Knowledge that Transforms

We examine the effects of audit quality on earnings management and cost of equity capital for two groups of Chinese firms: state-owned enterprises (SOEs) and non-state-owned enterprises (NSOEs). The differences in the nature of the ownership, agency relations and bankruptcy risks lead SOEs to have weaker incentives than NSOEs to engage in earnings management. As a result, the effect of audit quality in reducing earnings management will be greater for NSOEs than for SOEs. In addition, investors’ pricing of information risk as reflected in the cost of equity capital will be more pronounced for NSOEs than for SOEs with high and low audit quality. We find empirical evidence consistent with these hypotheses. Our findings indicate that (1) while high-quality auditors play a governance role in China, that role is limited to a subset of firms, and (2) even under the same legal jurisdiction, the effects of audit quality (in the form of lower earnings management and cost of equity capital) vary across firms with different ownership structures. Our study extends prior research by focusing on the economic consequences of SOEs’ and NSOEs’ auditor choices and underscores the importance of controlling for ownership type when conducting audit research.

This study investigates Arthur Andersen’s audit quality in the decade before the collapse of Enron. Andersen’s involvement in the Waste Management audit failures — which relate to audits of the company’s 1992- 1996 financial statements — led the SEC to accuse Andersen of issuing false and misleading audit reports and resulted in a permanent injunction that prohibited Andersen from further violation of securities laws. We examine whether the Waste Management audit failures were symptomatic of widespread audit deficiencies at Andersen. Using three empirical measures of audit quality — discretionary accruals, clients’ propensity to meet or just beat analyst forecasts, and accounting misconduct identified by Accounting and Auditing Enforcement Releases (AAERs) — we find no overall evidence suggesting lower average audit quality at Andersen relative to the Big 4 during the period 1992-2001 for a sample of S&P 1500 firms. Focusing on high litigation risk firms, however, we find larger absolute and income-increasing accruals and a greater propensity to meet or just beat analyst forecasts for Andersen clients relative to the Big 4 clients in the period August 7, 2000 to December 31, 2001, after Andersen’s divorce from Andersen Consulting. These findings provide some evidence that, after the divorce, Andersen was not able to constrain aggressive accounting where it may have mattered most, that is, among its clients with the highest litigation risk.

This paper presents an in-depth longitudinal case study examining the processes through which practitioners in two Big 4 professional services firms have attempted to construct sustainability assurance (independent assurance on sustainability reports). Power’s (1996, 1997, 1999, 2003) theorization of the way in which new subject areas are made auditable is used to frame the findings. The case analysis reveals the fragile nature of efforts to innovate with sustainability assurance and render sustainability reporting auditable. It suggests that innovation in new assurance practices may be constrained by an over-reliance on traditional financial audit training and techniques and certain internal professional services firm control procedures. Practitioners are shown to have experienced considerable discomfort in their attempts to construct a stable and legitimate knowledge base for assurance practice. Tacit knowledge embedded in highly subjective assessments of evidence has been frequently enrolled to make assurance possible in the presence of vague guidance from assurance standards. In light of ongoing practitioner struggles, both firms have publicly acknowledged the limitations of traditional financial audit practice operating alone in the conduct of sustainability assurance. In order to offset these limitations, they have proposed a coupling of ‘‘expert’’ stakeholder assessments of reporting completeness with traditional audit assessments of data reliability. This assigns part of the responsibility for delivering on a key assurance objective (reporting completeness) to what many practitioners perceive as questionable stakeholder expertise. The findings extend prior research highlighting the trial and error nature of the processes through which accountants seek to develop their presence in new markets for their expertise. They also question the extent to which the core aims being espoused for sustainability assurance can be substantively aligned with the operational capabilities available within Big 4 professional services firms.