he Sarbanes-Oxley Act of 2002 (SOX), which was enacted following heightened accounting scandals (e.g., WorldCom and Enron), switched the monitoring system of audit quality from a self-monitored peer review to an independent regulation by the Public Company Accounting Oversight Board (PCAOB). The main responsibilities of the PCAOB are standard setting for the audits of public companies and the registration, inspection, and sanction of
We appreciate the helpful comments of Pamela B. Roush (editor), two anonymous reviewers, Dana Hermanson, and workshop participants at the 2015 American Accounting Association Auditing Section Midyear Meeting. Editor’s note: Accepted by Pamela B. Roush. Submitted: March 2015 Accepted: May 2017 Published Online: May 2017 107
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public companies’ auditors.1 The PCAOB conducts annual inspections for audit firms (hereafter, annually inspected auditors) that provide audit reports for more than 100 public companies, and at least once every three years for audit firms (hereafter, triennially inspected auditors) that issue audit reports for 100 or fewer public companies. The PCAOB inspections include assessing the quality of audit work performed for the selected audit engagements and reviewing the quality control systems of the selected auditors. The PCAOB regularly publishes two types of inspection reports for all inspections conducted: a clean report that does not include any audit deficiencies, or a report disclosing audit deficiencies related to GAAS and/or GAAP violations. The PCAOB applies a risk-based approach to select audit engagements and to identify areas of audit deficiencies for inspections rather than inspecting every audit engagement and audit area.2 Only certain significant audit deficiencies that exceed the materiality threshold are publicly disclosed in inspection reports, and the client’s name is kept confidential. The fact that an auditor receives an unfavorable PCAOB report may indicate that lowquality audits were conducted for not only a client selected for the inspection, but also possibly other clients of the auditor. The shareholders of those client firms may then form a lower perception of the audit quality provided by the auditor and may express their opinion through shareholder voting on auditor ratification. For the empirical evidence supporting this argument, therefore, this study examines the effect of audit deficiencies disclosed in inspection reports (as a signal of audit quality) on shareholder perception, revealed through shareholder voting on auditor ratification. A primary function of the PCAOB is to oversee audits of public companies in order to ‘‘protect investors and the public interest by promoting informative, accurate, and independent audit reports’’ (PCAOB webpage; emphasis added). As a means of audit quality control, the PCAOB issues inspection reports, which contain new information about the quality of the audit work. Shareholders are expected to respond to this new information and to update their perceptions on the quality of the auditor. In turn, their revisions in the perception of audit quality imply revised confidence in the financial information on which the auditor provided audit services. High-quality audits are building blocks for strong and vibrant capital markets, which is closely related to the credibility of financial statements and subsequent investment decisions (Dao, Mishra, and Raghunandan 2008). Based on this notion, it is important to examine how shareholders change their perceptions in response to the updated information (audit deficiencies) contained in the inspection reports as a signal of audit quality. Although prior studies have examined the effect of the PCAOB reports on audit quality, there is no direct evidence, to the best of our knowledge, on whether shareholders actually vote against the ratification of an auditor who receives a deficiency report. In this paper, we fill that void and directly examine how shareholders react to audit deficiencies contained in the inspection reports. Although shareholders’ voting on auditor ratifications at shareholder meetings is not legally binding, it is important for shareholders to have an opportunity to get involved in the auditor selection process, because this involvement can be an important channel through which shareholders can express their dissatisfaction with the nominated auditor. Shareholder activists 1
2
Auditors subject to PCAOB inspections include U.S. and foreign auditors who provide audit reports to U.S. public companies. Foreign auditors who do not issue audit reports but still play a substantial role in audits are also subject to PCAOB inspections (PCAOB Rules 2100 and 4000). According to the PCAOB (2012), the risk factors the PCAOB considers when selecting audit engagements and identifying audit deficiencies include (1) the nature, market capitalization, and industry of the issuer; (2) particular audit issues; (3) significant operations in emerging markets; and (4) considerations related to the audit firm including partner, practice office, and prior inspection results. Accounting and the Public Interest 2017
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(ISS 2012; CalPERS 2011) consider adoptions of these shareholder votes as a good corporate governance practice.3 In this paper, we examine the following research questions. First, is the proportion of shareholders voting against auditor ratification higher in firms whose auditors receive inspection reports containing audit deficiencies than in firms whose auditors receive clean inspection reports? Second, is the proportion of shareholders voting against ratification of auditors who receive deficiency inspection reports higher in firms with weak corporate governance than in firms with strong corporate governance? We focus on clients of triennially inspected auditors rather than annually inspected auditors for three reasons. First, the audit service market is more competitive for triennially inspected auditors, which are usually small audit firms (Ghosh and Lustgarten 2006), and there will be greater variations in audit quality across these auditors. This may imply that auditor selection for this group is a more discriminating and serious issue. Second, triennially inspected auditors do not have an established reputation with respect to audit quality, where shareholders appear to be more sensitive to quality audit information. Finally, there is no variation in inspection reports for annually inspected auditors. None of the annually inspected audit firms received a clean report from the PCAOB during the 2005–2009 time period (Gunny and Zhang 2013). Using inspection reports of triennially inspected U.S. auditors during the 2004–2012 period, we do not find evidence that shareholders are more likely to vote against management proposals regarding auditor ratification when their auditor receives a deficiency inspection report. There are three potential reasons why our empirical tests fail to find predicted results. First, it seems that inspection reports are useful indicators of audit quality because shareholders significantly react to information on the inspection reports (Offermanns and Peek 2011; Dee, Lulseged, and Zhang 2011, 2015). However, we fail to find evidence that shareholders actually use the inspection reports in their decision on auditor ratification. Therefore, our study suggests that shareholders may use different information sets in auditor ratification decisions other than the inspection reports. Second, shareholders may be persuaded to believe that audit deficiencies are simply minor issues (i.e., lack of documentation and differences in professional judgment between auditors and inspectors) that do not contain serious risk factors. Finally, voting results across firms lack variation in that the proportion of positive votes in auditor ratification is extremely high, in general.4 We further investigate whether the possible association between shareholder votes and unfavorable inspection reports varies depending on the strength of corporate governance. We predict that when the monitoring system over financial reporting is weak, shareholders are more likely to view information in unfavorable inspection reports as a credible signal indicating the real quality of auditors and, therefore, vote against auditor ratification. We measure the strength of 3
4
Audit committees become responsible for the appointment, compensation, and oversight of the auditor based on Section 301 of SOX. However, even after SOX, CEOs and CFOs of companies often overpower audit committees and continue to have significant influence over auditor appointments and dismissals (Cohen, Krishnamoorthy, and Wright 2010; Dao, Raghunandan, and Rama 2012). Therefore, voting on auditor ratification is an important opportunity for shareholders to monitor and participate in the auditor selection process. According to the Audit Analytics database, about 98 percent of shareholders voted for auditor ratifications between January 2012 and September 2013 (see, http://www.auditanalytics.com/blog/auditor-ratificationshareholders-appear-content/). However, this argument is less persuasive in that a number of studies, despite a lack of variation in voting results, find significant results in various settings (e.g., Raghunandan 2003; Mishra, Raghunandan, and Rama 2005; Dao et al. 2008; Liu, Raghunandan, and Rama 2009; Hermanson, Krishnan, and Ye 2009). Accounting and the Public Interest 2017
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internal corporate governance using three important parties responsible for the auditor selection and financial reporting process: the CEO, the board, and the audit committee. We also estimate the strength of external corporate governance using blockholder ownership and institutional investor ownership. Our empirical tests show some evidence that shareholders tend to vote against auditor ratification for auditors receiving deficiency reports more frequently when the firm’s CEO serves as chair of the board and when the board is not diligent in holding its meetings. Our study contributes to the existing literature in several ways. First, we add to the growing literature on the value of the information contained in the PCAOB inspection reports by examining shareholders’ auditor ratification votes. Second, we extend a stream of literature that has examined factors affecting shareholder dissatisfaction over auditors by investigating a new determinant that prior studies have not considered (i.e., PCAOB reports). Our findings should be of interest to those who are concerned with consequences of the PCAOB inspection reports, such as shareholders, auditors, management, and regulators. The remainder of this paper is organized as follows. The next section discusses background, literature, and research questions. This is followed by the research design and empirical results. The last section provides concluding remarks, limitations, and future research opportunities.
BACKGROUND, LITERATURE REVIEW, AND RESEARCH QUESTION DEVELOPMENT Background A major change in audit regulations occurred in 2002 when SOX was enacted. Before SOX, a self-monitoring peer review system under the AICPA regulated the quality of audits. However, this peer review system was criticized for its lack of independence. For instance, the audit profession’s self-regulatory system never issued an adverse or qualified report on major accounting firms (PCAOB 2011). In response to such criticism, Congress created the PCAOB, a quasigovernmental organization, to oversee the audits of public companies, based on Section 101 of SOX. The PCAOB is responsible for setting audit standards for audits of public companies and for the registration, inspection, and sanction of the auditors of public companies. Furthermore, considering the importance of investor protection, the PCAOB seeks input and advice regarding broad audit policy issues from investors by holding investor advisory group meetings on an annual basis. According to Section 104 of SOX, the PCAOB conducts inspections for both annually inspected and triennially inspected auditors. At the end of 2012, there were 2,363 audit firms registered with the PCAOB, including 1,452 U.S. audit firms and 911 foreign audit firms (PCAOB 2013a). The actual budget consumed by inspections (by the Division of Registration and Inspections) constituted a significant portion of the PCAOB’s resources, accounting for about 52 percent of total outlays in 2012, and a similar level was expected by the projected budgets for 2013 and 2014 (PCAOB 2014a). This suggests that auditor inspections are a major task of the PCAOB. In its inspections, the PCAOB evaluates the quality of audit work for selected audit engagements and reviews the selected audit firms’ quality control systems. The PCAOB regularly publishes, for each inspection conducted, either a clean report not disclosing any audit deficiencies or a report disclosing audit deficiencies related to GAAS and/or GAAP violations. The PCAOB does not attempt to inspect every audit engagement and audit area. Rather, it exercises some discretion by applying a risk-based approach to select engagements to be investigated and to Accounting and the Public Interest 2017
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identify audit deficiencies to be reported. As a result, only certain audit deficiencies that exceed the materiality threshold are summarized and disclosed in inspection reports, with the client’s name kept confidential. The audit deficiencies disclosed are ‘‘of such significance that it appeared that the Firm, at the time it issued its audit report, had failed to obtain sufficient appropriate audit evidence to support its opinion’’ on either the client’s financial statements or their internal controls over financial reporting (PCAOB 2014b). In addition, quality control criticisms, another area of investigations, are made public on the PCAOB webpage only if the audit firm receiving an inspection report of quality control defects fails to remediate its defects within one year from the publication date of the report. It is important for shareholders to express their opinion on auditor selection and termination decisions because this involvement may help ensure high-quality audits and thus the credibility of the financial statements. Although shareholder voting on auditor ratification at shareholder meetings is not legally binding, shareholder activists consider it a good corporate governance practice (ISS 2012; CalPERS 2011). A problem in studying shareholder voting on auditor ratification is a lack of variation, since the proportion of positive votes in auditor ratification is extremely high, in general. This lack of variation is probably because shareholders may not be serious in their voting due to the nonbinding nature of the voting or because audit committees generally recommend that shareholders vote for auditor ratification (Hermanson et al. 2009). However, the existence of shareholders’ negative votes on auditor ratification, although tiny in number, means that ‘‘there is a non-zero probability of receiving a negative vote from shareholders,’’ which likely makes auditors increase their efforts to improve audit quality (Dao et al. 2012). Literature Related to PCAOB Inspections Several papers examine the effect of PCAOB inspections on audit quality. Gramling, Krishnan, and Zhang (2011) examine whether the inspections alter auditors’ behavior by investigating the change in auditors’ propensity to issue a going concern opinion before and after issuance of the inspection report. They find that audit firms receiving inspection reports containing audit deficiencies are more likely to issue a going concern opinion after the inspection than before. This suggests that the inspection process changes the behavior of audit firms in a desirable way (i.e., more conservative issuance of audit opinions). Carcello, Hollingsworth, and Mastrolia (2011) also examine whether the PCAOB inspections improve audit quality (proxied by abnormal accruals of audit clients) of the Big 4 audit firms. They find a significant decline in income-increasing abnormal accruals following the initial PCAOB inspection in 2004, which also suggests that the inspections improve audit quality. On the other hand, Gunny and Zhang (2013) examine whether the PCAOB inspection reports are able to distinguish between higher versus lower audit quality (i.e., the informativeness of inspection reports). More specifically, they find that the inspection reports containing GAAP-related audit deficiencies are associated with higher restatements and abnormal accruals, which indicate lower audit quality. This association suggests that inspection reports are informative to users of financial reporting who seek high-quality assurance. Another group of studies examines changes in the audit market share following the disclosure of PCAOB inspection reports with audit deficiencies or quality control defects, providing mixed empirical results. Lennox and Pittman (2010) do not find an association between disclosed audit deficiencies in the PCAOB reports and subsequent changes in the audit market share. They argue that this result may be caused by the legislative restrictions that prohibit the PCAOB from Accounting and the Public Interest 2017
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disclosing quality control defects and evaluative summaries of audit firms’ quality control systems. Similarly, Song and Ye (2014) do not find a significant change in the audit market share within one year after international audit firms receive inspection reports including audit deficiencies and/or quality control defects. In contrast, Daugherty, Dickins, and Tervo (2011) find that triennially inspected U.S. auditors receiving PCAOB reports of audit deficiencies are more likely to be dismissed by their clients and replaced with auditors who have received clean PCAOB reports. Abbott, Gunny, and Zhang (2013) also document that clients are more likely to dismiss triennially inspected auditors with GAAP deficiency reports, switching to auditors with clean reports. Similarly, Nagy (2014) documents that U.S. auditors lose a significant client base following the public disclosure of inspection reports that include detailed quality control defects. Prior studies also examine investors’ market reactions associated with PCAOB inspections and sanctions. Dee, Lulseged, and Zhang (2011) find that Deloitte clients experienced a significant negative market response following the news disclosure of PCAOB sanctions imposed on Deloitte in relation to the audit of Ligand Pharmaceuticals, Inc.’s 2003 financial statements. This is interesting in that an audit failure with one client has an adverse effect on other clients of the same auditor. Offermanns and Peek (2011) also find a significant market reaction to the publication of inspection reports, indicating that the stock market uses the information provided in the inspection reports. Unlike studies examining shareholders’ reactions to inspection reports in the stock markets, where many other factors may simultaneously affect the change in stock returns (e.g., concurrent other events), our study directly investigates whether audit deficiencies in the inspection reports negatively affect shareholders’ votes on auditor ratification. Following Dee et al. (2011), we predict that if an auditor receives a deficiency report for an audit of an unknown client,5 then the auditor’s entire portfolio of audit clients experiences negative consequences (i.e., more negative voting on auditor ratification). Shareholder Ratification of Auditors A stream of literature on shareholder ratification of auditors examines how shareholders view (in terms of voting results) particular events or status that may affect audit quality. Raghunandan (2003) documents that shareholders are more likely to vote against auditor ratification when the auditor provides a high level of nonaudit services. Further, Mishra et al. (2005) provide additional evidence regarding the relationship between the separate components of nonaudit fees and shareholder voting for auditor ratification. They find that shareholders’ voting against auditor ratification increases with both the tax fee ratio and the other fees ratio, but decreases with the audit-related fee ratio. In addition, Dao et al. (2008) document that shareholders’ voting against auditor ratification is positively related to auditor tenure, suggesting that shareholders view lengthy auditor tenure as a signal of low audit quality. Moreover, Liu et al. (2009) find that shareholders are more likely to vote against auditor ratification following restatements—evidence of audit failure. Similarly, Hermanson et al. (2009) provide evidence that shareholders’ voting against auditor ratification is high when firms restate their financial statements and when their internal control system has company-wide material weaknesses. By investigating the effect of PCAOB reports on auditor ratification votes, our paper extends this literature examining the relationship between audit quality indicators and shareholder dissatisfaction with auditors. 5
As noted earlier, the PCAOB does not disclose the identity of the audit client in the inspection reports. Accounting and the Public Interest 2017
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Research Questions Audit quality is a complex concept, incorporating audit inputs, audit processes, accounting firms, institutions, and economic consequences of audit outcomes (Francis 2011). Prior audit research has mostly used client-based outcome measures as a proxy for audit quality, because audit quality is unobservable and difficult to directly measure. However, as a client-based outcome measure (e.g., restatement or abnormal accruals) is generated by the joint work between the auditor and the client firm, it may be a noisy measure to use in assessing audit quality. Unlike client-based outcome measures, audit deficiency information included in the inspection reports directly captures performance of the audit work and thus should provide more precise information about audit quality. Audit deficiency information is also informative because it has enough variation across triennially inspected auditors.6 It also provides specific areas of GAAS-related and GAAPrelated deficiencies. For instance, the PCAOB discloses the root causes of audit deficiencies identified during the inspection process such as (1) a lack of technical competence, (2) a lack of due professional care and professional skepticism, (3) heavy workload and ineffective client acceptance and retention, and (4) ineffective engagement quality review (PCAOB 2013b). Furthermore, shareholders can easily gain access to publicly available inspection reports via the PCAOB website (available at: https://pcaobus.org/Inspections/Reports/Pages/default.aspx). Although inspection reports are publicly available, individual shareholders may not use the information and generally agree on the favorable recommendation by the board of directors regarding auditor ratification (Hermanson et al. 2009). However, large institutional investors— sophisticated financial information users—likely incorporate the inspection report information in their decision process and thus express dissatisfaction over auditors by voting against auditor ratification. In light of the information value that can be derived through audit deficiencies in the inspection reports, shareholders (especially institutional shareholders) may interpret reported deficiencies as evidence that the audit firm has been providing low-quality audits, which damages the audit firm’s reputation (reputation effects) (Dee et al. 2011). Also, if audit deficiencies are not remediated, then this can lead to PCAOB sanctions and potential litigation against the auditor. This reduces the insurance value of the audit because audit firm payouts that result from litigation can harm the financial health of the auditor (insurance effects) (Dee et al. 2011). Due to both effects, shareholders are likely to question the credibility of audit quality delivered by such audit firms and express their dissatisfaction through their votes on auditor ratification.7 6
7
Of 521 triennially inspected U.S. audit firms during 2005–2007, 265 inspection reports (50.9 percent) contain audit deficiencies and 61 reports (11.7 percent) contain GAAP deficiencies (Abbott et al. 2013). There is some anecdotal evidence that shareholders ( particularly institutional investors) consider inspection results to estimate auditor quality in their ratification decisions. The proposed Audit Quality Indicators (AQI) by the PCAOB include ‘‘PCAOB inspection results’’ (PCAOB 2015). Institutional investors such as the Council of Institutional Investors and CalPERS suggest that AQI would assist shareholders in the decision-making process of annual auditor ratification (CalPERS 2015, 4). In addition, the Council of Institutional Investors recommends that audit committees consider ‘‘inspection results and fines levied by the Public Company Accounting Oversight Board or other regulators ’’ when periodically considering changing the auditor (CII 2015). Academic studies (Offermanns and Peek 2011; Dee et al. 2015) also find that shareholders respond to information (e.g., audit deficiency and the existence of participating auditors) from PCAOB inspection reports in their investment decisions. Moreover, experimental studies (e.g., Persellin 2013; Robertson, Stefaniak, and Houston 2014) support the idea that sophisticated financial information users (e.g., audit committee members and financial executives) incorporate information from PCAOB inspection reports in their decision making such as auditor switching. Accounting and the Public Interest 2017
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However, there exist a number of other arguments that do not support an association between the deficiency inspection reports and shareholders’ votes on auditor ratification. Auditors could persuade members of the audit committee to believe that audit deficiencies published in the inspection reports raise merely minor concerns, such as lack of documentation and differences in the professional judgment between auditors and inspectors, thus downplaying the importance of audit deficiencies (PCAOB 2011). It is also possible that even institutional shareholders could be persuaded by the audit committee via various communication channels (e.g., investor relation events) that audit deficiencies are not major problems.8 Moreover, the PCAOB applies a risk-based approach in selecting engagements for investigations and in identifying areas of audit deficiencies for the selected engagements. As a result, audit deficiencies disclosed in the inspection report may not be representative of the inspected auditor’s general audit quality (PCAOB 2012; Gunny and Zhang 2013). The PCAOB also points out that audit deficiencies published in the inspection reports indicate that the auditor ‘‘did not do enough audit work and did not gather sufficient audit evidence to render its unqualified opinion,’’ but ‘‘it does not necessarily mean that those financial statements are misstated’’ (PCAOB 2011, 2014b).9 This position by the PCAOB may cause confusion among shareholders in interpreting the inspection results. Furthermore, the informational value of inspection reports may be questionable because inspection reports do not disclose the identity of particular clients and because the publication of inspection reports has been delayed.10 Along this line of argument, if shareholders do not consider audit deficiency reports seriously, then we should find that voting against auditor ratification is not significantly different between firms whose auditors receive audit deficiency reports and firms whose auditors receive clean inspection reports. This prediction is also possible in that shareholders’ votes on auditor ratification are not binding; that is, firms can decide not to consider the results even when the vote results are severely unfavorable.11 Facing mixed predictions, we propose the first research question as follows: 8
9
10
11
In order to get a better idea of these conflicting predictions, we investigate proxy statements of the firms in our sample for 2009–2012, but do not find any disclosure that describes a guide of the external auditor ratification. However, things are beginning to change. Recently, audit committees have begun to expand their disclosure regarding external auditor reappointment and evaluation criteria of the external audit firm (Audit Analytics and Center for Audit Quality 2016). Moody’s Corporation (2016), for instance, disclosed in its proxy statement that its audit committee considers PCAOB reports in the decision as to whether its external auditor is reappointed. Jay D. Hanson, a board member of the PCAOB, commented at the CBI 10th Annual Pharma/Biotech Accounting & Reporting Congress (PCAOB 2014b), ‘‘Such inspection findings are referred to as ‘audit failures’ in both our firm-specific inspection reports and our general summary reports. And of course, the firm, in fact, did not do enough work in the inspected areas. Nevertheless, calling every such deficiency an ‘audit failure’ appears to have caused confusion among investors, audit committees, and others, some of whom have interpreted our findings as meaning that the financial statements are misstated or that there is a problem in the company’s accounting or internal controls. In fact, however, only very few of our inspection findings ultimately can be linked to a problem in the company’s financial statements, and restatements arising out of our inspection process are rare, although they do occur.’’ The PCAOB inspectors examine the most recent audited financial statements for their inspections (Gunny and Zhang 2013). If audit problems occur in year t, then this is more likely to be discovered during the subsequent PCAOB inspections, mostly in year tþ1. Means of report lag (months from the end of inspection to the issuance of the report) for triennially inspected auditors are 10.41 months for auditors with deficiency reports and 4.62 months for auditors with clean reports (Hermanson, Houston, and Rice 2007). However, there also exists evidence that shareholders may seriously consider auditor ratification votes. For example, large institutional investors, such as CalPERS, TIAA-CREF, and AFL-CIO, likely vote against audit committee directors of firms that do not submit an agenda of the auditor selection for ratification (Wolf 2006; Liu et al. 2009). Accounting and the Public Interest 2017
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RQ1: Is the proportion of shareholders voting against auditor ratification higher when their auditor receives PCAOB inspection reports containing audit deficiencies than when their auditor receives a clean report? We further predict that shareholders are more likely to vote against auditor ratification for auditors receiving deficiency inspection reports in an environment of weak corporate governance. In a weak governance environment, where the monitoring system over financial reporting is minimal, shareholders likely view information in inspection reports as a credible signal indicating the actual quality of auditors. Moreover, shareholders may consider less seriously the negative information in inspection reports if the firm’s corporate governance is of high quality because a strong monitoring system of financial reporting is in place and, as a result, the information value of PCAOB reports relating to underperforming auditors may not be high. Therefore, our second research question is proposed as follows: RQ2: Is the proportion of shareholders voting against ratification of their auditor who receives inspection reports containing audit deficiencies higher for firms with weak corporate governance than for firms with strong corporate governance?
RESEARCH DESIGN Sample Selection We obtain all inspection reports for U.S. auditors during 2004–2012 from the PCAOB ‘‘Reports’’ file on Audit Analytics. We start with 1,537 inspection reports for U.S. auditors dated from August 26, 2004 to December 20, 2012. As stated earlier, our focus is on triennially inspected audit firms; therefore, we drop 73 inspection reports of annually inspected audit firms. Next, due to the high cost of hand collecting shareholders’ voting data, we retain only first-time inspection reports, after dropping 655 subsequent inspection reports. Of the remaining 809 auditors, we eliminate 274 audit firms because their client information is unavailable on Audit Analytics, resulting in 535 audit firms and 6,933 client-year observations.12 We then drop 4,842 client-year observations with financial data not available on Compustat. We additionally eliminate 363 observations that have more than a one-year difference between the inspection report date and the fiscal year-ends of financial statements, because shareholders are not expected to use stale inspection reports in their voting decisions. For the remaining 1,728 observations, we hand collect, from proxy filings (10-Q, 10-K, or 8-K filings available on the SEC’s website), the following data: management proposals and shareholder voting results regarding auditor ratification, CEO duality, audit committees, boards of directors, and voting results for director elections. We further eliminate 1,154 observations for the following reasons: 711 observations without proxy filings, 116 observations without voting results for auditor ratification, 6 without voting results for director election, and 321 observations without management proposals for auditor ratification.
12
Since we are interested in shareholder voting on auditor ratification after releases of inspection reports, we restrict our analysis to clients of the 535 audit firms that issued audit reports right after the publication of inspection reports. Accounting and the Public Interest 2017
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TABLE 1 Sample Selection Procedure Number of Number of Audit Firms Clients PCAOB inspection reports for U.S. auditors during 2004–2012 from the PCAOB ‘‘Reports’’ file on Audit Analytics Less: Inspection reports for annually inspected audit firms (i.e., audit firms with more than 100 issuers) Less: Inspection reports for subsequent inspections after first-time reports were released Less: Audit firms not available on Audit Analytics Available Audit Firms/Clients Less: Clients not available on Compustat Less: Clients that have more than a one-year difference between inspection report dates and fiscal year-ends Less: Clients with missing data for CEO duality, audit committee and board of directors data, voting results on auditor ratification and director elections, and management’s proposal on auditor ratification Less: Clients that switch their auditors after the publication of inspection reports Less: Clients with missing data for other control variables Final Sample
1,537 73 655 274 535 128 15
6,933 4,842 363
181
1,154
8
19
8
29
195
526
Furthermore, we drop 19 observations where a new auditor was selected at the shareholder meeting immediately after publication of the inspection report.13 Finally, we exclude 29 observations for which other control variables are not available. As shown in Table 1, our final sample consists of 526 client firms (195 audit firms).14
Empirical Model LVOTE ¼ b0 þ b1 AUDDEF þ b2 LASSET þ b3 ROA þ b4 ADJRET þ b5 DIRVOTE þ b6 ARFEES þ b7 TAXFEES þ b8 OTHERFEES þ b9 RESTATE þ b10 ICW þ b11 LATEFILING þ b12 LAUDTEN þ b13 CEOCHR þ b14 ACEXP þ b15 ACSIZE þ b16 ACMEETING þ b17 ACIND þ b18 BSIZE þ b19 BMEETING þ b20 BIND þ Industry dummies þ Year dummies þ e ð1Þ 13
14
Audit committees can appoint a new auditor on behalf of the shareholders as a sign of dissatisfaction over the incumbent auditor who receives deficiency inspection reports. Inclusion of such examples would add noise to our estimation, as the ratification voting in these cases is for the new auditor, not for the inspected auditor. Of 195 audit firms, 95 firms (49 percent) had GAAS-related deficiencies and 23 firms (12 percent) had GAAPrelated deficiencies. Accounting and the Public Interest 2017
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The dependent variable, LVOTE, measures the logarithm of the percent of shareholder votes against or abstaining from the auditor ratification.15 We use the log-transformed variable of VOTE to be consistent with prior studies (Dao et al. 2008; Liu et al. 2009). The variable of interest for the test of RQ1 is a dichotomous variable presenting audit deficiencies (AUDDEF). Size (LASSET) is included as a control variable because shareholder activists pay closer attention to large firms, which often become targets for shareholder activism (Dao et al. 2008; Hermanson et al. 2009). We expect LASSET to be positively associated with LVOTE. We also control for firm performance using return on assets (ROA) and industry-adjusted stock returns (ADJRET). ROA is an accounting-based measure, while ADJRET is a market-based measure. Shareholders are more likely to vote against auditor ratification when the firm is performing poorly (Dao et al. 2008; Liu et al. 2009). Thus, ROA and ADJRET are expected to be negatively correlated with LVOTE. Shareholders likely vote against auditor ratification when they are dissatisfied with the firm’s directors. To control for this tendency, we include the average percentage of votes withheld for the election of all director nominees (DIRVOTE). The coefficient of DIRVOTE is predicted to be positive. We also include variables that proxy advisors (e.g., Glass Lewis & Co. and ISS) consider in determining their voting recommendations.16 These variables include the nonaudit fee ratio (Raghunandan 2003; Mishra et al. 2005), restatements (Liu et al. 2009), material weaknesses in internal control over financial reporting (Hermanson et al. 2009), and auditor tenure (Dao et al. 2008). Following the suggestion of Mishra et al. (2005) that more finely partitioned nonaudit fees are useful in the regressions, we include audit-related fees (ARFEES), tax fees (TAXFEES), and other fees (OTHERFEES). We predict that the coefficient of audit-related fees (ARFEES) is negative and that the coefficients of tax fees (TAXFEES) and other fees (OTHERFEES) are positive. In addition, we predict positive coefficients for restatements (RESTATE),17 material weaknesses in internal control over financial reporting (ICW), late filings (LATEFILING), and the natural logarithm of auditor tenure (LAUDTEN). We also control for internal corporate governance variables representing important players in the financial reporting and auditor selection process—CEO, board, and audit committee.18 CEO 15
16
17
18
As a sensitivity test, we drop abstention votes from both the denominator and the numerator in the calculation of LVOTE, and rerun the regression to capture strong dissatisfaction effects. Results are qualitatively unchanged. Proxy advisors provide voting recommendations to shareholders ( primarily institutional investors) based on their independent research, which could affect shareholder voting on auditor ratification. Glass Lewis & Co. and ISS, both prominent proxy advisors, describe in their guidelines the criteria that lead to an ‘‘against’’ recommendation on auditor ratification (Glass Lewis & Co. 2012; ISS 2012).Their criteria include breaches of auditor independence (e.g., excessive nonaudit services) and indicators of poor financial reporting quality (e.g., restatements, material weaknesses in internal controls, late filings, and aggressive accounting policies). We also conduct tests after adding performance-adjusted abnormal accruals as another proxy for aggressive accounting policies. However, as the sample size is reduced to 345 observations, this variable is excluded from our analysis. Gillan (2006), in his review paper of corporate governance, provides a corporate governance framework that falls into internal and external governance. Internal governance consists of the board of directors, managerial incentives, capital structure, antitakeover measures, and internal control systems, whereas external governance includes law regulation, a labor/product/capital/corporate control market, providers of capital market information, accounting/financial/legal services, and media/external lawsuits. Similarly, Baber, Liang, and Zhu (2012) use an internal and external governance system category to examine its relationship with financial reporting quality. Accounting and the Public Interest 2017
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duality (CEOCHR), which indicates a dual role as both the CEO and the chair of the board, is expected to be positively associated with LVOTE because shareholders view CEO duality negatively (Raghunandan and Rama 2003; Dao et al. 2008). The effectiveness of an audit committee is important in monitoring the financial reporting process and external auditor’s work. We include audit committee expertise (ACEXP), size (ACSIZE), diligence (ACMEETING), and independence (ACIND).19 Audit committees with more financial experts, more independent directors, and frequent meetings can increase the effectiveness of audit committees and improve the financial reporting process (Beasley, Carcello, Hermanson, and Lapides 2000; Abbott, Parker, and Peters 2004). Also, audit committees with more members are considered as better corporate governance (Goh 2009). We predict that shareholders are less likely to vote against auditor ratification when the effectiveness of an audit committee is high, because a high-quality audit committee promotes shareholders’ interests and, therefore, positively affects shareholders’ perception on the auditor (Raghunandan and Rama 2003; Hermanson et al. 2009). We expect negative coefficients for ACEXP, ACSIZE, ACMEETING, and ACIND. Board effectiveness is also important in monitoring the financial reporting process (Beasley 1996; Dechow, Sloan, and Sweeney 1996) and in ensuring external audit quality (Carcello, Hermanson, Neal, and Riley 2002). We include board size (BSIZE), diligence (BMEETING), and independence (BIND) as proxies for the board effectiveness. Independent, diligent, and small boards can increase board effectiveness (Yermack 1996; Cotter, Shivdasani, and Zenner 1997; Vafeas 1999). Shareholders may be less likely to vote against auditor ratification when highly effective boards enhance the financial reporting process. We expect negative coefficients for BMEETING and BIND, and a positive coefficient for BSIZE.20 To examine RQ2, we construct interaction variables between AUDDEF and each corporate governance variable (CEOCHR, ACEXP, ACSIZE, ACMEETING, ACIND, BSIZE, BMEETING, and BIND). Finally, we include industry dummies (two-digit SIC codes) and year dummies to control for industry and year effects.
EMPIRICAL RESULTS Descriptive Statistics Table 2 presents descriptive statistics for the clean and the deficiency samples. To alleviate the outlier problem, all continuous variables are winsorized at the 1 percent and 99 percent levels. The shareholder votes against auditor ratification (VOTE and LVOTE), regardless of measures in mean or median, are not significantly different between the two samples. This univariate test suggests that shareholders’ votes on auditor ratification are not influenced by deficiency reports. As the results of firm size (LASSET) and two performance measures (ROA and ADJRET) indicate, auditors whose client firms are small and poorly performing, on average, more frequently receive inspection reports containing audit deficiencies. In addition, auditors of client firms with 19
20
Independent board and audit committee members are outside directors who are not employed by firms and not classified as gray directors. Directors are designated as gray if they have familial or economic relationships with the firm (Raghunandan and Rama 2003; Krishnan and Ye 2005). The CEO, board, and audit committee are components of the internal governance mechanism. For the external governance mechanism, we also include two ownership variables for other analyses (not the main empirical model) because of sample attrition: the proportion of shares held by blockholders (shareholders owning 5 percent or more of the firm’s stocks) and institutional investors, both of which are obtained from the Thomson Reuters (CDA/Spectrum) database. Accounting and the Public Interest 2017
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TABLE 2 Descriptive Statistics Mean Variable VOTE LVOTE LASSET ROA ADJRET DIRVOTE ARFEES TAXFEES OTHERFEES RESTATE ICW LATEFILING LAUDTEN CEOCHR ACEXP ACSIZE ACMEETING ACIND BSIZE BMEETING BIND n
Median
AUDDEF ¼ 0 AUDDEF ¼ 1 AUDDEF ¼ 0 AUDDEF ¼ 1 t-statistic Wilcoxon-Z (1) (2) (3) (4) (2) (1) (4) (3) 1.873 0.228 4.664 0.096 0.256 5.301 0.133 0.121 0.085 0.135 0.119 0.059 1.164 0.427 0.368 3.519 5.427 0.976 7.330 8.784 0.722 185
2.017 0.154 4.054 0.420 0.563 4.707 0.139 0.108 0.113 0.144 0.188 0.147 1.321 0.507 0.345 3.276 5.358 0.971 6.856 8.173 0.714 341
0.730 0.198 4.551 0.007 0.119 3.200 0.022 0.079 0.000 0.000 0.000 0.000 1.099 0.000 0.330 3.000 5.000 1.000 7.000 8.000 0.750 185
0.860 0.117 3.933 0.009 0.230 2.320 0.000 0.056 0.000 0.000 0.000 0.000 1.386 1.000 0.330 3.000 5.000 1.000 7.000 7.000 0.714 341
0.50 0.58 3.49*** 4.05*** 2.16** 1.07 0.17 0.79 0.54 0.27 2.04** 3.00*** 2.32** 1.76* 1.27 2.91*** 0.28 0.54 2.16** 1.47 0.60
0.54 0.56 3.23*** 4.21*** 1.99** 1.28 1.58 1.58 1.00 0.27 2.03** 2.98*** 2.56** 1.76* 0.81 2.62*** 0.51 0.72 1.94* 1.54 0.52
***, **, * Represent significance at the 1 percent, 5 percent, and 10 percent levels, respectively (two-tailed). See Appendix A for variable definitions.
material weaknesses in internal control (ICW), late filings (LATEFILING), long auditor tenure (LAUDTEN), CEO duality (CEOCHR), and small board (BSIZE) and audit committee (ACSIZE) tend to receive inspection reports with audit deficiencies. These results are generally consistent with our predictions. The industry composition of the full sample (not tabulated) shows that durable manufacturing has the highest number of observations (17 percent), followed by computers (13 percent) and pharmaceuticals (8 percent). Association between Deficient Reports and Voting on Auditor Ratifications (RQ1) Table 3 presents regression results for the full sample, where the variable of interest is audit deficiency.21 As the test variable AUDDEF has an insignificant coefficient after controlling for other 21
We find that all Spearman correlation coefficients among the independent variables are below 0.6 (not tabulated). Moreover, the variance inflation factors in the regressions are less than 4. Thus, multicollinearity is not a concern. Accounting and the Public Interest 2017
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TABLE 3 Regression Result Variable Intercept AUDDEF LASSET ROA ADJRET DIRVOTE ARFEES TAXFEES OTHERFEES RESTATE ICW LATEFILING LAUDTEN CEOCHR ACEXP ACSIZE ACMEETING ACIND BSIZE BMEETING BIND
Expected Sign ? þ þ þ þ þ þ þ þ þ þ þ
Year and Industry Fixed Effects Adjusted R2 n
Dependent Variable: LVOTE Coefficient
t-statistic
1.125 0.155 0.009 0.070 0.033 0.078 0.555 0.702 0.151 0.076 0.367 0.285 0.030 0.003 0.227 0.087 0.007 0.571 0.017 0.006 0.412
1.15 1.20 0.17 0.85 0.80 7.75*** 2.78*** 1.74** 0.96 0.44 2.16** 1.43* 0.34 0.02 0.73 1.02 0.26 0.94 0.49 0.39 0.82 Included 0.14 526
***, **, * Represent significance at the 1 percent, 5 percent, and 10 percent levels, respectively (one-tailed where signs are predicted, two-tailed otherwise). See Appendix A for variable definitions.
variables, there is no statistically significant difference in adverse shareholder votes between deficiency inspection reports and clean inspection reports.22 Shareholders seem not to care about inspection reports containing audit deficiencies related to GAAS and/or GAAP violations. They may use different information sets in auditor ratification decisions other than the inspection reports. Alternatively, they may not seriously consider auditor ratification votes since vote results are not binding. Results for the control variables are generally consistent with prior research, which reduces the possibility that the failure to find significant results on the variable of interest is attributable to an 22
As sensitivity tests, we also replace LVOTE with (1) raw values of voting results (VOTE), and (2) a ranktransformed variable of LVOTE. Results from both alternative measures are qualitatively similar to those presented in Table 3. Accounting and the Public Interest 2017
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issue of the model specification or lack of power in our tests.23 Shareholders are more likely to vote against auditor ratification when their firms disclose material weaknesses in internal control (ICW), consistent with prior studies (Dao et al. 2008; Hermanson et al. 2009; Liu et al. 2009). The disapproval votes also increase when shareholders are dissatisfied with their directors (DIRVOTE) and when firms are late for their filings (LATEFILING). As predicted, we find a negative coefficient for audit-related fees (ARFEES) and a positive coefficient for tax fees (TAXFEES).24 This result indicates that shareholders view audit-related fees favorably and tax fees adversely, consistent with Mishra et al. (2005). The Moderating Effect of Corporate Governance (RQ2) Next, we construct the interaction variables between the test variable (AUDDEF) and each internal corporate governance variable (CEOCHR, ACEXP, ACSIZE, ACMEETING, ACIND, BSIZE, BMEETING, and BIND) to investigate RQ2. As shown in Table 4, Panel A, the coefficient for the interaction variable between AUDDEF and CEOCHR is significantly positive (one-tailed; p ¼ 0.07). In Panel B, the coefficient of the interaction variable between AUDDEF and BMEETING is significantly negative (one-tailed; p ¼ 0.06).25 This result implies that shareholders’ disapproval reflected in auditor ratification votes increases for the auditor receiving deficient inspection reports when a firm’s CEO also serves as chair of the board of directors (CEOCHR) and when boards are not diligent in holding their meetings (BMEETING).26 There is some evidence that shareholders in an environment of weak governance, where a monitoring system of financial reporting quality is not in place, make their voice heard through auditor ratification votes if the proposed auditor is of low quality, as evidenced by the PCAOB deficiency reports.27 Both boards and auditors serve as monitors over the activities of the CEO on behalf of shareholders. Dao et al. (2008) argue that the level of involvement by shareholders in auditor ratification votes increases as the strength of boards’ monitoring weakens 23
24
25
26
27
There is little variation in auditor ratification votes due to extremely high approval rates. However, we find some significance in control variables in the predicted way, which suggests that our model has power to be able to isolate the predicted effect in our test variable. This is likely to lead us to conclude that shareholders do not use PCAOB inspection reports, rather than that our model does not have enough power to find a predicted effect. We replace three separate nonaudit fee variables with a total nonaudit fee variable (scaled by audit fees) and rerun the regression. The coefficient for the total nonaudit fee variable is not significant. We conduct univariate analyses (untabulated) on shareholder votes on auditor ratification for the weak versus the strong corporate governance groups. However, differences in the percentage of shareholder against votes for the two groups, regardless of governance measures, are not statistically significant based on t-tests. The following is the percentage of shareholder against votes on auditor ratification for the weak versus strong governance groups: CEOCHR (2.05 percent) versus no CEOCHR (1.89 percent); ACEXP below median (1.95 percent) versus ACEXP above median (1.97 percent); ACSIZE below median (1.91 percent) versus ACSIZE above median (2.10 percent); ACMEETING below median (1.94 percent) versus ACMEETING above median (1.99 percent); ACIND below median (1.27 percent) versus ACIND above median (2.01 percent); BSIZE above mean (2.01 percent) versus BSIZE below mean (1.92 percent); BMEETING below median (1.90 percent) versus BMEETING above median (2.04 percent); BIND below median (1.88 percent) versus BIND above median (2.05 percent). Interestingly, we find some results in two measures of corporate governance—CEO and boards—but not in audit committee. It is possible that part of the problem in not finding any results on RQ1 and weak effects on RQ2 may be due to the large number of variables in the model relative to the small number of observations. To address this concern, we conduct regression tests after dropping insignificant variables (thus reducing the number of variables) and find similar results. However, we cannot completely rule out this possibility. Accounting and the Public Interest 2017
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TABLE 4 The Moderating Effect of Corporate Governance Panel A: The Moderating Effect of CEO Duality Variable
Dependent Variable: LVOTE
Expected Sign
Coefficient
t-statistic
? þ þ þ þ þ þ þ þ þ þ þ þ
0.940 0.011 0.237 0.365 0.007 0.064 0.033 0.078 0.547 0.723 0.128 0.084 0.377 0.287 0.026 0.213 0.077 0.006 0.503 0.022 0.003 0.370
0.95 0.06 1.17 1.46* 0.12 0.78 0.80 7.79*** 2.74*** 1.79** 0.81 0.48 2.21** 1.45* 0.30 0.69 0.90 0.24 0.82 0.64 0.22 0.73
Intercept AUDDEF CEOCHR AUDDEFCEOCHR LASSET ROA ADJRET DIRVOTE ARFEES TAXFEES OTHERFEES RESTATE ICW LATEFILING LAUDTEN ACEXP ACSIZE ACMEETING ACIND BSIZE BMEETING BIND
Year and Industry Fixed Effects Adjusted R2 n
Included 0.14 526
***, **, * Represent significance at the 1 percent, 5 percent, and 10 percent levels, respectively (one-tailed where signs are predicted, two-tailed otherwise). Variables not shown below are defined in Appendix A. Variable Definitions: AUDDEF ¼ 1 if a firm’s auditor receives inspection reports containing audit deficiencies, and 0 otherwise; CEOCHR ¼ 1 if a CEO also serves as chair of the board of directors, and 0 otherwise; and AUDDEFCEOCHR ¼ interaction variable between AUDDEF and CEOCHR.
Panel B: The Moderating Effect of Board Diligence Variable Intercept AUDDEF BMEETING
Dependent Variable: LVOTE
Expected Sign
Coefficient
t-statistic
? þ
1.287 0.522 0.022
1.31 1.98** 0.98 (continued on next page) Accounting and the Public Interest 2017
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TABLE 4 (continued) Variable AUDDEFBMEETING LASSET ROA ADJRET DIRVOTE ARFEES TAXFEES OTHERFEES RESTATE ICW LATEFILING LAUDTEN CEOCHR ACEXP ACSIZE ACMEETING ACIND BSIZE BIND
Dependent Variable: LVOTE
Expected Sign
Coefficient
t-statistic
þ þ þ þ þ þ þ þ þ
0.043 0.005 0.068 0.031 0.078 0.572 0.720 0.153 0.060 0.388 0.276 0.032 0.030 0.178 0.079 0.009 0.584 0.020 0.491
1.59* 0.10 0.83 0.75 7.76*** 2.86*** 1.78** 0.98 0.34 2.28** 1.39* 0.37 0.24 0.57 0.92 0.34 0.96 0.59 0.97
Year and Industry Fixed Effects Adjusted R2 n
Included 0.14 526
***, **, * Represent significance at the 1 percent, 5 percent, and 10 percent levels, respectively (one-tailed where signs are predicted, two-tailed otherwise). Variables not shown below are defined in Appendix A. Variable Definitions: AUDDEF ¼ 1 if a firm’s auditor receives inspection reports containing audit deficiencies, and 0 otherwise; BMEETING ¼ number of board meetings; and AUDDEFBMEETING ¼ interaction variable between AUDDEF and BMEETING.
and thus high audit quality is demanded. More specifically, shareholders are expected to more (less) actively vote in a shareholder ratification of the auditor when the perceived monitoring role of boards is weak (strong). Our results are consistent with this argument that shareholders’ response to PCAOB inspection reports is stronger in auditor ratification votes for firms whose CEOs also serve as chair of the board (weak monitoring), while their response is weaker for firms with diligent board activity (strong monitoring). Further, we rerun the regression using the reduced sample (445 observations) that survived after merging with two variables for external corporate governance (the proportion of shares held by blockholders and institutional investors). We find (untabulated) insignificant coefficients for both the test variable (AUDDEF) and the interaction variables between AUDDEF and the two ownership variables. Accounting and the Public Interest 2017
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Additional Analyses We also conduct a battery of sensitivity tests for further inferences. Even though all tests are not tabulated to save space, our inferences remain unchanged. GAAS Deficiency and GAAP Departure Audit deficiencies identified during the inspection process consist of GAAS-related and GAAP-related deficiencies. The PCAOB states that there was a ‘‘failure to perform sufficient audit procedures’’ in a report containing GAAS-related audit deficiencies, a failure that indicates that the auditor did not fully apply GAAS in the audit procedures (PCAOB 2013c). On the other hand, the PCAOB describes GAAP-related audit deficiencies as a ‘‘failure to identify a departure from GAAP’’ or a restatement of ‘‘its financial statements to address a GAAP departure’’ (PCAOB 2005, 2013c). GAAS-related deficiencies could directly affect auditor ratification voting more than GAAP deficiencies, because the auditor can fully control audit procedures. However, GAAP-related audit deficiencies could be more severe, because they suggest ‘‘direct financial accounting implications’’ and ‘‘a breach in the traditional definition of audit quality’’ (Gunny and Zhang 2013; Abbott et al. 2013). To test whether any difference exists in the shareholders’ perceptions between these two deficiencies, GAASDEF is coded 1 if the inspection report contains only GAAS-related deficiencies, and 0 otherwise. GAAPDEF is coded 1 if the inspection report contains departures from GAAP or if the client restates its financial statements in response to the inspection, and 0 otherwise.28 In test results of the regression that includes GAASDEF and GAAPDEF as the test variables, both GAASDEF and GAAPDEF have insignificant coefficients, and the difference in coefficients of GAASDEF and GAAPDEF is not statistically significant.29 Information Asymmetry We also test whether shareholder voting is more sensitive in an environment of high information asymmetry, where the information available to determine audit quality is scarce. To test this prediction, we construct a composite measure of information asymmetry, based on Kothari, Shu, and Wysocki (2009), by a factor analysis using five variables: (1) market-to-book ratio, (2) stock volatility, (3) leverage ratio, (4) high-tech industry, and (5) regulated industry. Next, we partition the full sample into subsamples of above and below the median of the information asymmetry measure and rerun the regression on each subsample. The coefficients for AUDDEF are not significant in both subsamples. We also find that the coefficients for AUDDEF are not significant in any of the quintile subsamples on the information asymmetry measure. Financial Distress and Financial Performance We further test whether shareholders’ dissatisfaction with auditors receiving deficiency inspection reports is high in firms that are in financial distress. To test this prediction, we partition the full sample into two subsamples of above and below the median Zmijewski z-score, which is 28
29
Similar to Gunny and Zhang (2013), we also include both audit deficiencies and GAAP deficiencies in the same regressions to test the additional informational value of GAAP departures over audit deficiencies. However, we find insignificant coefficients for both variables. As another sensitivity test, for a subsample of firms whose auditors receive inspection reports containing audit deficiencies, we run regressions to test whether there is additional informational value for GAASDEF over GAAPDEF. The regression results (untabulated) show that the test variable GAASDEF has an insignificant coefficient. Accounting and the Public Interest 2017
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widely used as a financial distress measure. The coefficients for AUDDEF are not significant in both subsamples or in any of the z-score quintile subsamples. Similarly, we also test whether the dissatisfaction of shareholders with auditors receiving deficient inspection reports is high in poorly performing firms. Again, our sample is partitioned into two subsamples of above and below median performance using various proxies for financial performance (return on assets, industry-adjusted return, buy-and-hold return, and abnormal buyand-hold return). We do not find consistent evidence that shareholders more frequently vote against auditor ratification for auditors receiving audit deficiency reports when the performance of the firm is poor than when it is good. Other Contexts Finally, we test our research questions in various contexts where high audit quality is demanded or implied, such as high-litigation industries, firms facing financing needs, and auditor tenure. High-litigation industries are defined as industries with the following two-digit SIC codes: 28, 35, 36, 38, 60, and 67 (Hogan and Jeter 1999). Financing needs are defined as firms that obtain equity or debt financing in the current year. Short tenure is defined as firms whose auditor tenure is less than four years, long tenure as those whose auditor tenure is ten or more years, and median tenure as the remaining firms (Dao et al. 2008). We partition the full sample into subsamples of (1) high- and low-litigation industries; (2) firms with and without financing needs; and (3) firms whose auditors have long, median, and short tenure. When we rerun the regression on each subsample, we find that the coefficients for AUDDEF are not significant in any of those subsamples.
CONCLUSION, LIMITATION, AND FUTURE RESEARCH We examine the effect of inspection reports containing audit deficiencies on shareholder voting against management proposals regarding auditor ratification. We also examine whether shareholders are more likely to vote against the ratification of auditors receiving audit deficiency reports in a weak corporate governance environment. Generally, we do not find evidence that shareholders are more likely to vote against auditor ratification when the firm’s auditor receives an inspection report containing audit deficiencies than when the firm’s auditor receives a clean inspection report. However, we find weak evidence that the dissatisfaction rates of shareholders for firms whose auditors receive deficiency inspection reports increase in cases of weak corporate governance: (1) when the CEO also serves as chair of the board of directors, and (2) when the board is not diligent in holding its meetings. The findings in this paper have implications for regulators and users of information contained in the inspection reports. Shareholder voting on auditor ratification is a unique channel for shareholders to directly participate in the auditor selection process in a number of firms where management exercises enormous influence on the selection of an external auditor. The PCAOB inspection reports can be a reliable and direct source to inform shareholders of audit quality, which they would not observe otherwise. However, our results suggest that shareholders seem not to incorporate the inspection reports as an indicator of auditor quality in their decisions of auditor ratification. Although the PCAOB faces confidentiality restrictions in SOX, which appears to limit the informativeness of inspection reports, the PCAOB may consider some modifications to the inspection reports in order to provide more useful information, such as the severity of audit deficiencies, to information users. It also would improve the informative value of inspection reports if the inspection reports were released in a timelier manner. The release time after the end of an inspection is too long, several months (see footnote 10). Moreover, firms are encouraged to Accounting and the Public Interest 2017
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expand the disclosure about activities of their audit committees, particularly the decision process regarding auditor ratifications and selection criteria of the external auditor, so that shareholders can assess the audit quality of the current external auditor more easily and make the right decisions on auditor ratifications. These results must be interpreted in light of the following limitation. Despite a number of sensitivity tests, we cannot rule out the possibility that our failure to find strong results for our research questions is due to our choice of research design. The PCAOB discloses detailed quality control defects of registered auditors on its webpage if the auditors, who receive the inspection reports containing unpublicized quality control defects, fail to remediate such defects to the satisfaction of the PCAOB. Future research may examine shareholders’ view on the disclosure of detailed quality control defects for these auditors and the interplay of such views with corporate governance mechanisms. In addition, future research can examine the decision-making process for external auditor ratification through behavioral or experimental methodologies.
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APPENDIX A Variable Definitions Variable
Definition
¼ percentage of shareholders’ against or abstention votes on auditor ratification; ¼ natural log of VOTE; ¼ 1 if a firm’s auditor receives inspection reports containing audit deficiencies, and 0 otherwise; LASSET ¼ natural log of total assets; ROA ¼ ratio of net income to total assets; ADJRET ¼ two-digit SIC industry-adjusted one-year stock returns (one-year stock returns of a firm minus the mean of one-year stock returns in the same industry); DIRVOTE ¼ average percentage of votes withheld from the election of all incumbent director nominees; ARFEES ¼ ratio of audit-related fees to audit fees; TAXFEES ¼ ratio of tax fees to audit fees; OTHERFEES ¼ ratio of other fees to audit fees; RESTATE ¼ 1 if a firm has a restatement in the current year, and 0 otherwise; ICW ¼ 1 if a firm discloses material weakness(es) in internal control over financial reporting under SOX Section 302, 404(a), or 404(b), and 0 otherwise; LATEFILING ¼ 1 if a firm files a Form NT 10-K in the current year, and 0 otherwise; LAUDTEN ¼ natural log of auditor tenure; CEOCHR ¼ 1 if CEO also serves as chair of the board of directors, and 0 otherwise; ACEXP ¼ proportion of audit committee members with financial expertise on the audit committee; ACSIZE ¼ number of audit committee members; ACMEETING ¼ number of audit committee meetings; ACIND ¼ proportion of independent audit committee members on the audit committee; BSIZE ¼ number of board members; BMEETING ¼ number of board meetings; and BIND ¼ proportion of independent directors on the board. VOTE LVOTE AUDDEF
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