Abstract
We examine whether monitors are likely to compromise their monitoring objectivity in the face of economically important clients in international business settings. In the context of external auditing and assurance services, we measure monitor objectivity by whether auditors are more (or less) likely to issue to their important clients modified audit opinions, that is, audit opinions provided to outside investors about the firm that demotes explicit areas of concern. Using a large cross-country sample, we document that auditors are more likely to issue modified opinions to their economically important clients relative to other clients. Furthermore, we find that this association is stronger (1) for Big N auditors, (2) for multinational audit clients, and (3) in countries with stronger legal regimes. These results suggest that monitors prioritize the protection of their reputation over lucrative economic relationships, and such information certification function is more pronounced for international auditors, multinational client firms, and in strong legal regimes.
Abstract
Nous examinons si des auditeurs sont susceptibles de compromettre leur objectivité en matière d’audit en face de clients importants au niveau économique dans des contextes d’affaires internationales. Dans le domaine des services d’audit externe et d’assurance, nous mesurons l’objectivité en matière d’audit par le fait que les auditeurs sont plus (ou moins) enclins à fournir à leurs clients importants des avis d’audit modifiés, c’est-à-dire, des avis d’audit donnés à des investisseurs externes sur l’entreprise qui affichent des domaines de préoccupation explicites. Utilisant un échantillon multi-pays, nous montrons que les auditeurs sont davantage enclins à émettre des avis modifiés à leurs clients importants au niveau économique en comparaison à d’autres clients. Par ailleurs, nous constatons que cette association est plus forte (1) pour des auditeurs Big N, (2) pour des clients multinationaux d’audit, et (3) dans des pays avec des régimes juridiques plus solides. Ces résultats suggèrent que les auditeurs donnent la priorité à la protection de leur réputation par rapport aux relations économiques lucratives et que cette fonction de certification de l’information est plus prononcée pour les auditeurs internationaux, les entreprises clientes multinationales et dans des régimes juridiques plus solides.
Abstract
Examinamos si es probable que los monitores afecten la objetividad del monitoreo de cara a clientes económicamente importantes en los entornos de negocios internacionales. En el contexto de auditorías externas y servicios de aseguramiento, medimos la objetividad del monitor probando si es más (o menos) factible que los auditores emitan a los clientes importantes opiniones modificadas de la auditoria, esto supone que, las opiniones de auditoria que se dan a inversionistas externos acerca de la empresa denota la modificación de opinión a los clientes económicamente importantes en relación a otros clientes. Asimismo, encontramos áreas específicas de preocupación. Usando una amplia muestra internacional, documentamos que es más probable que los auditores hagan esta asociación: (1) para auditores Big N, (2) para clientes multinacionales auditados, y (3) en países con regímenes legales más fuertes. Estos resultados sugieren que los monitores priorizan la protección de su reputación encima de relaciones económicamente más lucrativas, y dicha función de certificación de la información es más marcada en auditores internacionales, empresas de clientes multinacionales, y en regímenes legales fuertes.
Abstract
Examinamos se monitores são suscetíveis a comprometer sua objetividade no monitoramento diante de clientes economicamente importantes em ambientes de negócios internacionais. No contexto dos serviços de auditoria e de garantia externas, medimos a objetividade do monitoramento pela probabilidade de auditores emitirem a seus clientes importantes pareceres de auditoria modificados, isto é, pareceres de auditoria prestados a investidores externos que reduzem explícitas áreas de preocupação. Usando uma grande amostra cross-country, relatamos que os auditores são mais propensos a emitir opiniões modificadas a seus clientes economicamente importantes do que a outros clientes. Além disso, concluímos que esta associação é mais forte (1) para auditores Big N, (2) para clientes de auditoria multinacionais e (3) em países com regimes legais mais fortes. Esses resultados sugerem que monitores priorizam a proteção da sua reputação em relação a relações econômicas lucrativas, e tal função de certificação de informação é mais pronunciada em auditores internacionais, em empresas-cliente multinacionais, e em regimes jurídicos fortes.
Abstract
我们检查了在国际商业环境中监控人员是否可能会在面对经济上重要的客户时在监控客观性上让步。在外部审计和保险服务的情境下, 我们通过监控人员是否会更多 (或更少) 可能地向其重要客户发出修正过的审计意见, 即向外部投资者提供的关于该公司对明显关注领域减少的审计意见来测量监控客观性。使用大型的跨国样本, 我们用文件证明相对于其他客户来说审计师更可能向其经济上重要的客户发出修正的意见。此外, 我们发现这种关联对 (1) 大N审计师、 (2) 跨国审计客户, 及 (3) 具有强大法律制度的国家更强。这些结果表明 : 监控人员优先保护他们的声誉而不是有利可图的经济关系, 而且这些信息认证功能在面对国际审计师、跨国客户公司以及强大的法律制度时更加显著。
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Notes
Information asymmetry is likely to be higher in an IB setting due to cross-jurisdictional differences in languages and cultures, geographical distance, and the difficulties associated with internal controls and external monitoring (e.g., Han et al., 2010; Kang & Kim, 2010).
By keeping distance with the management (or being “independent”), the monitor loses the potential advantages of obtaining private knowledge relevant to monitoring through establishing a proximate relationship with the management (Macey, 2004); but the attribute of independence by itself is considered valuable because an objective certification provides credibility to outside investors (and other contracting parties), and they are willing to pay more for securities with objective monitors.
At the extreme, a modified audit opinion could trigger regulatory actions. For example, in 2001 the Securities Exchange Commission (SEC) in the United States obtained a court order to freeze the assets of three Heartland municipal-bond funds after the funds failed to obtain an unqualified audit report from the auditor, PwC. The SEC commented that, “auditors’ refusal to opine on the valuations of the securities held in the Funds raises serious concerns about the value of the Funds, and whether investors in the Funds are redeeming shares in the Funds at correct values” (Damato, 2001).
The matched sample is obtained with the following procedure. For each observation in the OP=1 group with available market reaction data (future growth in sales or industry market share), we obtain a matched firm with OP=0 in the same country, industry and year with closest firm size and profitability. We drop the observation with OP=1 if we fail to obtain a proper matched firm with OP=0.
For example, while the 2-year ahead growth in industry market share for non-MNE clients receiving modified opinions is 2.5% lower than matched non-MNE clients, the MNE clients that receive modified audit opinions have 27% lower growth in industry market share than matched MNE clients that do not receive modified opinions.
In this article the term “conservative audit reporting” refers to auditors’ tendency to apply a stricter standard in deciding the type of audit opinion given the same (or similar) level of audit evidence obtained. Auditors with more conservative reporting behavior are therefore more likely to issue modified audit opinions.
In our sample period 1994−2012, the Big N auditors are the Big 6 during the 1994−1997 period (Arthur Andersen, Coopers & Lybrand, Deloitte Touche Tohmatsu, Ernst & Young, KPMG Peat Marwick, and Price Waterhouse), the Big 5 during the 1998–2001 period (Coopers & Lybrand and Price Waterhouse merged in 1998 to form PwC) and the Big 4 from 2002 onwards (subsequent to the demise of Arthur Andersen).
As Bell et al. (2012: 118) state, “[the] value of third-party endorsements (e.g., prestigious underwriters, audit firms, and alliance partners) in reducing the degree of uncertainty surrounding security issues is built upon the social status of the certifying organization. Therefore a relationship with a high-status partner can be considered a powerful endorsement for the unfamiliar firm, and thus act as a reputational source of legitimacy”.
For example, subsequent to the Enron debacle, it was reported that a sizable number of clients dismissed Arthur Andersen even before the audit firm was legally convicted by the court and barred from providing auditing services to publicly listed companies in the United States (Barton, 2005).
In the absence of litigation exposure, our test using non-US countries is also a more powerful setting to test the reputation argument.
From a global perspective, it was reported in 2013 that the aggregated global revenues of the Big 4 auditors rose to $113.8 billion and the number of staff approached 0.75 million (Financial Times, 2014). PwC, for example, revealed in their 2013 Annual Report that they had offices in 157 countries and provided services to 421 of the Fortune Global 500 companies and 452 companies in the Financial Times Global 500 in 2013. The revenue of PwC in 2013 was $32.1 billion, approximately one-third of that of IBM in 2013 ($99.7 billion).
For example, KPMG, one of the Big N audit firms, describes its own business as follows “sustaining and enhancing the quality of this professional workforce is KPMG’s primary objective … we contribute to the effective functioning of international capital markets” (www.kpmg.com/Global/en/about/Overview/Pages/default.aspx). Deloitte considers itself “the brand under which tens of thousands of dedicated professionals in independent firms throughout the world collaborate to provide audit, consulting, financial advisory, risk management, tax and related services to select clients” (www2.deloitte.com/global/en/pages/about-deloitte/articles/about-deloitte.html). EY explicitly recognizes the concept of globalization in its global approach: “At EY, we have long thought that globalization is one of the defining issues of our time. Our response has been to transform our organization so that we keep in step with the changing needs of our clients and our people … we’re not merely a loose collection of national practices – we are a global organization, unified in our approach” (www.ey.com/GL/en/About-us/Our-global-approach/2020-Vision_Our-global-approach). Finally, PwC states in its 2013 global annual review that “the key factors that differentiate PwC among the world’s leading professional services organizations are the talent of our people, the breadth of the PwC network and the standards with which PwC firms comply. These standards cover important areas such as service quality, governance arrangements, independence, risk management, people and culture, and brand and communications. PwC firms agree to follow network standards and their compliance with these standards is monitored regularly” (www.pwc.com/gx/en/annual-review/transparency.jhtml).
This can be achieved through a number of mechanisms. First, Big N auditors are organized into country-specific partnerships, and they superimpose a global administrative agency on top of each country-specific partnership (Francis &Wang, 2008) and register their country-specific partnerships under one brand name. Second, through specific organizational arrangements and agreements, these firms share technology and strategy within the global network. For example, Arthur Andersen maintained a training facility to ensure that staffs around the world were trained to use the same audit procedures (see Toffler, 2003). PwC also structures its network in such a way that, by “[focusing] on key areas such as strategy, brand, and risk and quality, the Network Leadership Team and Board of PwC International develop and implement policies and initiatives to achieve a common and coordinated approach among individual firms where appropriate. Member firms … can use the PwC name and draw on the resources and methodologies of the PwC network. In addition, member firms may draw upon the resources of other member firms and/or secure the provision of professional services by other member firms and/or other entities. In return, member firms are bound to abide by certain common policies and to maintain the standards of the PwC network” (www.pwc.com/gx/en/corporate-governance/network-structure.jhtml).
For example, subsequent to the Enron debacle, it was shown that Arthur Andersen’s larger clients with better corporate governance switched to other auditors more quickly (Barton, 2005), suggesting that losses associated with independence impairment could be huge for the Big N auditors.
For example, after Best Buy, the large electronics store, dismissed EY as its auditor due to conflicts of interest in 2005 (Taub, 2005), the firm had only three other large international accounting firms to choose from who were capable of performing the audit. Once Best Buy chose a new auditor, it had two remaining accounting firms to choose from to provide its management advisory services.
For example, establishing multinational businesses may require licensing a foreign manufacturer to produce its product, setting up a wholly owned subsidiary in a foreign country, opening up a sales office, setting up a warehouse, forming a joint venture with another firm, or buying into an existing firm in another jurisdiction. Moreover, because MNEs operate in a number of countries, their worldwide-consolidated financial statements are usually drawn up according to the accounting standards and practices of one country only, usually those of the MNE’s headquarters. Given the complexity of MNE operations, Duru and Reeb (2002) find that greater corporate international diversification is associated with less accurate analysts’ earnings forecasts, partly because analysts find it more difficult to generate forecasts when income is earned from a number of different jurisdictions.
The stronger demand for information certification process arises from the following sources: (1) the operational activities involved in international purchases and sales are much more complex than a domestic transaction. A firm that receives an unsolicited inquiry or purchase order from a foreign buyer may have to go through additional procedures to assess the credit period of the payment. The buyer may not be listed in any of the international credit rating directories, and the firm may need to ask its bank to have its foreign affiliates check on the buyer’s credibility. Alternatively, it may ask the buyer to supply financial information. The buyer may be willing to supply financial statements, but these statements may be difficult for the firm to interpret (e.g., the statements may be in a foreign language and may be based on foreign accounting assumptions and procedures). These procedures will be facilitated if that financial information is audited at certain acceptable quality levels. (2) More extreme information asymmetry across countries necessitates a credible set of financial statements to ensure smooth contracting among international business partners. More stakeholders (including regulators and investors from multiple countries) rely on auditors’ assurance on financial statements before they can properly assess whether international business activities are advantageous or detrimental to them (Radebaugh et al., 2006: 24).
As an example, Tata Nano is one of the cheapest and fuel-efficient models of automobile in recent years. However, the failure to achieve safety standards and its incidents of failure in crash tests and of the cars spontaneously erupting into flames contribute to the failure of the model to sell internationally (see Kinetz, 2010).
In a sensitivity test, we use an alternative design by including measures of legal regimes and the relevant interaction terms in the pooled sample, and the results (not tabulated) are similar.
It ranges from a significant change in an accounting policy or a justifiable deviation from local reporting practices to more serious issues identified by auditors such as uncertainties about the use of going-concern assumptions in preparing the financial statements, severe disagreement with the client on the acceptability of the accounting policies selected or the methods of application, or even a disclaimer of opinion when the auditor is not able to obtain sufficient evidence to arrive at an opinion. For example, we observe that the proportion of firms that receive modified audit opinions is very high for some countries included in our test sample (e.g., the mean OP in Greece is 0.644, as shown in Panel A of Table 3) due to different local requirements and reporting practices.
For countries with more than 100 observations in our sample, we randomly select a sample of modified audit reports that appeared in our sample for the most recent 3 years (2010−2012), and trace these observations to the source documents. In total, we checked 200 firms with 382 modified auditor reports from 32 countries (covering 96% of the total sample countries used in our tests) and confirmed the validity of our measure. Based on the audit reports we checked, we also find that the audit scope and the opinions based on the audit scope vary in different jurisdictions. For example, auditors are required to assess the representation of the company in management reports in Germany. In Greece, auditors need to assess various compliance requirements, including whether financial reports as well as the director’s report comply with IFRS and the code of law (including tax). Despite these differences, we also find that the modified audit opinions we checked demonstrate auditors’ refusal to give a clean report due to their concerns about the quality of financial reporting. In one sensitivity test, we remove from our sample those countries where validity checks on modified audit opinions were not practically feasible. The results are similar to those reported in this article. In another sensitivity test, we also include country-fixed effects in our empirical models to further control for the difference in the practice of issuing modified audit opinions across countries, and we obtain similar results as those reported.
We admit that OP is not the perfect measure of audit quality. However, if the imperfection of the measure comes from the noise caused by the regulatory requirements of some countries requiring auditors to issue modified opinions unrelated to their judgment on the clients’ financial reporting quality, then such noise is likely to include clean cases as OP=1 in an incorrect way, that is, this overstates Prob(OP). The errors in the measure, if any, will therefore be likely to be biased against us finding the results consistent with our expectations.
In principle, the audit fee received by the auditor is a better measure than client total assets to compute our client importance measure. However, because not all countries in our sample require the disclosure of audit fees, our analyses using audit fees to measure client importance will be limited by data constraints. In particular, imposing the requirement on the availability of audit fees reduces the sample size from 43,189 to 25,670 (a drop of 40.6%). We also run a simple regression of audit fee on client size and find that the R2 is 62.13%, suggesting that the use of assets to replace audit fees to measure client importance is reasonable. Nevertheless, we use audit fee instead of client size as the basis to compute client importance in a sensitivity test and yield similar results.
Adjusting CI with country-year medians has the advantage of controlling for the client size differences across countries that may affect the economic importance of clients to auditors. Consider, for example, that auditor X has audit clients in both the United Kingdom and in Kenya; the clients in the United Kingdom are likely to be larger than those in Kenya so all clients in the United Kingdom will be considered as economically important clients if we use CI (i.e., not adjusted by country-year medians). However, using the country-year median-adjusted CI (i.e., CIMP) also has the disadvantage that our results may wrongly classify economically unimportant clients in a small country (such as Kenya) as equally important as an important client in a large country (such as the United Kingdom). We use CIMP in our main tests because errors in this measure will be biased against us finding the results consistent with our expectations. In a sensitivity test, we replace CIMP with CI and re-run all analyses and the results are qualitatively similar (not reported for brevity).
As pointed out by Kim et al. (2012), the Wingate index may not capture recent changes in the legal environment. We therefore include also the two other dimensions to measure the strength of a legal regime.
In a sensitivity test, we remove LAG(OP) and define OP as 1 only for the first-time modified audit opinion in the sample. The untabulated results are qualitatively similar to our main findings. Note that this reduces the power of our test variable significantly in our sample, as the percentage of observations with OP=1 drops from 18.7% to 8.0%.
One may argue that voluntary IFRS adopters are associated with better accounting quality (Barth, Landsman, & Lang, 2008) and thus reduced audit risk, leading to a lower probability of receiving modified audit opinions. On the other hand, IFRS is likely to increase audit complexity, as it is a comprehensive standard (Kim et al., 2012), and such complexity could lead auditors to issue more modified opinions when clients’ reporting is not consistent with the accounting standards.
Francis & Wang (2008) and Francis et al. (2013) note that there is an auditor miscoding problem for Japan, South Korea, India and Pakistan (e.g., on average the market share of Big N auditors in Japan is less than 1%, which is unlikely to be true); and there are miscoding problems after 2005 for all countries. We manually collected auditor identity data from Capital IQ and corrected the miscoding issue in Compustat Global after 2005 for most countries. However, the auditor identity data for the aforementioned four countries are still largely miscoded (for example, the average market share of Big N auditors for Japan is still less than 1%). Hence we use the sample period from 1994 to 2012 and exclude these four countries. In a robustness check, we re-run all analyses using the period from 1994 to 2004, and the results are qualitatively similar.
In a sensitivity test, we exclude from our analyses those countries with unusually high country mean OPs (>0.40), including Egypt, Greece, Indonesia, Jordan, Portugal, and Turkey, and our inferences remain unchanged.
Consistent with prior literature (e.g., DeFond et al., 2002), we find that “contrary” factors such as LEV, CLEV, ZSCORE, LOSS, BETA, and STDRET are significantly associated with greater probability of issuing modified audit opinions (OP). In contrast, mitigating factors including SIZE, TURNOVER, and CFO are negatively associated with the probability of issuing modified audit opinions (OP). For the country-level control variables, the results show a significantly negative relationship between stronger legal regime (STRONG) and OP, suggesting that clients’ tendency to manipulate financial reporting is constrained by investor protection regime and thus these clients are less likely to receive modified audit opinions. We also find that, consistent with Kim et al. (2012), a higher MB proxied for greater complexity and risk is associated with greater likelihood of receiving modified audit opinions. Also, a country’s overall economic development level (GDP) and economic growth (GDPGR) are positively associated with OP. GDP per capita is negatively associated with OP. The estimated coefficients of the other control variables are generally consistent with the literature (e.g., Chen et al., 2010; DeFond et al., 2002) although they are not statistically significant.
The benefit of this approach is that it controls for country-level characteristics that may affect the likelihood of issuing modified audit opinions. The cost, however, is the loss of some sample countries in our analyses due to the unavailability of certain country-level data, which reduces the generalizability of our findings. For example, only 49 countries have data available for FACTOR, 44 countries have data available for WINGATE, and 42 countries have data available for RULE.
For example, the accounting or audit profession has its own law, statutory requirements, minimum education and entry requirements, auditing standards, independence and ethics codes, and oversight mechanisms (Michas, 2011), which are different from other industries. In terms of organizational form, auditing practices typically operate in the form of partnerships or limited liability companies (LLCs). Further, unlike MNEs that promote and sell tangible products overseas, international auditors develop their businesses through promoting their professional competence and reputation. Objectivity or independence is therefore a central issue constituting their reputation building.
The concerns about the impairment of auditor independence to the quality of the client firms’ financial reporting lead governments or professional bodies in different jurisdictions to introduce ethical standards and rules to regulate auditors. For example, SOX of 2002 introduced a number of initiatives in the United States to improve auditor independence in response to the accounting scandals in the early 2000s, and the European Commission vigorously reviews and recommends the rules and practices in the field (European Commission, 2010). The International Federation of Accountants (IFAC, 2012) also identifies independence as an important component of ethics standards. In addition to regulators and the accounting profession, international investor communities such as the International Organization of Securities Commissions (IOSCO, 2002) express similar concerns, emphasizing the importance of independence in upholding the confidence of international information users on financial reporting. These new regulations and discussions not only have implications for the auditing profession, but ultimately affect the way in which international businesses are regulated. For example, it is believed that the SOX has “forever changed the landscape of corporate governance. It has increased the accountability expectations we have of directors and officers, and their legal and accounting advisers as well …. All of these are hallmarks of a more active, engaged and informed board” (Peregrine, 2012).
For example, Berry, Guillen, and Zhou (2010) provide a framework that accommodates the different dimensions of cross-national distance. In addition to the legal regime or legal protection of investors (what they call the “national systems of governance”), other dimensions such as “national business systems” and “national innovation systems” may also affect the information certification roles of auditors.
The institutional theory suggests that the interaction between the firm and its institutional environment is by no means a one-way street from the regulators to the regulated (Forsgren, 2013: 140), and in certain cases MNEs may obtain favorable treatments from institutions compared with domestic firms (Edman, 2009).
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Acknowledgements
We are grateful to David Reeb (the editor), three anonymous reviewers, Andy Chui, Chuck Kwok, Woo Jong Lee, Grace Pownall, Suresh Radhakrishnan, Katherine Schipper, Bin Srinidhi, Nancy Su, and workshop participants at the AFAANZ 2011 annual meeting and 2014 Journal of International Accounting Research (JIAR) conference for their helpful comments. Xindong (Kevin) Zhu acknowledges financial support from the City University of Hong Kong (Grant no. 7200309).
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Accepted by David Reeb, Area Editor, 23 June 2015. This article has been with the authors for three revisions.
Appendices
APPENDIX A
APPENDIX B
Construction of Investor Protection Measure (FACTOR)
Following a stream of prior studies that investigates the effect of investor protection (e.g., Francis & Wang, 2008; Francis et al., 2013; La Porta et al., 1998, 2006), we construct an aggregate measure of investor protection (FACTOR) based on five important elements that constitute a country’s investor protection (COMMON, ANTIDIR, DISC, LIAB, and PUBENF, as defined in Appendix A). We identify the commonalities underlying the various measures of investor protection through a factor analysis, where we attempt to reduce the number of variables by constructing a range of variables that contain most of the information. Panel A of Table B1 below presents the Pearson correlations among the five measures of investor protection indices. All pairwise correlations are significantly positive (p<0.01), suggesting that these five indices are highly correlated. We then perform a principal factor analysis using maximum likelihood estimation procedures on the five investor protection measures to extract a proxy for the unobserved investor protection construct. We obtain five factors using this analysis, and their eigenvalues are reported in Panel B of Table B1. The first factor is retained because it is the only factor that has an eigenvalue greater than 1 (eigenvalue=2.389), and this factor accounts for essentially all of the shared correlation among the five investor protection measures (the cumulative proportion=1.026). To extract an estimate of the unobserved investor protection measures, we develop a composite index by combing the five original investor protection indices using the scoring coefficients as shown in Panel C. We label the composite investor protection index FACTOR. The value of FACTOR is standardized, with a mean of zero and Table B2 shows that it ranges from −1.39 in Austria to 1.72 in Canada.
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Fung, S., Zhou, G. & Zhu, X. Monitor objectivity with important clients: Evidence from auditor opinions around the world. J Int Bus Stud 47, 263–294 (2016). https://doi.org/10.1057/jibs.2015.22
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DOI: https://doi.org/10.1057/jibs.2015.22