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Firm versus Partner Measures of Auditor Industry Expertise
and Effects on Accounting Restatements
Abstract
This paper examines whether the likelihood of accounting restatements is associated with the Big 4 industry auditor specialists, measured at both the partner–level and audit firm-level leadership. We focus on a sample of listed firms in Taiwan where audit reports must be audited and signed by the two signing auditors as well as by an audit firm. Extending previous studies (e.g., Francis et al., 2005, 2006), we classify industry specialists into three groups: (1) auditors that are industry specialists at both the individual partner-level (i.e. the lead signing auditors) and the firm-level; (2) auditors that are industry specialists at the individual partner-level, but not at the firm-level; and (3) auditors that are industry specialists at the firm-level, but not at the individual partner-level. The results reveal that clients of signing auditor specialists, either alone or in conjunction with firm-level specialists, are less likely to make accounting restatements relative to those of other auditors. However, we find no evidence that firm-level auditor specialists alone are associated with a smaller likelihood of accounting restatements. The results suggest that differential likelihood of accounting restatements due to the Big 4 industry expertise is primarily attributable to the signing partner specialists (i.e. lead auditor specialists) rather than auditor specialists at the firm level. We also find that differential restatement likelihood due to signing auditors’ expertise is driven by lead auditor’s expertise rather than concurring auditor’s expertise. Finally, we find that restatements involving material or core earnings are less likely as auditors’ industry expertise increases.
Keywords: partner industry specialist, audit firm industry specialist, accounting restatements
1. Introduction
The incidence of accounting restatements and financial reporting fraud has increased dramatically over the past decade (GAO-03-138,GAO 2002a; Wu, 2002). The erosion in the quality of financial reporting as evidenced by the proliferation of accounting restatements has caused concern among academics, practitioners, and regulators (e.g., Richardson et al., 2003; Hirschey et al., 2003). Despite the number of researches on the determinants of accounting restatements (e.g., Baber et al., 2006; Myers et al., 2005), little work to date explores the association between industry auditor specialists and accounting restatements. The objective of this paper is to explore whether the accounting restatement likelihood is associated with Big 4 auditor’s industry expertise,1 as measured by the audit-firm level and signing-auditor level leadership. Specifically, we investigate whether differential restatement likelihood due to Big 4 audit industry expertise is driven by firm expertise, individual partner expertise, or perhaps some combination of both. Second, this study further investigates whether the association between restatements and industry auditor specialists varies between lead and concurring auditor industry experts.
It is well documented that Big 4 auditor expertise generally enhances earnings and financial reporting quality. For example, prior studies find that firms retaining specialist auditors tend to experience higher ERC (Balsam et al., 2003), lower discretionary accruals (Myers et al., 2005), higher client satisfaction (Behn et al., 1999), and higher disclosure levels (Dunn and Mayhew, 2004). On the other hand, accounting restatements generally signal that prior financial statements are incredible and are of relatively lower quality. Prior studies find that accounting restatements
1 The term “Big 4” dates back from 2002 and refers to the remaining four large international audit firms after the
lead to both decreases in expected future earnings and increases in the firm’s cost of equity capital (Hribar and Jenkins, 2006), and in turn result in a substantial loss of market value, with abnormal returns ranging from -4 to -12% (e.g., Dechow et al., 1996; Palmrose et al., 2004). Lev et al. (2007) further find that restatements that eliminate or shorten histories of positive earnings or of earnings growth trigger a negative market reaction to the restatement announcement and an increase in the likelihood of class action lawsuits. During his term as SEC chairman, Arthur Levitt (2000) stated “In recent years, countless investors have suffered significant losses as market capitalizations have dropped by billions of dollars due to restatements of audited financial statements”. Thus, we first investigate whether clients of the Big 4 industry specialist auditors are less likely to restate statements than those of the Big 4 non-specialist auditors.
There are two contrasting views of conceptualizing the operation of a Big 4 audit firm (Ferguson et al., 2003; Francis et al., 1999). The national-level perspective assumes that audit firms capture industry expertise through knowledge-sharing practices such as internal benchmarking of best practices, the use of standardized industry-tailored audit programs, and extending the reach of professionals from their primary local-office clientele to other clients through travel and internal consultative practices. An alternative perspective (i.e. office-level or city-specific perspective) is that auditor expertise is indelibly tied to individual professionals and his/her deep personal knowledge of clients, and thus cannot be readily captured and distributed by the firm to other offices and clients. Recent studies provide evidence more consistent with the latter perspective (e.g., Ferguson et al., 2003; Francis et al., 1999, 2005, 2006).
This paper extends these two perspectives by examining the association between accounting restatements and Big 4 industry expertise at both the partner-level (i.e. signing
auditor specialists) and the audit firm-level,2 and further investigate the relative effectiveness of
firm-level and partner-level industry specialists in reducing accounting restatement likelihood.
To address these issues, we use a sample of listed firms in Taiwan to test our hypotheses. The audit report in Taiwan contains two signing auditor names (lead and concurring auditors) as well as the audit firm’s name, in contrast to the U.S., where the audit report only contains the audit firm’s name. Data availability of names of the signing auditors as well as the audit firm provides us with a unique setting for investigating the alleged association between auditor specialization and accounting restatement likelihood at the individual-auditor level and at the audit-firm level simultaneously.
From a city-specific perspective, the individual practice office is the decision-making unit of the firm wherein auditors contract with clients, administer audits, and issue audit reports. Therefore, the individual practice office is a more appropriate unit of analysis for evaluating its potential effect on auditor reporting decisions (Reynolds and Francis, 2001), and national market share data obscures city-city variation, both between Big 6 firms and within the same Big 6 firm across different city markets (Francis et al., 1999). Recent studies on the association between industry expertise and audit quality (or auditor fees) provide direct evidence of a city-specific perspective (e.g., Francis et al., 2005, 2006; Ferguson et al., 2003). The argument for a city-specific perspective can be extended to the partner-level industry expertise. Signing partners plan and implement the engagement, and ultimately determine the type of audit report to be issued to the client. Following the same rationale underlying this perspective, signing
2The Big 4 audit firms are organized as national partnerships with national administrative offices that set firm-wide
policies and provide technical support for their city-based practice offices in the U.S. In contrast, the city offices in Taiwan are mainly located in five cities (i.e. Taipei, Taichung, Kaoshiung, Tainan, and Hsinchu), which are very close to one another, as the area of Taiwan’s territory is smaller. In addition, the signing auditors are primarily concentrated in the Taipei office. Since there is a lack of publicly available data on city-level auditors, in combination with the above features of city offices in Taiwan, we do not further investigate the association between audit quality and industry expertise at the city-specific level.
partner-level specialists thus might be expected to have the most critical and direct effect on audit quality and are a more appropriate unit of analysis relative to firm-level specialists. In addition, by revealing their name to users of financial statements, signing partners (lead and concurring auditors) could perceive inclusion of their names in the audit report as an increase in risk of suffering from loss of personal reputation and monetary assets in the case of an audit failure. Thus, disclosure of signing partners’ names on audit report provides them with a stronger incentive to enhance audit quality. For these reasons, whether clients of the Big 4 signing auditor specialists have a more pronounced effect on accounting restatements likelihood than firm-level audit specialists is an intriguing but unanswered question.
Following and extending studies from Ferguson et al. (2003) and Francis et al. (2005, 2006), we classify industry specialists into three groups: (1) auditors that are industry specialists at both the partner-level (i.e. the lead signing auditors) and at the firm-level; (2) auditors that are industry specialists at the partner-level, but not at the firm-level; and (3) auditors that are industry specialists at the firm-level, but not at the partner-level. Consistent with our prediction, the empirical results reveal that signing auditor specialists, either alone or in conjunction with firm-level specialists, are significantly associated with lower likelihood of making accounting restatements than counterparts that are non-specialists. Contrary to our expectation, we find no evidence that firm-level auditor specialists alone are associated with the smaller likelihood of accounting restatements. The results suggest that the differential likelihood of accounting restatements due to industry expertise is primarily attributable to the partner specialists (i.e. lead auditor specialists) rather than auditor specialists at the firm level. We further find that differential restatement likelihood due to signing auditor specialists is primarily driven by the lead rather than concurring auditor.
Finally, we perform several additional analyses. First, since there is variation in the severity of the response to market restatements, we thus focus on misstatements most likely to be of consequence to investors, and in turn, of greatest concern to regulators. We find that restatements involving material or core earnings are less likely as auditors’ industry expertise increases. Next, we investigate whether our results are driven mainly by accounting restatements initiated by companies/auditors or the Taiwanese Securities and Futures Bureau (hereafter TSFB), and show that our findings are driven by both. Third, we examine whether the association between auditor expertise and accounting restatements varies across annual and interim restatements, and also find that the association is driven mainly by signing auditor expertise, regardless of annual or interim subsamples, consistent with those based on a full sample; however, we find the weak association between firm-level audit expertise and the accounting restatements likelihood for the interim restatements sample. Lastly, we find that the TSFB-initiated restatements are more “serious” than are the companies/auditors-initiated restatements.
Our paper contributes to the literature in several ways. First, we contribute to the literature on industry auditor expertise and accounting restatements by linking industry auditor expertise and restatements. Prior studies on industry audit expertise use various measures to proxy for audit (or earnings) quality, including the discretionary accruals and missed going concern reports. In contrast, this paper explores and documents the significant effect of industry auditor expertise on the incidence of accounting restatements. Although high accruals may proxy for the poor quality of financial restatements, but these accruals may not arise from a violation of GAAP. Thus the auditors would not necessarily have the backing of GAAP when he/she is to advise a company to change its financial reporting with extreme discretionary accruals. Analogously, missed going concern reports don’t reflect on the accuracy of accounting use to prepare financial
reporting. In contrast, our analyses focus exclusively on restatements (and material restatements) arising from the violation of GAAP, which arguably impose greater costs on companies and investors (e.g., Palmrose et al., 2004).
Second, we contribute to the literature by further documenting that differential effects on restatements due to industry auditor expertise is mainly driven by a signing auditor, in particular a lead auditor. However, prior studies on auditor industry expertise are mainly based on the assumption that auditors are homogeneous within the audit firm or within the practice office.
The remainder of this paper is organized into five sections. Section 2 describes the institutional background and reviews relevant literature, Section 3 describes our research design, sample selection, and data sources, Section 4 reveals the empirical results and findings, and Section 5 presents our conclusions.
2. Background and Literature 2.1 Institutional background
Audit firms in Taiwan
In the United States, the audit report of a publicly listed company bears the signature of the audit firm and indicates the city in which the audit firm is located but does not include the partner’s identity. Therefore, the extant studies on industry expertise are primarily based on firm-level industry expertise. However, a number of studies find that industry knowledge and expertise in auditing are derived from the firm’s human capital investments in accounting professionals and his/her experiences in servicing clients mainly out of city-based practice offices (Francis et al., 1999; Solomon et al., 1999). Thus, recent studies on industry expertise re-evaluate this research in light of city-level specialists (Ferguson et al., 2003; Francis et al., 1999, 2005, 2006).
In contrast, the Taiwanese Securities and Futures Bureau (hereafter TSFB, which is similar to the Securities and Exchange Commission in the U.S)3 passed Article 2 of the Criteria
Governing Approval for Auditing and Certification of Financial Reports of Public Companies by
Certified Public Accountants (hereafter CGAAC) in 1972, which stipulated that the financial
reports of a public company in Taiwan must be audited by a practicing certified public accountant from an audit firm and signed by the practicing auditor. Furthermore, to enhance the credibility of audit quality, the Securities and Futures Bureau amended the CGAAC law in 1982 and mandated that after 1983, the financial reports of a listed company are required to be jointly audited and signed by two practicing auditors as well as the audit firm. Additionally, Statement of Auditing Statement of Auditing Standard No. 33 “Auditor Report on Financial Statements” also requires that audit reports should be signed in the name of two independent auditors as well as in the name of the audit firm. Generally, in addition to reinforcing their independence, joint-auditorship has advantage to offer a double check of audit’ diligences. In practice, joint-auditorship is often characterized by the lead auditor, who imposes its quality standards, and a “second auditor” (i.e., concurring auditor) of a lower caliber (Piot and Janin, 2005). This unique regulation provides us with a setting to further investigate whether accounting restatements due to audit industry expertise is driven by firm expertise, partner expertise, or some combination of both.
In Taiwan, auditors are governed by the Security and Exchange Act, Business Accounting Law, and Certified Public Accountant Law. According to the regulations, since auditors,
3 The TSFB has stipulated four policy directives for the purpose of administering and supervising securities
issuance, securities trading and futures trading, facilitating national economic development, protecting investors’ interests, developing the futures market, and maintaining futures trading orders. The four general policy directives are: (1) To foster the sound development of the capital markets and to encourage fund raising through public offering of securities; (2) To improve the operation of the securities and futures markets and to ensure a fair and efficient market environment; (3) To promote the development of the securities service industries and to facilitate the flow from savings into investment; (4) To regulate certified public accountants and to enhance their professional standards (http://www.sfb.gov.tw/e1-2.asp).
including the signing two partners and the audit firm, co-sign the same audit report, they are jointly held liable for the potential civil liability and administrative sanctions arising from fraudulent financial statements. In addition, the former are also jointly held for potential criminal responsibility related to fraudulent financial statements.4 Moreover, according to the above regulations and Corporate Law, issuers and managers are also jointly held liable for the civil and criminal liability arising from fraudulent financial statements.5
Accounting restatements in Taiwan
The Generally Accepted Accounting Principle (GAAP) and Generally Accepted Auditing Standard (GAAS) in Taiwan are very similar to those under the U.S. regulation since they are modeled after the American GAAP and GAAS. Thus, the causes and types of accounting restatements in Taiwan are generally the same as those in the U.S. Like the U.S., the need for restatement can be identified by the company, an independent auditor, or the TSFB. There are various requirements under the Taiwan Securities Acts for companies to correct inaccurate, incomplete, or misleading disclosures. Auditors who become aware of facts indicating that previously issued financial statements contain material omissions or misstatements are required by the Taiwan GAAS to advise the client to make appropriate disclosures, and to take whatever steps are necessary to be sure this is done. However, it can be hard to distinguish between the company- and auditor-prompted restatements from the public sources in Taiwan, since the restatements decisions are typically made jointly by both the company and the auditors.
4 See, for example, Articles 32 and 174 of Security and Exchange Act, Articles 71 and 72 of Business Accounting
Law, and Articles 39 and 40 of Certified Public Accountant Law.
5 For example, for the well-known Procomp scandal in Taiwan, which involves fraudulent financial statements and
top management fraud, managers were subject to criminal punishment, and the signing partners were all suspended from practicing for two years. In addition, the audit firms were also subject to substantial civil monetary penalties.
Finally, Article 6 of the Securities and Exchange Law Enforcement Rules (thereafter SELER) stipulates that in case the total adjusted sum of the after tax profit and loss is equivalent to or more than NTD 10,000,000, and reaches one percent of the originally audited operating revenue, or is five percent or more of the paid-in capital of the company, the financial reports shall be restated, and publicly disclosed. According to this rule, the TSFB would require companies to restate financial reporting when misstatements meet this “seriousness” or “materiality” threshold. Thus, the TSFB-initiated restatements are generally perceived to be more serious or material than those initiated by the others.
Like the U.S. (see Wu, 2002), accounting restatements in Taiwan typically occur when the party identifying the need for the restatements determines that the company’s financial statements involved either errors resulting from mathematical mistakes, oversight, or misuse of facts at the time they were filed, or accounting irregularities. This paper defines restatements as these corrections of financial statement that did not comply with existing GAAP at the time they were filed. Required and routine revisions of prior results are not included in our sample, such as changes in accounting principles or policies resulting from adoption of a new accounting standard or policy, dividend distributions,6 discontinued operations, mergers and acquisitions, and change of the accounting period, etc.
In Taiwan, restatements can involve TSFB-filed annual reports, which are audited, and possibly quarterly (reviewed) reports. The TSFB requires that companies file amended financial statements to replace the original reports when prior results have been misstated. Therefore, the filling of amended annual or quarterly reports with corrected results is an important criterion in the determination of whether a restatement was actually a correction of non-GAAP reporting.
6 Article 156 of Company Act and Article 14 of Regulations Governing Handling of Stock Affairs by Public
Companies in Taiwan stipulated that each share shall have the same par value, and the par value of stock certificates shall be ten New Taiwan Dollars. Therefore, stock split is prohibited in Taiwan.
2.2 Literature
Industry expertise and audit quality
Auditor specialists typically have the incentive and the ability to provide high quality audit services. For example, industry-focused audit firms invest more in technologies, physical facilities, personnel, and organization control systems that improve the quality of audits in the firms’ focal industries (Simunic and Stein, 1987). In addition, industry-experienced auditors are better able to detect errors within their industry specialization than outside their specialization (Owhoso et al., 2002; Bedard and Biggs, 1991; Wright and Wright, 1997). Auditor specialists also exhibit greater compliance with audit standards than non-auditor specialists (O’Keefe et al., 1994) and are less likely to be associated with SEC enforcement actions (Carcello and Nagy, 2004). Research also indicates that earnings quality (i.e., abnormal accrual) is higher for client firms audited by industry specialists than non-specialists (Balsam et al., 2003; Krishnan, 2003, 2005). Using Taiwan data, Chen et al. (2005, 2006) also report higher earnings quality for clients of the Big 4 industry experts relative to those of non-experts. Overall, these findings indicate that firm-level industry expertise has value to clients and capital markets view audits provided by industry specialists as having higher quality.
Recent studies suggest that audit research could usefully focus on practice offices where auditors contract with clients and conduct audit services. Two recent studies in the audit pricing report that higher audit fees for the Big 4 industry auditor specialists are driven mainly by the city-specific specialists, and auditors that are firm-wide leaders alone do not earn a premium.7
7 There is evidence form the U.S., Australia, Taiwan, and Hong Kong that a Big 4 audit firm’s national industry
expertise results in higher fees relative to non-Big 4 audit firm (Craswell et al., 1995; Defond et al., 2000; Chen et al., 2004; Francis et al., 2005). For example, using Taiwan data, Chen et al., (2006) also find that Big 4 auditors that are firm-level experts charge higher audit fees, indicating that Big 4 auditor specialists provide higher quality services.
Based on the Australian data, Ferguson et al. (2003) document an audit premium for auditors that are both firm- and office-level industry expert; however, auditors that are firm-level experts alone do not earn a premium. Francis et al. (2005) examine the U.S. audit market using the framework in Ferguson et al. (2003), and report a premium for auditors that are office-level experts alone, and find that audit fees are highest when the Big 4 auditors are jointly firm-level and office-level experts. They also report a premium for auditors that are office-level experts alone, and that firm-level experts alone do not earn a premium.
Finally, using the same sample of firms in Francis et al. (2005), Francis et al. (2006) further find that earnings quality (accrual and whether to meet or beat analysts’ earnings forecasts) are higher for firms audited by industry experts, either alone or in conjunction with national industry expertise. In contrast, earnings qualities of firms audited by national industry experts alone are never significantly different from earnings quality of firms audited by non-industry experts. These results indicate that the audit fee premium for office-level industry expertise document in Francis et al. (2005) maps to higher quality client earnings in the study by Francis et al. (2006).
Accounting restatements
The other stream of literature that is related to our paper examines the determinants of accounting restatements. Kinney and McDaniel (1989) find that, relative to other companies in their industry, restating companies are smaller, less profitable, have more debt, grow more slowly, and receive more uncertainty-qualified audit opinions. Richardson et al. (2003) show that restatement companies have high market expectations for future earnings growth, higher levels of outstanding debt, a string of consecutive positive earnings growth, and consecutive positive quarterly earnings surprises.
Kinney et al. (2004) analyze the role of audit committees and auditors on earnings restatements. They find a significant negative association between tax-service fees and restatements and a positive association between audit, audit-related, and non-audit service fees and restatements. Abbott et al. (2004) explore the effect of audit committee characteristics on the likelihood of accounting restatements by companies. They document a negative association between restatements and an audit committee that includes at least one member with financial expertise, consistent with the recommendations of the Blue Ribbon Committee (BRC). Similarly, Agrawal and Chadha (2005) find that the probability of restatements is negatively related to the incidence of independent board directors with a background in accounting or finance on the board or audit committee and to the presence of the CFO on the audit committee.
In summary, there is no work to explore whether auditor industry expertise affects the likelihood of accounting restatements in the context of partner level and/or audit firm level.
2.3 Office-level / partner-level
As mentioned above, there are two contrasting views of conceptualizing the operation of a
Big 4 audit firm (Francis et al., 1999; Reynolds and Francis, 2001; Craswell et al., 2002), and
recent studies provide supporting evidence on an office-level perspective (Ferguson et al., 2003; Francis et al., 2005, 2006). The office-level perspective assumes that accounting professionals are based on specific offices and that they audit clients mainly in the same locale. Thus, the auditors’ expertise and knowledge are both office specific and client specific. Big 4 firms operate in a decentralized organizational structure, which, in turn, enables their personnel to develop better knowledge of existing and potential clients in a particular location. In addition, clients thus have greater knowledge of and confidence in the expertise of the locally based personnel who actually perform the audits (Carcello and Nagy, 2004).
The argument for an office-level perspective might be extended, at least to some degree, to a partner-level perspective. In general, knowledge and innate ability provide better explanatory for variation in the auditor’s industry expertise. Prior studies find that auditor expertise is uniquely held by individual partners through their deep personal knowledge of local clients and can not be readily captured and uniformly distributed by the firm to other offices and clients (Carcello and Nagy, 2004), even to other partners. Additionally, an individual partner’s expertise is also closely tied to the innate ability of each individual partner (e.g., Owhoso et al., 2002; Bonner and Levis, 1990; Libby and Tan, 1994).
When knowledge provides important explanations for variation in auditor’s industry expertise, it is difficult for partners to share knowledge with other partners within an audit firm or practice office, to at least some degree. A survey by Ernst & Young reveals that 87 percent of executives identified knowledge as critical to competitiveness, yet 44 percent reported that they were poor or very poor at sharing knowledge within their organization (Stimpson, 1999).8 First, knowledge comes in two types --- explicit and tacit. The former is amendable to codification, while the latter resides in individual personal beliefs, experiences and values (Polanyi, 1966). As such, the former is not easily articulated since it is subconsciously understood and applied (Vera-Munoz et al., 2006; Ambrosini and Bowman, 2001; Polanyi, 1966). For example, knowledge of GAAP with regard to fair value requirements is explicit knowledge, while an auditor’s insights as to how a client’s management develops fair value estimates and whether those estimates conform to GAAP represent tacit knowledge (Vera-Munoz et al., 2006). Prior studies further show that most of the knowledge in any organization, including an audit firm, is tacit knowledge (Bonner, 2000; Knechel, 2000). Thus, it can be argued that the difference in
8 Research on organization learning and psychology also consistently reveals that knowledge sharing within
knowledge between an industry expert and a non-expert is primarily driven by their tacit knowledge. Second, another obstacle to knowledge sharing is not innate ability or tacit knowledge, but due to business culture. A number of scholars and practitioners argue that organization culture is a critical determinant affecting attitudes toward communication and communication processes and systems (Brown and Starkey, 1994; Vera-Munoz et al., 2006). If an audit firm’s culture norms encourage knowledge hoarding as a source of power or job security, auditors may refrain from sharing what they know (Vera-Munoz et al., 2006).9
In the meantime, Vera-Munoz et al. (2006) also identify several reasons why it is difficult for partners to share knowledge with other partners within an audit firm or practice office. First, a large number of knowledge in audit firms can not be easy to document, and identifying a firm’s best practices is difficult for partners. Next, even if a firm manages to collect and codify an extensive array of knowledge, individual partners still need to sort through the available databases and to exercise judgment about which pieces are applicable to the situation at hand. Third, field studies (Irmer et al., 2002) and anecdotal evidence (Head, 2001; Power, 2000) indicate that knowledge sharing using IT-based expert knowledge systems is not automatically embraced by everyone. Finally, evaluation apprehension is greater when knowledge is freely shared via collective database-related technologies due to the number of people with access to the knowledge.10
In addition, Wallman (1996), a former SEC commissioner, indicates that in assessing issues of auditor independence the focus should be on the individual, office or other unit of the firm
9 For example, John Hudson, former vice-present of strategic planning and knowledge management at the American
Institute of Certified Public Accountants argues that “The obstacle to knowledge sharing is… a business culture that rewards keeping what you know close to your vest. If I know something that a peer does not know, all things being equal, that gives me a competitive advantage. Since I am measured against my peer, this can impact my advantage and my salary. It sort of simplicity encourages individuals in an organization not to share what they have” (Stimpson, 1999).
10 Rosenberg (1969) describes evaluation apprehension as a person’s concern that he/she won’t receive positive
making audit decisions with respect to a particular audit client. Wallman posits that independence issues are much more powerful and thus auditor independence is more likely to be subject to criticism if a firm’s individual partner, office, or other unit of an audit firm receives a substantial portion of its revenues from a single audit client, or is dependent on that client for status within the firm. He is also critical of the fact that neither the Commission’s published independence requirements nor the AICPA’s standards address independence issues from an individual partner’s or office perspectives.
Lastly, SEC 33-7919 (2000) argues that reputational interests of the audit firm are not the same as the reputational interest of the audit engagement partner or the office of the partner that performs most of the work for an audit client. Specifically, the SEC argues that the audit engagement partner and the office have more to gain by acquiescing to the client’s aggressive accounting treatment than they have to lose if it results in audit failure. Reputational damage will be spread across the entire firm, whereas income from the client will be concentrated in the partner and the office out of which he/she works. Therefore, it seems that SEC rulings on auditor
independence are also starting to focus on an individual partner or practice office perspective. In sum, based on the above discussion, we argue that industry expertise is not standard and
homogeneous across individual partners, even within a same Big 4 audit firm. Thus, it is reasonable and important to extend the office-level perspective to the partner-level perspective, and use partners as units of analyses later.
3. Research Design, Sample Selection, and Data Sources 3.1 Measures of auditor industry expertise
Following and extending prior studies (Gramling and Stone, 2001; Balsam et al., 2003; Krishnan, 2003), we use auditor market shares, EXPERT, as a proxy for auditor specialists at both the individual partner and audit firm levels.
Measure of audit firm expertise
In line with prior studies (Balsam et al., 2003), we use the number of clients as the base. Such a base avoids a bias toward large clients that is implied by using sales as the base. Thus, situations where an auditor has a number of small clients in an industry and has developed the knowledge base to be a specialist may be captured by a number-of-clients-based measure and not by sales-based measures.11
We measure market share using the number of clients audited by an audit firm within an industry (Balsam et al., 2003). We then ranked audit firms in each industry by their market shares (EXPERT_MSF) and define the audit firm as a specialist at the firm-level in an industry if the audit firm is the largest supplier in the industry. Finally, we set a dummy variable FSPEC equal to one if an audit firm is an industry specialist, and zero otherwise.12
Measure of lead partner expertise
Following and extending prior studies (Balsam et al., 2003), we measure market share using the total clients audited by a lead auditor within an industry. We then ranked lead auditors in each industry by their market share (EXPERT_MSL) and define the lead auditor as a specialist at the partner level in an industry if the lead auditor is the largest supplier in the industry. Finally,
11 Some behavioral research also suggests that “task-specific experience and training often provided the best
explanations of auditor expertise” (Bonner and Lewis, 1990, 18). To the extent that such experience is industry-specific, having a large number of clients in an industry rather than having a few large clients may achieve industry specialization.
12 The reason for defining the top-ranked audit firm (lead partner) in an industry as a firm-level specialist (lead
we set a dummy variable LSPEC equal to one if the lead auditor is an industry specialist, and zero otherwise.
3.2 Models for empirical analysis
We first examine the association between auditor expertise and accounting restatements using the following probit regression model:
RES = 0 + 1 SIZE + 2 ROA + 3 LEV + 4 PE + 5 MB + 6 CPA1 + 7 CPA2 + 8 CPA3 +
YEAR+ INDUSTRY+ (1)
where RES is an indicator variable equal to one if the company restates its financial statement and zero otherwise. This paper considers the probability of accounting misstatement at the time the misstatement occurs, not at the time when the misstatement is later disclosed publicly as an accounting restatement. Thus the independent variables indicate auditor and firm characteristics at the time when the misstatement occurs, and not at the time when the misstatement is announced (Richardson et al., 2003; Myer et al. 2005; Barber et al., 2006). SIZE equals the natural logarithm of sales. ROA equals the net income before extraordinary items divided by total assets. LEV equals total liabilities divided by total assets. MB equals market to book value of equity at year-end (a proxy for growth). PE is measured as the company's year-end closing price divided by earnings per common share-excluding extraordinary items. YEAR includes a set of dummy variables representing the fiscal year. INDUSTRY includes a set of dummy variables representing industry.
We are primarily concerned with the signs of the three auditor indicator variables. CPA1 is coded one if the auditors are industry specialists at both the firm-level (FSPEC =1) and the partner-level (i.e. lead auditor; LSPEC =1). CPA2 is coded one if the auditors are firm-level industry specialists (FSPEC =1), but not partner-level industry specialists (LSPEC =0). CPA3 is
coded one if the auditors are individual partner-level industry specialists (LSPEC=1), but not firm-level industry specialists (FSPEC =0). The default comparison is the Big 4 auditors that are non-specialists at either the firm-level or individual partner-level.
Although we match our restatements and control companies on size as measured by assets, we include an additional size-related control variable based on sales. The inclusion of this variable recognizes that assets and sales need not similarly measure size (Meyer et al, 2005). We include ROA and LEV as control variables since prior research finds that restatement companies tend to be less profitable (ROA) and have higher leverage (LEV) than non-restating companies (Kinney and McDaniel, 1989; DeFond and Jiambalvo, 1991). We control for firm growth by including market-to-book ratio (MB) and the price-to-earnings ratio (PE) as additional independent variables because the market-to-book ratio and the price-to-earnings ratio are higher for the restating companies (Richardson et al., 2003; Jagadison et al., 2005).
3.3 Sample selection and data sources
Data
Our sample is restricted to Taiwanese listed companies audited by the Big 4 firms from 1990 to 2004.13 Financial data, audit firm data, signing auditor names data, and accounting restatements were obtained from the Taiwan Economic Journal (hereafter TEJ) Database. Our sample period starts from 1990 because the TSFB passed the SELER in the mid-year of 1989 effective in 1990.
13 The extant literature on industry expertise focuses primarily on a sample of clients audited by Big 4 firms
(Balsam, 2003; Krishnan, 2003; Ferguson et al., 2003; Francis et al. 1999, 2005). Using Taiwan data, Chen et al. (2005, 2006) consistently find that clients of the Big 4 audit firm have higher earnings quality. They also find that clients of the Big 4 industry experts have higher audit quality relative to those of Big 4 non-industry experts. This is consistent with prior literature (e.g., Becker et al., 1998; Francis and Krishnan, 1999). Following prior studies, this paper thus restricts our sample to companies audited by Big 4 audit firms.
Table 1, Panel A summarizes the sample selection process. There are 605 accounting restatements during our sample period. First, we exclude 58 observations audited by non-Big 4 firms since our sample is restricted to companies audited by Big 4 firms. Second, we delete 15 restatement observations due to the missing audit firm’s name. Further, to meet our restatements criteria, as described in section 2.1, we further eliminate 20 observations from our sample due to required and routine revisions of prior results, such as dividend distributions, and discontinued operations, etc. We also exclude 27 and 135 observations from our sample due to the accounting changes and changes in reporting entity, respectively. Finally, we eliminate 24 restatement observations without sufficient financial data. The selection procedure yields 326 restatement observations.
Matched and non-matched approaches
There is long history in auditing research of employing a research design that involves matched samples or choice-based samples while others use full samples. For example, for accounting restatements research, Myers et al. (2005) identify 556 restatement observations, and fully matched the firms by size, audit firm, and 2 digit-SIC; they then use logit regression to identify the determinants of accounting restatements.14 On the other hand, Richardson et al. (2003) and Barber et al. (2006) employ non-matched (i.e. full samples) to examine the effect of earnings manipulation on earnings restatements likelihood. While the former is pervasive in auditing research, some research argues that a research design that involves matched sampling is susceptible to technical errors in the statistical analysis that can cause the researcher to either reject the null hypothesis when the null is true or fail to reject the null hypothesis when the null
14 Other examples of restatement studies based on matched samples include Kinney et al. (2004) and Abbot et al.
is false (Palipu, 1986; Zmijewski, 1984; Richardson et al., 2003; Cram et al., 2005; Cram et al., 2007).
To avoid potential errors arising from a matched approach, we use the non-matched approach as well as the matched approach to test our expectations. For our matched approach, we follow Myers et al. (2005) and identify control firms for the restatement firms by finding the firm closest to the restatement firm in size (as determined by total assets), and drawn from the same (TEJ Industry Code) industry and year in which the misstatement initially occurs. For the non-matched approach, we have 34,682 non-restatement observations in our sample, as shown in Panel A of Table 1.
[Insert Table 1 here]
4. Empirical results 4.1 Distribution of sample and descriptive statistics
Table 1, Panel B presents the restatement focus categories for our sample, tabulated by two types of restatements initiators. The accounting focus categories shown in Panel B follow the groupings used in the U.S. General Accounting Office (GAO-04-216, GAO2003) study. Every event is assigned to a single category that reflects the main (but not exclusive) error or irregularity that is the accounting focus of the restatement. Panel B shows that 121 of 326 restatement samples involve revenue recognition issues, while 92 contain cost or expense issues. Of the 326 restatement announced during our sample period, 118 restatements were identified by the TSFB, and 208 cases were identified by company or the auditor. Following Myer et al. (2005),15 Panel B classifies the restatement sample into interim and annual restatements. Panel B
15 Specifically, we define annual misstatements as those that include at least one misstated annual financial
statements, and quarterly-only misstatements as those that involve only quarterly financial statements. Like the SEC in the U.S., the TSFB in Taiwan requires registrants to report interim financial information with their quarterly
indicates that 183 of 326 restatement observations misstate quarterly financial statements only, and 143 observations are misstatement of annual financial statements.
Panel C presents the descriptive statistics for sample compositions through time, tabulated by the party responsible for identifying the need for a restatement. It shows that the frequency of restatement has risen dramatically over time, with approximately 50 percent of the observations occurring in the last four years of the 15-year sample period, regardless of the TSFB- or non-TSFB-initiated restatements. Similar to that in the US, the possible reason is that law environment and the capital market have become more mature and more stringent. In addition, an increase in restatement frequencies may be due to the TSFB activism and more complex accounting rules and transactions (see Wu, 2002).
Table 2 provides the market shares of each Big 4 firm and the market shares of each individual partner in all 18 industries for our sample. Averaged across all 18 industries, the Big 4 market shares are as follows: the top-ranked Big 4 firm has an average market share of 45 percent, the second-ranked firm has a market share of 28 percent, the third-ranked firm has a market share of 16 percent, and the fourth-ranked firm has a market share of 11 percent. Leadership in the 18 industries is distributed as follows: Deloitte Touche (DT) is the national leader in 8 industries; KPMG (KP) is the national leader in 4 industries; PricewaterhouseCoopers (PW) is the national leader in 4 industries; and Ernst & Young (EY) is the national leader in 2 industries.
Table 2 also reports market shares of the top four individual partners for each industry
filings. During our sample period, regulation requires a review of the interim earnings by auditors (see Taiwanese Statement on Auditing Standard No. 16).
category.16 Averaged across all 18 industries, market shares of the top four auditors are as follows: the top-ranked individual partner has an average market share of 11 percent, the second-ranked auditor has a market share of 8 percent, the third-ranked auditor has a market share of 5 percent, and the fourth-ranked auditor has a market share of 3 percent.17 Thus, the sum of the market shares of the top four individual partners is approximately 27%. Individual
partner level industry leadership is distributed among Big 4 firms as follows: PW has 4 of the
top-ranked individual partners, DT has 7 of the top-ranked individual partners, KP has 4 of the top-ranked individual partners, and EY has 3 of the top-ranked individual partners.18
[Insert Table 2 here]
Table 3, Panel A presents the descriptive statistics for our variables used in our probit regression, tabulated by the restatement-sample with RES =1 and the non-restatement-sample with RES = 0. Except for industry expertise, all other variables are winsorized at the 1st and 99th percentiles. It reveals that the mean and median of FSPEC for the restatement sub-sample are significantly smaller than those for the non-restatement sub-sample, as predicted. Consistent with our predictions, the mean and median of LSPEC are significantly smaller than those for the non-restatement sub-sample (p < 0.001). For example, 33.1 percent of restatement firms retain industry auditor specialists at the firm-level while 40.3 percent of control firms retain industry auditor specialists at the audit-firm level. Approximately 5.5 percent of the lead signing auditors
16 Table 2 is based on the market share of signing lead auditors rather than those of concurring auditors since
differential audit quality due to industry expertise is primarily driven by lead auditor specialists. We will discuss this argument in detail later.
17 Table 2 only presents the market share of the top four auditors for the following reasons. First, the market share
of the other auditors are very trivial. For example, the fifth-ranked auditor has only a market share of 2 percent. Second, this presentation is consistent with that which presents market share of each Big 4 firm.
18 Untabulated results show that descriptive statistics for mean individual partners’ market share percentages across
all industries are as follows: the mean, standard deviation, Q1, median, and Q3 are 0.033, 0.039, 0.011, 0.011, and 0.033. The results show that the variable is skewed to the right, consistent with the results that the market share of the top four individual partners represents 27% of the full sample, as shown in Table 2.
are industry auditor specialists for restatement companies while 17.1 percent of the lead signing auditors are industry auditor specialists for control companies.
The remaining variables in Panel A also indicate several significant differences in the economic characteristics of companies in the two subsamples. The mean SIZE is significantly smaller for restatement companies than those for control companies. Restatement companies are significantly less profitable than our control companies. The mean and median LEV for restatement companies are significant larger than those for the control companies. Finally, the mean PE and MB are significantly greater for restatement companies.
Panel B and C show the correlations among the variables used in our regressions for restatement and non-restatement samples, respectively. They reveal that there are correlations between the proxies for auditor specialists for both subsamples. Further, they also show that though there are significant correlations among control variables, they are relatively small; the largest is 0.373 (0.278) between MB (LEV) and PE (ROA) for Panel B (C). The findings from the regression analyses below provide evidence of the variable associations after controlling for all of the posited effects.
[Insert Table 3 here]
4.2 Multivariate analysis: comparisons between the firm and the partner-levels
In this section, we explore the relative effectiveness of the individual partner-level and firm-level auditor specialists in reducing the likelihood of accounting restatements. Based on the non-matched approach, Table 4 shows the results from the probit regression analysis of accounting restatements on auditor specialists at both the partner and the audit-firm levels, as well as the control variables. In testing the statistical significance of the coefficient estimates, we use robust standard errors adjusted for clustering on companies, which means observations from the same companies are not treated as independent. Adjusting for clustering does not affect the
coefficient estimates but tends to produce larger standard errors and lower test statistics (Rogers, 1993). In all the regressions, we use a two-tailed test for the coefficients. The dummy variables representing year and industry are included in all regressions in the paper. For simplicity, the results are untabulated.
As in Francis et al. (2005, 2006), three models are reported for comparative benchmarking purposes. Model (1) codes the auditor test variable (i.e. FSPEC) equal to one if the auditor is the firm-level industry specialist, and zero otherwise, and affords a comparison with the firm-level measure of industry expertise in Balsam et al. (2003) and Francis et al. (2006). Model (2) codes the auditor test variable (i.e. LSPEC) equal to one if the lead auditor is an industry specialist, and zero otherwise. However, our main interest is in model (3) which reveals the results of estimating equation (1), based on the specification of three auditor indicator variables.
Model (1) analyzes firm-level industry expertise alone. It shows that the coefficient of
FSPEC is significantly negative at the 1.6 percent level, indicating that the firm-level auditor
specialist is associated with lower likelihood of restating financial statements relative to non-specialists, after controlling for other factors related to accounting restatements. This is consistent with the firm-level analysis performed in Balsam et al. (2003) and Francis et al. (2006). In model (2), which analyzes auditor specialists at the individual partner-level alone, there is a negative association between industry expertise of lead auditors and the probability of restating financial reporting at the one percent level. The results suggest that restatement likelihood of client retaining partner specialists, i.e., lead auditor specialists, is smaller than that of client retaining non-specialists.19
19 Following Ferguson et al. (2003) and Francis et al. (1999, 2005, 2006), the estimation of model (1) is an iterative
process. We start with only one indicator variable for the top-ranked firm at the firm-level in the first estimation, and then add a second indicator variable for the second-ranked firm in the second estimation, and so on until the introduction of an additional ranking variable is not significant. The iterative process results in only the top Big 4
Model (3) reveals the empirical results for equation (1) and is the primary model of interest. It shows that the coefficient of CPA1 is significant and negative (p < 0.001), indicating that the probability of clients restating financial reporting is lower if auditors are joint firm-level and partner-level industry specialists. It also reveals that the coefficient of CPA3 is significant and negative (p < 0.001), suggesting that the probability of clients restating financial reporting is smaller when auditors are industry specialists at the individual partner-level (alone) but not at the firm-level. Model (3) also shows that the coefficient of CPA2 is insignificant, suggesting that auditors that are firm-level specialists but not individual partner-level specialists have no association with client restatements. The findings in model (3) suggest that restatement likelihood is lower when auditors are industry specialists at the individual partner-level, either alone or joint individual partner and firm-level industry specialists, and the Big 4 industry specialists at the firm-level alone are never significantly different from Big 4 non-specialists. In summary, we conclude from these analyses that differential restatement likelihood due to Big 4 industry expertise is primarily driven by lead auditor expertise rather than firm-level industry expertise.20
For these three regressions, the coefficients on company return ratio (ROA) is significantly negative. The coefficient on firm growth by including the market-to-book ratio (MB) and the price-to-earnings ratio (PE) are significantly positive. These results are consistent with the
firms having significant restatement relative to the remaining Big 4 firms. The estimation of model (2) follows the same iterative process, and the results also indicate that only the top auditors have significant coefficients. For example, in models (1) and (2), when the two-ranked auditors are added as an additional indicator variable, the coefficients are insignificant (p =0.121, and 0.594, respectively). Similarly, for the tests in Table 5, we also conduct the same iterative process, and the process also results in the top-ranked firm and top-ranked auditor having significant coefficients in model (1) and (2), respectively.
20 The results don’t indicate that Big 4 firm-level expertise does not contribute to reduce the restatement likelihood;
instead, they just suggest that given that the audit firms are Big 4 firms, Big 4 firm-level experts alone are never significantly different from Big 4 non-industry experts.
findings in prior studies.21 The pseudo-R2 shows that the independent variables explain approximately 7.2% to 8.5% of the variation in restating financial reporting. The log likelihood ratio ranges from -1,692 to -1,716, indicating that the explanatory powers are significant. For model (3), untabulated statistics show that the estimation equation correctly classified 98.23% of the restating financial report.22 23
[Insert Table 4 here]
As an additional specification check, Table 5 presents the same tests as those reported in Table 4 using the matched approach rather than the non-match approach. Generally, the results from the matched approach corroborate the results from the non-marched approach. The primary difference is that the coefficient of firm size, SIZE, is significantly negatively related to a restatement, and the coefficient of firm’s debt ratio, LEV, is also significantly associated with restatements. In addition, the Pseudo R2 is higher for the matched-model relative to the non-matched model (0.41 and 0.09 for model 3, respectively).24 Therefore, our findings are robust for alternative model specifications. For brevity, we present only the empirical results using the non-matched approach in later analyses.
[Insert Table 5 here]
4.3 Further analysis: comparison between the lead and concurring auditors
21 In model (2) which focuses on individual partner specialists, we include an additional control variable, industry
market share of an audit firm (EXPERT_MSF or FSPEC), to control for its potential effects on accruals. The results are qualitatively the same as those in model (2) of Table 4.
22 A restatement is considered correctly classified if its predicted probability based on equation (1) is greater (less)
than the unconditional probability, which equals the proportion of restatements in the estimating equation.
23 We sequentially estimate the probit model with one variable omitted each time. None of the results changed
when the variables were dropped from the model. We also estimate the model using OLS and compute variance inflation factors (VIFs). None of the VIFs are greater than 1.60. Similarly, we conduct the same analyses in Table 5, and none of the VIFs are greater than 1.37. These results suggest that our findings are not affected by harmful multi-collinearity.
24 In later analyses, the explanatory powers for the matched approach are consistently and significantly higher than
The extant literature on industry expertise implicitly assumes that industry expertise is homogeneous across individual partners within the same audit firm (national-level perspective) (e. g., Balsam et al., 2003; Krishnan, 2003, 2005) or within the same city for a given firm (office-level perspective) (e.g., Francis et al., 2005, 2006) and exclusively explores the impact of audit firm expertise on audit quality. However, experimental work on industry expertise shows that an individual partner’s expertise is not only tied to each individual professional and his/her deep personal knowledge of clients, but also the innate ability of each individual partner (e.g., Owhoso et al., 2002; Bonner and Levis, 1990; Libby and Tan, 1994). The lead engagement partner typically directs the total effort, interprets the audit evidence, and ultimately determines the appropriate audit report (Francis et al., 1999; Reynolds and Francis, 2001). In addition, the lead partner generally exhibits more hands-on experience on the audit engagement than the concurring partner. In this section, we further investigate whether the lead auditor specialists have a more pronounced association with accounting restatements than concurring audit specialists.
To test our prediction, we run the following regression:
RES = 0 + 1 SIZE + 2 ROA + 3 LEV + 4 PE + 5 MB +6 EXPERT_MSF + 7 SIGN1 +
8 SIGN2 + 9 SIGN3 + YEAR+ INDUSTRY+ (2)
All variables in equation (2) are the same as those in equation (1) except for EXPERT_MSF and three auditor indicator variables. In equation (2), which focuses on individual partner specialists, we include an additional control variable, industry auditor expertise at the firm level (EXPERT_MSF),25 to control for its potential effects on restatements.
25 We use an alternative proxy (FSPEC) for firm-level industry expertise to control for its potential effects on
Following and extending prior studies (Balsam et al., 2003), we measure market share using the total clients audited by the concurring auditor within an industry. We then ranked
concurring auditors in each industry by their market shares (EXPERT_MSC) and define the
concurring auditor as a specialist at the partner level in an industry if the concurring auditor is
the largest supplier in the industry.26 Finally, we set a dummy variable CSPEC equal to one if the concurring auditor is an industry specialist, and zero otherwise. SIGN1 is coded one if both the lead and concurring auditors are industry specialists (LSPEC =CSPEC =1). SIGN2 is coded one if the concurring auditor is an industry specialist, but the lead auditor is not (LSPEC=1,
CSPEC =0). SIGN3 is coded one if the lead auditor is an industry specialist, but the concurring
auditor is not (LSPEC =0, CSPEC =1).
Table 6 shows the results of estimating regression (2). In testing the statistical significance of the coefficient estimates, we use robust standard errors adjusted for clustering on companies (Rogers, 1993). Model (1) analyzes the industry expertise of the signing lead auditor alone. It reveals that, as predicted, the coefficient on LSPEC is statistically significant and negative at the one percent level, suggesting that lead auditor specialists are negatively associated with client restatements relative to non-specialists. In model (2), which analyzes industry expertise of the concurring auditor alone, the coefficient on CSPEC is significantly negative at the 0.1 percent level, indicating that the restatements probabilities of clients retaining concurring auditors that are specialists are lower than those of clients retaining concurring auditors that are non-specialists.27
26 Similarly, the reason for defining the top-ranked concurring partner in an industry as concurring partner
specialists will be discussed later.
27 The estimation of models (1) and (2) follows the same iterative process as those in Table 4. In model (1), the
iterative process results in the top-ranked lead partners having significant restatement (p < 0.001). When the two-ranked lead partner is added as an additional indicator variable, the coefficient is insignificant (p < 0.465). In model (2), the iterative process results in the top-ranked concurring partners having significant coefficient (p <
Model (3) shows that the coefficients of both SIGN1 and SIGN3 are significantly negative, indicating that there is a negative association between accounting restatements if both lead and concurring auditors are industry specialists, and if the lead auditor is an industry specialist (alone) but the concurring auditor is not an industry specialist (p<0.001). The results show that the lead auditor specialist, either alone or in conjunction with a concurring auditor specialist, is associated with lower restatement probability. However, model (3) reveals that the coefficient of SIGN2 is marginally different from zero. In other words, the results, in combination with the fact that
SIGN3 is significant negative, indicate that although concurring auditor specialists are not
directly related to lower restatement probability, they can indirectly reduce restatement likelihood via their combination with lead auditor specialists.
In sum, clients of lead auditor specialists, either alone or joint lead-concurring auditor specialists, have lower restatement probability than those of other Big 4 auditors. In addition, the differences due to industry expertise of signing auditors are primarily driven by the lead auditor rather than the concurring auditor.
For these three regressions, as predicted, the coefficients on company return ratio (ROA) and firm-level auditor market share (EXPERT_MSF) are significantly negative, and the coefficients on the market-to-book ratio (MB) and the price-to-earnings ratio (PE) are significantly positive. These results are consistent with the findings in prior studies.
[Insert Table 6 here] 4.4 Additional analysis:
Severity of restatements
Although regulators express concern over the number of accounting restatements, there is
0.009), and the two-ranked concurring partner having insignificant coefficient (p=0.227). Therefore, we define the top-ranked lead and concurring partners as specialists in our paper.
variation in the severity of the response to restatements. For example, Palmrose et al. (2004) find that the market reaction to restatements announcement is associated with characteristics presumed to be related to the severity of the underlying error. In this section, we focus on misstatements most likely to be of consequence to investors, and further investigate the effect of industry auditor expertise on these characteristics of restatements.
Material restatements
Following Kinney et al. (2004), we define a misstatement as material if its absolute size is greater than or equal to 5% of the absolute value of the net income or loss originally reported. Of the 326 restatements during our sample period, 99 meet this materiality threshold. We rerun equation (1) where the dependent variable is an indicator for whether or not the restatement is material. Column 1 of Table 7 reveals that the coefficients of CPA1 and CPA3 are significant and negative (p < 0.01), and the coefficients CPA2 is insignificant, indicating that companies of industry auditor specialists are less likely to make material misstatement, and the differential restatements likelihood due to industry expertise is primarily attributable to the signing partner specialists (i.e. lead auditor specialists) rather than auditor specialists at the firm level.
[Insert Table 7 here] Core earnings
In addition to considering the materiality of the restatements, we also consider whether they affect core earnings. We make this distinction because we posit that investors are differentially concerned about restatements that effect core versus non-core earnings. Core earnings are more persistent or sustainable into future periods and are fundamentally linked to the expected future prospects of the company (Penman, 2001). Thus core earnings are more value relevant than are non-core earnings (Bradshaw and Sloan, 2002). Recent studies also document that restatements containing core earnings have a more negative effect on stock returns
than do those involving non-core earnings (Palmrose et al., 2004) and are associated with litigation against restating companies and their auditors (Palmrose and Scholz, 2004).
Following Palmrose et al. (2004), we define core-earnings restatements as those involving revenue, cost of sales or on-going operating expenses. In addition, non-core earnings are defined as those from all other activities. Of the 326 restatements in our sample, 116 contain core earnings. Consistent with our prediction, Column 2 of Table 7 reveal that the lead auditor specialists, either alone or in conjunction with firm-level specialists, are significantly associated with lower likelihood of core earnings restatements, indicating that companies retaining auditor specialists are less likely to misstate core earnings.
Pervasiveness and duration of restatements
Our third characteristic of restatements is related to the pervasiveness of the restatements within the income statement. We follow Palmrose et al. (2004) and count the number of account groups that represent the focus of the restatements: revenue, cost of goods sold, on-going operating expenses, special items/one-time events, merger accounting, non-operating income accounts, and other items. Thus this variable can range from one to seven. We expect this variable to be negatively associated with the industry experts. Finally, we consider a variable for the persistence of the misstatement, DURATION, as measured by the number of years’ financials restated (where a restated quarter = 0.25). We expect this variable to be negatively related with the industry experts.
Column 3 of Table 7 shows that the coefficient of CPA1 is negative and significant, while
CPA3 have predicted signs, but is marginally different from zero. Therefore, our results indicate
that the auditors that are industry specialists at both the firm-level and the partner-level are negatively associated with the pervasiveness of the restatements. Finally, Column 4 reveals
that the coefficients of CPA1 and CPA3 are marginally significant in the predicted signs, indicating that the empirical results do not support our prediction that industry auditor specialists are negatively associated with the persistence of the restatements.
Initiator of restatements
According to Article 6 of SELER, the TSFB should require companies to restate financial reporting when misstatements of companies meet a “serious” threshold. Thus, the TSFB-initiated restatements are generally perceived to be more serious than those initiated by the others. In this section, we will provide direct evidence on whether or not the TSFB-initiated restatements are more “serious” than are the companies/auditors-initiated restatements.
Table 8, Panel A profiles the restatements sample according to characteristics of accounting restatements as described in previous analyses, tabulated by the TSFB-initiated and voluntary restatements (i.e., companies or auditors-initiated restatements). Panel A shows that the duration for the TSFB-initiated subsample is significantly longer than those for voluntary subsample, but there is no significant difference in the mean (median) pervasiveness between these two subsamples. The results suggest that the TSFB-initiated restatements, on average (at the median), affect more financial reports than do voluntary restatements. Panel A also shows that the TSFB-initiated restatements tend to have more material effect on incomes and are more likely to effect core earnings than do voluntary restatements. The results provide compelling evidence that the TSFB-initiated restatements generally are more serious than are voluntary restatements.
To gain further insights into whether the findings regarding effect of industry specialists on restatements are primarily driven by the TSFB-initiated group, we rerun equation (1) using the TSFB-initiated and voluntary restatements subsamples, respectively. Panel B reveals that for these two groups, the coefficients of CPA1 and CPA3 are significant in the predicted signs (p <
