Summarize and PowerPoint

Make a summary and PowerPoint and answer case study (A,B) (Please use easy words and easy sentences)

A. prepare a 3 or 4 pages summaryof each paper (3 Article) (including the Libby box)

Focus on summarizing the most salient points of the article.

. After that make sure the summaries address the following questions (I will send them).

B.and make PowerPoint slides for each study.

Three Articles in the attachments

Received: 15 September 2021
Revised: 5 May 2022
Accepted: 5 May 2022
DOI: 10.1111/ijau.12285
ORIGINAL ARTICLE
The homogeneity of BIG4 audit reports after the
implementation of key audit matters in the context of fair
value accounting
Tuomas Honkamäki1,2
1
| Markus Mättö1 |
Henri Teittinen1
University of Tampere, Tampere
2
Business School, University of Eastern
Finland, Kuopio
Correspondence
Tuomas Honkamäki, The University of
Tampere, Tampere, Finland; or The University
of Eastern Finland, Kuopio, Finland.
Email: thonkama@uef.fi
This study examines the homogeneity of BIG4 audit reports after implementing key
audit matters (KAMs) in the context of fair value accounting. We focus on reported
KAMs and the procedures related to the fair values of investment properties, particularly those related to challenging management’s estimations and valuation specialists’
use. Our data consist of 235 individual audit reports from the real estate sector from
2017 to 2018 and cover 60% of the listed real estate companies in the EU,
Switzerland, and Norway. We found that the BIG4 audit firms are not homogenous
in their audit reports. There is a statistically significant difference among the BIG4
audit firms in reporting the challenge of management estimates and in the number of
audit procedures. We also found that a country’s legal origin plays a significant role
when auditors report KAMs. Our findings contribute to the current audit quality and
reporting literature.
KEYWORDS
audit quality, BIG4, fair value, IFRS, investment properties, key audit matter, the challenge of
management estimation, use of specialists
1
|
I N T RO DU CT I O N
Simunic & Stein, 1987). BIG4 audit firms also face more litigation than
non-BIG4 audit firms because of the deep pocket hypothesis, which
When assessing audit quality, the BIG4 audit firms have been consid-
encourages the firms to perform at a higher quality (Khurana &
ered a single entity (Bennouri et al., 2015; DeAngelo, 1981). Grouping
Raman, 2004; Krishnan et al., 2017; Palmrose, 1988).
is based on the assumption that the BIG4 audit firms have more to
There
is
no
unambiguous
definition
of
audit
quality
lose (because of reputation capital), which encourages the BIG4 audit
(Francis, 2004; Knechel et al., 2013), but some regulators have
firms to produce higher quality audits than non-BIG4 firms (Choi
established an audit quality framework (FRC, 2008; IAASB, 2011), and
et al., 2008; Comprix & Huang, 2015; Coram, 2014; DeAngelo, 1981).
there is a common understanding of the elements of audit quality
Even though audit quality has not been explicitly determined, var-
(Francis, 2004; Knechel et al., 2013). One stream of audit report
ious studies have concluded that the audit quality of BIG4 audit firms
research (presenting audit quality) recognizes the importance of word-
is better than that of non-BIG4 audit firms (Becker et al., 1998;
ing in audit reports (Bédard et al., 2019; Christensen et al., 2014;
Francis & Krishnan, 1999; Kim et al., 2003; Sercu et al., 2002;
Menon & Williams, 2010).
This article has not received any funding.
ment of audit quality (e.g., Financial Reporting Council [FRC], 2008;
Previous studies on audit report quality have indicated one ele-
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in any
medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.
© 2022 The Authors. International Journal of Auditing published by John Wiley & Sons Ltd.
354
wileyonlinelibrary.com/journal/ijau
Int J Audit. 2022;26:354–370.
355
HONKAMÄKI ET AL.
Francis, 2004; Francis & Krishnan, 1999; Weber & Willenborg, 2003).
properties in the EU, Switzerland, and Norway. In these countries,
Furthermore, clear and transparent reporting has been considered a
publicly listed companies follow International Financial Reporting
characteristic of audit quality (Knechel et al., 2013; Knechel &
Standards (IFRS), allowing the recognition of investment properties at
Shefchik, 2014; Reid et al., 2015; Segal, 2019). In addition, transparent
fair value (IAS 40.30) (IASB, 2016b) and fair value change to recognize
reporting clarifies the performed audit procedures beyond those
profit and loss accounts (IAS 40.35).
described in audit standards, which can enhance audit quality
(Jermakowicz et al., 2018).
The real estate sector provides an excellent opportunity to
examine an auditor’s procedures and reporting in more detail. The
In the current study, we are particularly interested in the homoge-
value of investment properties usually forms a significant part of
neity of BIG4 audit reports after implementing key audit matters
the financial year’s results and balance sheet’s value in the real
(KAM). When BIG4 audit firms are considered a homogeneous group
estate industry (Muller et al., 2011; Sangchan et al., 2020). In addi-
in audit quality, there should be no significant qualitative or material-
tion, previous studies have recognized that investment properties in
ity differences among the audit reports’ transparency or reported
the real estate sector comprise about 70–80% of total assets
audit procedures. Although auditing standards do not provide tem-
(Muller et al., 2011; Sangchan et al., 2020), while other assets are
plates for reporting KAMs, they guide audit work (ISA 701 – Communi-
not relevant to an individual basis. In addition, although in other
cating key audit matters in the independent auditor’s report). Therefore,
business sectors, investment properties or fair value changes, which
because the required audit procedures affect reporting (ISA 701.13b,
are recognized through profit and loss, are widely used, the real
ISA 701.A46-A51), we can assume that reporting transparency will
estate sector can provide a closed research environment. Other
still be at the same level among the BIG4 audit firms and other audit
businesses than real estate noise would not disturb the results. Our
firms and that the quality of the audit will be consistent and high
study covers 60% of the listed real estate companies in the EU,
quality.
Switzerland, and Norway.
Previous studies have shown that the BIG4 audit firms are a
The current study contributes to the audit literature in several
homogenous group when it comes to audit quality (DeAngelo, 1981;
ways. First, we contribute to Glover et al.’s (2017) study on the chal-
Defond et al., 2000; Ferguson et al., 2003; Francis, 2004; Francis &
lenges in auditing fair value measurements and complex estimates.
Krishnan, 1999; Francis & Wilson, 1988; Simunic & Stein, 1987). Pre-
Although Glover et al.’s (2017) study is based on a survey of audit
viously, though, the differences among BIG4 audit firms have been
partners, our study focuses on the actual reporting from the published
recognized at the fee level (Simunic, 1980), in industry specialization
audit reports. Glover et al. (2017) report that 87% of partners use a
(Ferguson et al., 2003; Francis et al., 2005), and within transparency
specialist for nonfinancial fair value audits. Our results show that 50%
reports (Fu et al., 2015). However, the differences in audit quality
of audit reports indicate that a specialist has been used. When Glover
among the BIG4 audit firms have not been recently studied.
et al. (2017) report that 87% of auditors use specialists, the state-
In the current paper, we approach the homogeneity of BIG4 audit
ments written on audit reports do not support this finding. Second,
reports using the concept of equifinality, which means that the final
we contribute to Asbahr and Ruhnke’s (2019) study of the real effect
results can be reached from different initial conditions and in different
of reporting KAMs on auditors’ judgement and choice of action.
ways (Grezov & Drazin, 1997). Equifinality is a strategic choice of
Asbahr and Ruhnke (2019) show that sceptical actions tend to be
organizational design to achieve high performance (see Child, 1972;
lower when the accounting estimates are reported as a KAM. We
Grezov & Drazin, 1997). The fundamental question in equifinality
have found that 50% or less of auditors reported sceptical procedures
revolves around the organizational processes that generate equi-
on published KAMs. Third, we contribute to previous studies regard-
finality. Because the premise in the current study is that all BIG4 audit
ing the differences among the BIG4 audit firms by giving a new angle
firms strive to maintain high-quality audits, that is, equifinality in high-
for comparing companies. Previous studies have concentrated on fee
quality audits, we are particularly interested in how the auditing pro-
differences (Simunic, 1980), specialization (Ferguson et al., 2003), and
cesses of BIG4 firms differ (in auditing reports in forms of KAM) in the
transparency reports (Fu et al., 2015). Our study provides information
real estate sector when generating quality audits.
about the reporting style among BIG4 audit firms, showing statistically
Previous studies have shown that countries’ legal origins impact
significant differences in the reported tasks on the audit reports. Fifth,
auditors’ behaviour (Alexeyeva & Mejia-Likosova, 2016; Choi
we contribute to the overall research on audit reputation and quality
et al., 2008; Eierle et al., 2021; Kim et al., 2012). Porta et al. (1998)
by adding detailed evidence of the work reported by the auditor,
recognized that legal origins are different relating to the protection of
hereby showing a statistically significant difference when it comes to
investors. There has been a recognized positive association between
reporting in the use of valuation specialists and the challenge of man-
earnings quality and investor protection, and legal origins can affect
agement. Finally, the current study also gives audit practitioners and
auditors’ behaviour to avoid legal liability (Alexeyeva & Mejia-
inspectors detailed information about the wording of KAM in one spe-
Likosova, 2016; Ball et al., 2000). The legal origin could impact the
cial area—the fair value of investment properties—and gives new
content of the auditors reporting.
insights into how to provide helpful information to the users of audit
The current study examines the homogeneity of audit reports by
reports. In addition, the current study provides new information on
KAMs disclosed by the BIG4 audit firms in the real estate sector, con-
the prevalence of reported sceptical procedures relating to challeng-
necting these reports with the audit of the fair values of investment
ing audit tasks and how auditors can improve their reporting.
356
HONKAMÄKI ET AL.
Our paper is structured as follows: In this section, we have intro-
(Wallace, 1980; Watkins et al., 2004). The audit aims to reduce this
duced the field of our research topic. In Section 2, we describe
information asymmetry and minimize managers’ reporting opportun-
accounting treatment under the IFRS for investment properties.
ism (Grand, 1996; Piot, 2001). However, there has been much criti-
Section 3 provides an overview of fair value accounting. Section 4
cism that the audit report has not answered the increased information
provides a theoretical background on KAM. In Section 5, we present
needs of investors (Bédard et al., 2014; Church et al., 2008; Cohen
our research questions. Sections 6 and 7 present our data and the
Commission, 1978; Geiger, 1993; Mock et al., 2013). One solution for
main findings. Finally, we conclude and discuss our theoretical contri-
this deficiency of reporting has been a requirement for providing more
bution in Section 8.
information about audit procedures and how auditors have gotten
enough comfort from audit evidence to release audit reports
(Botez, 2017; IFAC, 2015; Li et al., 2019; PCAOB, 2014; Segal, 2017,
2 | A C C O U NT I N G F O R I N V E S T M E N T
P R O P E R T I ES I N T H E R E A L ES T A T E SE C T O R
2019; Velte & Issa, 2019). The regulator’s solution for this lack of
information has forced the auditor to provide a new type of audit
report (IFAC, 2015; Jermakowicz et al., 2018; PCAOB, 2014). New
Investment properties play a vital role in the real estate sector. Typi-
reporting requirements could also decrease the expectation gap
cally, investment properties comprise 70–80% of the total assets in
between auditors and investors (Sirois et al., 2018) and increase the
the real estate sector (Sangchan et al., 2020). The accounting guidance
communicative value of the auditor’s report (Köhler et al., 2020).
for investment properties under the IFRS is based on IAS 40 – Invest-
IFRS 13 (IASB, 2016a) recognizes three levels of fair value hierar-
ment properties. IAS 40 – Investment properties give two alternatives
chy; in level 1, fair value is based on market information. In level 2, fair
for accounting: fair value or at cost (IAS 40.30). Under the fair value
value is based on the observable inputs for valuation purposes. Level
model, fair value change is recognized through profit and loss (IAS
3 fair value is based on nonobservable inputs (IFRS 13.74). Accounting
40.35) at each reporting date, and no depreciation is recognized.
estimates with high estimation uncertainty (mainly level 3 fair value)
When investment properties are recognized at cost, the valuation of
are often interesting to users of financial statements (Barth, 2006;
the investment properties should be based on IFRS 5 – Noncurrent
Griffith, Hammersley, Kadous, & Young, 2015). Fair values in level
assets held for sale and discontinued operations (if the assets meet the
3 are highly dependent on management’s judgement and assumptions
classification criteria), IFRS 16 – Leases (if the company is recognized
and may require an expert (Christensen et al., 2012; Griffith,
as a right-of-use asset), or IAS 16 – Property, plant, and equipment
Hammersley, & Kadous, 2015). Estimations with high management
(in every other case).
involvement may be identified as significant risks (ISA 701.A14). Man-
The IAS 16 – Property, plant and equipment standard requires
agement estimates are also subject to management bias for earnings
investment properties initially recognized at cost (IAS 16.15). If the
management purposes (Christensen et al., 2012; Jarva, 2009;
investment properties are accounted for based on IAS 16, the subse-
Selling & Nordlund, 2015). Finally, management estimations are also
quent measure should be a cost less depreciation (IAS 40.56 c). There-
subject to possible fraud (Jones & Jones, 2010). The above reasons
fore, the revaluation model described under IAS 16 cannot be
explain why the fair value of investment properties is considered a
followed (IAS 40.56 c).
KAM in the auditor’s report in the real estate sector.
The accounting difference between the fair value model from IAS
Investment properties could be valued based on the financial
40 – Investment properties and IAS 16 – Property, plant, and equipment
statements based on fair value (IAS 40.30), and a change of fair value
is essential. While using the fair value model (IAS 40), fair value is rec-
could be recognized as profit and loss statements (IAS 40.35). The fair
ognized through profit and loss; the cost model does not recognize
values of disclosed investment properties are usually level 3 in the
(at all) the positive fair value changes. IAS 16 requires that assets are
IFRS fair value hierarchy (IFRS 13.72; Ghosh et al., 2020). The fair
depreciated to the residual value within the economic life of assets.
value for level 3 is not based on the public sources’ information but
Therefore, revaluation models described in IAS 16 are not acceptable
rather on unobservable inputs (IFRS 13.86). In fair value level 3, there
for investment properties (IAS 16.5). When investment properties are
have been some doubts about the fair value’s reliability (Song
sold, the outcome is the same. IAS 40’s fair value model recognizes
et al., 2010). Fair value accounting has been recognized as relevant
positive and negative fair value changes and can cause more volatile
and reliable when at levels 1 or 2 of the fair value hierarchy (Song
profit and loss impact than accounting at cost less depreciation.
et al., 2010).
Because the magnitude of the investment property assets complying with the real estate company’s total assets is typically material,
3 | F A I R V A L U E R E P O R T I N G I N TH E R E A L
ESTATE SECTOR
a slight change in the assumptions can cause significant changes in
the company’s result. Thus, the real estate company’s results are sensitive to fair value calculation variables (Dietrich et al., 2000).
Because managers have more insider information about a company’s
The fair value calculation variables include many different
financial situation, there is information asymmetry between managers
assumptions that management can directly or indirectly affect
and owners (Banker et al., 2013). Auditor monitoring reduces noise
(Dietrich et al., 2000). As a result, auditors typically face difficulties in
and
auditing highly uncertain fair values (Christensen et al., 2012; Griffith,
management
bias
while
improving
information
quality
357
HONKAMÄKI ET AL.
Hammersley, & Kadous, 2015; Rowe, 2019). Auditors have difficulty
audit procedures to cover those risks are based on decision-making
identifying misstatements that are signified by problematic patterns
(Knechel, 2000). However, there could be a different approach to
among those assumptions underlying complex estimates when those
gathering enough audit evidence to state that there is no material mis-
assumptions appear reasonable individually (e.g., Cannon & Bedard,
statement in the financial statement. Low (2004) points out that
2017; Griffith, Hammersley, & Kadous, 2015; Griffith, Hammersley,
selected audit procedures depend on the auditor’s specialization.
Kadous, & Young, 2015; Hurtt et al., 2013; Nelson, 2009). Based on
Recent studies have shown that the audit’s KAM in the auditor’s
Phillips’s (1999) study, the auditor can rarely identify a single piece of
report is relevant to investors (Christensen et al., 2014; Sirois
evidence that explicitly contradicts reporting rules.
et al., 2018). Christensen et al. (2014) examine, for example, whether
In the current study, we are particularly interested in the homoge-
the audit report’s outcome in the audit report is relevant to investors;
neity of BIG4 audit reports in the context of fair value accounting.
the study shows that the new reporting format to disclose KAM
The real estate sector, which mainly reports the fair values of invest-
affects investor decision making when compared with the previous
ment properties as KAMs in audit reports, provides an excellent
reporting model (Christensen et al., 2014; Moroney et al., 2021). The
opportunity to investigate the differences in reporting among BIG4
auditor’s report means a lot to investors, even though its actual bene-
audit firms. To the best of our knowledge, there are no studies relat-
fits have been criticized (e.g., Carcello, 2012; Carson et al., 2013;
ing to BIG4 audit reporting differences, focusing specifically on KAM.
Church et al., 2008; Smieliauskas et al., 2008). Additional information
compared with standard reporting is relevant to investors, but the
information must give some new insights; otherwise, it does not
4 | K E Y A U D I T M A T T E R S (K A M s ) I N A U D I T
REPORTS
impact investors (Bédard et al., 2019).
Although standard setters have had high expectations of the
impact of KAM reporting, the recent results from different studies
Publicly listed companies in the EU, Switzerland, and Norway are obli-
have been controversial. Creating a new requirement could cause uni-
gated to report KAMs in the auditor’s reports from the financial year
ntentional consequences (Giddens, 1984; Power, 2004; Vinnari &
ending on or after December 15, 2016, as required by ISA 701.6.
Skærbæk, 2014). Some unintentional consequences could be that
KAMs explain the judgement areas of financial statements, why those
sceptical actions have decreased because of the new reporting type
are important for auditors, and how auditor’s audit procedures gather
(Asbahr & Ruhnke, 2019). Bédard et al. (2019) point out that extended
enough evidence to release the auditor’s report (ISA 701.8; Dennis
reporting has low communicative value because investors already
et al., 2019). In addition, there is no standard model for auditors’
know reported matters from other sources.
reports, so KAMs provides an excellent opportunity to investigate the
differences in auditors’ reporting.
A KAM that has been a mandatory requirement since the ISA
Although standard setters have had high expectations for KAMs
to improve audit reports, the impact might be weakened because of
boiler-plate, technical, or ambiguous texts (Bédard et al., 2019; Mock
audit-related audit report (ISA 701.11) of publicly listed companies
et al., 2013), and audit reports have low communicative value for
(ISA 701.5) after December 2016 explains the auditor’s responses to
investors. Only a few studies relating to the new reporting require-
the key audit risk areas (ISA 701.13a). This KAM always requires
ment’s impact on the audit itself (Asbahr & Ruhnke, 2019; Fuller,
judgement (ISA 701.7). Hence, the sufficiency and appropriateness of
2015) have shown some unintended consequences of the KAM
the work description performed are a matter of professional judge-
reporting
ment (ISA 701.A46). Nevertheless, the description is still intended to
Nguyen (2020) study, KAM reporting could lead auditors to accept an
provide a concise explanation, enabling users of the financial state-
aggressive accounting estimate. Asbahr and Ruhnke (2019) recognize
ments to understand how the KAM has been audited (ISA 701.13b;
a decrease in sceptical actions when the issue has been reported as
Cordos & Fülöp, 2015; Segal, 2017). Furthermore, limiting the use of
a KAM.
requirement.
For
example,
based
on
Kend
and
highly technical auditing terms helps users who do not have the
The auditing standards do not mention additional information and
proper knowledge of auditing to understand the basis for the auditor’s
procedures in the auditor’s report. For example, such matters in the
focus on particular matters during the audit (ISA 701.A30).
audit of the fair value of investment property include using a valuation
Auditors must use professional judgement when deciding on the
specialist in connection with the valuation audit and the auditor’s
audit procedures to be performed. Hogarth (1980) has created a the-
scepticism about the valuation (Nelson, 2009). According to
ory about the judgement process of financial users (see also Bedard
Hurtt’s (2010) definition, scepticism manifests itself, for example, in
et al., 2012). Following Hogarth’s theory (1980), the auditor’s audit
challenging the calculations presented by management. Asbahr and
procedure decisions could be explained by how the auditor has
Ruhnke (2019) find that sceptical actions in the proposed adjustment
selected which procedures to perform.
amounts are significantly lower when the accounting estimates are
Defining and reporting a KAM is risk based (Sierra-García
reported as KAMs.
et al., 2019). Sierra-García et al. (2019) qualify KAMs into two differ-
The use of valuation specialists and the challenge of management
ent types: entity-level risk and account-level risk, here based on
estimations have been recognized as deficiencies in audit work as
Lennox et al.’s (2018) definition of the risk of material misstatement.
reported by the auditors’ inspectors (FRC, 2020; PCAOB, 2014). The
Reporting KAMs is based on significant audit risks (ISA 701), and the
inspectors expect a valuation specialist to review complex fair values,
358
HONKAMÄKI ET AL.
and they expect management’s assumptions to be challenged
are concerned about reputational risk and possible lawsuits
(FRC, 2020; PCAOB, 2014).
(Khurana & Raman, 2004), using a valuation specialist on the auditor’s
We primarily focus on two issues in KAMs in audit reports: the
risk of being prosecuted in court has been investigated in previous
challenge of management estimations and the use of a valuation spe-
studies (Brown et al., 2020). Brown et al.’s (2020) research show that
cialist in the auditor’s report as additional information for the user of
a valuation specialist’s use is relevant to a court visit’s outcome. Using
financial statements. Accordingly, we next present our research
a valuation specialist in the auditor’s report reduces litigation risk and
questions.
decreases reputational risk (Khurana & Raman, 2004; Pinto &
Morais, 2018). However, evidence relating to the effects of experience on audit judgement has been mixed (Bonner, 1990). Because
5
RESEARCH QUESTIONS
|
using valuation specialists seems to decrease both the reputational
and litigation risks, our second research question is as follows:
5.1 |
firms
Fair value reporting among the BIG4 audit
RQ2. Does the use of valuation specialists differ among
the BIG4 audit firms?
Knechel et al. (2013) write that one element of the audit quality
framework is the audit report. Francis (2011) argues that an audit
report is a signal of audit quality, but the audit report as an indicator
of audit quality has been limited because audit report content has
5.3 | Challenging management estimates among
the BIG4 audit firms
been restricted. The fact and expectation and information gaps that
Mock et al. (2013) point out have been solved or reduced in a new
Auditors’ reputations and risk of litigation require high-quality
reporting format. Mock et al. (2013) point out that one missing ele-
auditing; thus, we can assume that the BIG4 audit firms aim to main-
ment is significant audit risks. Reporting KAMs has resolved and
tain high-quality audits. However, the effects of challenging the man-
reduced this limitation.
agement estimates on the auditor’s reputational risk and risk of
Our premise is that the audit report of the BIG4 auditor is of high
litigation have not been investigated. Past studies have concentrated
quality. The content of the auditor’s report can be examined in terms
on scepticism regarding management estimates on financial state-
of the number of items to be reported. Another substantive research
ments (Feng & Li, 2014; Niemeier, 2007; Selling & Nordlund, 2015).
object is whether the reported audit tasks differ from those men-
Sceptical procedure’s impacts on KAM reporting have been
tioned in the standards (in the current study, examining the KAMs in
researched by Asbahr and Ruhnke (2019). Therefore, it can be
audit reports). Accordingly, our first research question is as follows:
assumed that a reported challenge to management estimates may not
have the same significance as using the valuation specialist described
RQ1. Does the number of reported audit tasks con-
above (Martin et al., 2006). Challenging management estimates is also
cerning the fair value of investment properties differ
not required in all situations (FRC, 2020). Reporting management chal-
among the BIG4 audit firms?
lenges could lead to Type I and Type II reporting errors. Type I means
that the auditor has unnecessarily challenged management estimates.
In a Type II reporting error, the auditor has failed to challenge man-
5.2 | The use of fair value specialists among the
BIG4 audit firms
agement estimates, even though they should have. Audit inspectors
also expect auditors to challenge management assumptions more frequently (FRC, 2020; PCAOB, 2014). Therefore, auditors can reduce
BIG4 audit firms have been considered a homogeneous group when
inspection findings by adding challenges to their audit reporting. The
considering audit quality (Bennouri et al., 2015; DeAngelo, 1981).
BIG4 audit firms are accustomed to keeping a unified set of reporting
BIG4 audit firms’ reputational and litigation risks increase the incen-
qualities based on previous research. This assumption introduces us
tives to perform higher audit quality (Boone et al., 2010;
to the final research question:
Palmrose, 1988; Simunic & Stein, 1987). There is no absolute requirement under IAS 540 (Auditing accounting estimates and related disclo-
RQ3. Does the number of management estimates that
sures) that valuation specialists should be used for fair value auditing.
are challenged differ among the BIG4 audit firms?
However, it is typical for auditors to use fair value specialists when clients use external valuers in the real estate sector (Cannon & Bedard,
2017; Glover et al., 2017; Griffith, 2020; Sangchan et al., 2020).
6
EMP I RICAL D ES IGN
|
Despite the contradictory findings when it comes to using valuation specialists to improve audit quality (Boritz et al., 2020;
6.1
|
Data
Griffith, 2018; Joe et al., 2017), auditors expect that using valuation
specialists will increase because of the requirement from auditor
The focus of the current study is the reporting of KAMs in the real
inspectors (FRC, 2020; PCAOB, 2014). Furthermore, since auditors
estate sector. Our sample includes data from companies operating in
359
HONKAMÄKI ET AL.
NACE Rev.2. Industry 68 “Real estate activities” and that apply IFRS
book-to-market ratio gets extreme values because of negative equity
standards. We compared the gathered company list to the list of com-
capital observations. Previous auditing literature has pointed out that
panies at EPRA (European Public Real Estate Association) for EPRA
a
nomination. All missing companies from the previous list were added
(e.g., Abdolmohammadi et al., 2017; Francis, 2004). Therefore, we
country’s
legal
system
may
affect
auditors’
behaviour
to the data. We deleted all financial statements in which investment
include legal origin dummies in our analysis. Table 1 presents the vari-
properties are not classified as a separate balance sheet item, as
able definitions, Table 2 presents the descriptive statistics, and
defined by IAS 40. Our data contain companies for Europe, covering
Table 3 presents the sample observations by country. Table 3 also
60% of the listed real estate companies in the EU, Switzerland, and
presents the number of REIT clients per auditor in each country, along
Norway. Country frequencies are tabulated in the Table 3. We hand-
with the country’s legal origin. Legal origins are based on Porta
collected all available English versions of the financial statements from
et al. (1998) and the CIA Fact Book.
2017 to 2018. Information about challenging management’s view
From Table 2, we can see that our data do not have any extreme
about the fair value and valuation specialists’ use is collected from
values. The standard deviations are also reasonable when compared
audit reports. Next, we hand-collected the change of investment
with the mean values. Our data contain more than 50 observations
properties’ fair value as recognized in the profit and loss account and
for each BIG4 auditor. PWC covers 28.5% of our observations. The
the carrying value of investment properties. The financial data are
corresponding shares for other BIG4 auditors are 26.8%, 23.0%, and
complemented from the Refinitiv Eikon database. We have excluded
21.7% for KPMG, Deloitte, and EY, respectively. Most of our observa-
observations with missing data for any variables. Our sample consists
tions (39.6%) fall into common law legal origin countries, 23.8% into
of 127 individual companies, of which 108 have data from 2017 and
French, 15.74% into German, and 20.85% into Scandinavian.
127 from 2018, making up 235 firm-year observations.
6.3
6.2
|
|
Methods
Variables
We use a one-way ANOVA to compare the mean RESPONSE values
RESPONSE is our primary variable of interest, which is the number of
between groups to compare auditors’ reporting behaviour. We also
audit procedures in the KAMs reported in the audit report. The maxi-
present a post hoc Bonferroni statistic for pairwise group compari-
mum number of reported issues in the audit report related to the key
sons. To consider the nature of the RESPONSE distribution (0–8), we
audit matter of the fair value of investment property is eight, with the
also provide a nonparametric Kruskal–Wallis test and Dunn’s rank-
minimum being zero. So, for example, if an auditor has pointed out
sum test for pairwise comparisons. Finally, in the case of CHALLENGE
concerns about all possible KAMs, this RESPONSE takes a value of
and SPECIALIST, we provide cross-tabulations with chi-squared test
8. Two of these eight issues—CHALLENGE and SPECIALIST—are not
statistics.
included in the audit standards. In our research setting, these are the
We use the ordered logit model for RESPONSE and the binary
most interesting because they concern with challenging the manage-
logit model for CHALLENGE and SPECIALIST in a multivariate analy-
ment’s fair value opinion and valuation specialists’ use. CHALLENGE
sis. In both cases, the logit model is reasonable because of the depen-
takes a value of 1 if an auditor has challenged the fair value opinion
dent variable’s binomial or ordered nominal nature and because our
and 0 otherwise. SPECIALIST takes a value of 1 if an auditor has used
auditor variables are dichotomous. In the ordered logit model, we
a valuation specialist and 0 otherwise.
We are interested in the differences among auditors’ reporting,
especially among the BIG4 audit firms. Therefore, our sample includes
TABLE 1
Variable definitions
Variable
Definition
RESPONSE
Number of reported (KAM) issues in the audit report
CHALLENGE
1 if an audit report includes KAM concerning F.V.
and 0 otherwise
SPECIALIST
1 if an auditor has used valuation specialist and 0
otherwise
FVCHANGE
Change of fair value/investment properties
only BIG4 audit firms. We also exclude joint audits because of hard
directing the appropriate BIG4 auditor.
In regression models, we provide a set of control variables that
may influence audit reporting. Because our focus is on the real estate
industry and our dependent variables are expected to be related to
fair value, we control the absolute value of change of fair value
divided by the fair value before the change (FVCHANGE). In addition,
we include firm-specific controls that have been used in auditing
LNASSETS
Natural logarithm of total assets
the total assets (LNASSETS) (e.g., Kallunki et al., 2019; Khurana &
ROA
P/L after tax/Total assets
Raman, 2004), the return of assets (ROA) (e.g., Kallunki et al., 2019),
LEVERAGE
Total debt on period average/Total assets
LEVERAGE (e.g. Kallunki et al., 2019; Khurana & Raman, 2004), and
TOBINQ
Tobin’s Q = (MarketCap + TotalAssets

TotalEquity)/TotalAssets
LEGAL
Legal origin, 1 = common law, 2 = French,
3 = German, 4 = Scandinavian
research. We control for firm size, which is the natural logarithm of
Tobin’s Q (TOBINQ). Several studies have used the book-to-market
ratio or market-to-book ratio as a control variable s(e.g., Gul
et al., 2002; Khurana & Raman, 2004). We use Tobin’s Q because the
360
HONKAMÄKI ET AL.
N
Mean
St.dev
Min
Max
RESPONSE
235
4.545
1.396
0
8
CHALLENGE
235
0.277
0.448
0
1
1
SPECIALIST
235
0.502
0.501
0
FVCHANGE
235
0.043
0.067

0.409
0.291
LNASSETS
235
15.509
5.131
6.874
25.799
ROA
235
0.052
0.063

0.619
0.232
LEVERAGE
235
0.362
0.165
0
TOBINQ
235
1.654
4.966
EY
51
21.7%
COMMONLAW
93
39.57%
PWC
67
28.5%
FRENCH
56
23.83%
KPMG
63
26.8%
GERMAN
37
15.74%
Deloitte
54
23.0%
SCANDINAVIAN
49
20.85%
235
100.0%
235
100.0%
TABLE 2
Descriptive statistics
TABLE 3
country
Sample market shares by
1.563
0.465
63.54
Note: Variable definitions are shown in Table 1.
Country
1 = EY
2 = PWC
3 = KPMG
4 = Deloitte
Austria
3
0
2
2
7
German
Belgium
8
7
0
6
21
French
Cyprus
0
1
0
0
1
Common law
Total
Legal origin
Denmark
1
2
0
0
3
Scandinavian
Estonia
0
3
0
0
3
German
Finland
2
0
6
0
8
Scandinavian
France
0
0
2
1
3
French
Germany
0
3
11
1
15
German
Great Britain
14
20
19
24
77
Common law
Greece
0
3
0
0
3
French
Ireland
0
3
1
2
6
Common law
Italy
2
1
0
0
3
French
Luxembourg
0
0
2
0
2
French
Malta
0
5
1
0
6
Common law
Netherlands
5
4
3
0
12
French
Norway
1
2
4
2
9
Scandinavian
Poland
0
0
0
2
2
French
Spain
0
5
0
5
10
French
Sweden
7
7
6
9
29
Scandinavian
Switzerland
8
0
4
0
12
German
Virgin Islands
0
1
2
0
3
Common law
Total
51
67
63
54
235
Note: The number of REIT clients per auditor in the country. Total number of observations by country
and countries legal origin.
assume that the RESPONSE categories have equal distances. We also
auditors’ industry specialization. We present our sample country sta-
run our analysis with country dummies to consider the possibility that
tistics with corresponding client numbers in Table 3. Year dummies
one or several countries may be driving our results. We include legal
are also included in the model, and standard errors are clustered at
origin dummies in our analysis as an alternative control for country
the firm level. The linearized version of our regression model is pres-
differences. Our data do not provide the possibility to observe
ented in Equation (1).
361
HONKAMÄKI ET AL.
Depi,t ¼ β0 þ
4
X
βk ðAuditorÞk þ ctrlsi,t þ βl Year2018 þ
21
X
7
βm ðCountryÞm,
RE SU LT S
|
m¼1
k¼1
7.1
ð1Þ
|
Research question 1
We begin our analysis by comparing the RESPONSE of auditors.
where Dep is RESPONSE, CHALLENGE, or SPECIALIST and the audi-
Table 4 presents the mean values and mean ranks for each auditor
tor is a dummy for each audit company. Common law legal origin is
group. Pairwise comparison statistics are Bonferroni for mean differ-
treated as a reference category in the regressions, and Deloitte is the
ences and Dunn’s rank test for ranks. We observe differences in
reference category for BIG4 firms.
RESPONSE mean values. Deloitte has the highest value of 5.056,
TABLE 4
Pairwise comparison statistics for RESPONSE
1
2
3
4
1 EY
Mean
4.078
(n = 51)
Mean rank
94.67
2 PWC
Mean
0.28
4.358

1.34*
111.18
0.60
0.32
4.683

2.30**

1.046
123.35
0.98***
0.70**
0.37
5.056

3.68***

2.56***

1.54*
142.26
(n = 67)
Mean rank
3 KPMG
Mean
(n = 63)
Mean rank
4 Deloitte
Mean
(n = 54)
Mean rank
(n = 235)
ANOVA F = 5.17***
Kruskal–Wallis χ 2 = 13.949***
Note: Variable definitions are shown in Table 1. Group means, mean ranks, Bonferroni (italics) and Dunn’s (bolded and italics) statistics.
*p < 0.1. **p < 0.05. ***p < 0.01. TABLE 5 Ordered logit regression (1) OR (2) OR (3) OR 1. EY
1.365*** (0.482) 0.255
1.134** (0.491) 0.322
1.237*** (0.457) 0.290 2. PWC
0.912** (0.378) 0.402
1.366** (0.547) 0.255
0.991** (0.385) 0.371 0.559
0.244 (0.505) 0.784
0.381 (0.428) 0.683 3. KPMG
0.582 (0.419) LNASSETS 0.007 (0.032) 0.039 (0.045) 0.022 (0.033) FVCHANGE 2.674 (2.553) 1.720 (3.352) 4.008* (2.411) ROA
1.985 (3.639)
0.157 (4.066)
2.083 (3.227) Leverage
0.456 (1.109) 0.847 (1.460) 0.950 (1.281) TOBINQ
0.013 (0.015)
0.005 (0.014)
0.011 (0.013) Legal origin 1. FRENCH
0.791** (0.373) 0.453 2. GERMAN
1.683*** (0.474) 0.186 3. SCANDINAVIAN
1.074*** (0.407) 0.341 Year fixed effects Yes Yes Yes Country fixed effects No Yes - Obs. 235 235 235 Pseudo R2 0.022 0.104 0.048 Note: Robust standard errors are in parenthesis. Variable definitions are shown in Table 1. Dependent variable: RESPONSE. Coefficients, (std. errors). Reference categories are Deloitte for auditor and common law for legal origin. *p < 0.1. **p < 0.05. ***p < 0.01. 362 HONKAMÄKI ET AL. KPMG 4.683, and PWC 4.358; EY has the lowest value of 4.078. The held constant. Likewise, the odds of the combined highest rates ver- ANOVA F test (F = 5.17) and the Kruskal–Wallis ( χ 2 = 13.949) point sus the lowest response rate is 3.9 times lower. to significant differences between groups. The Bonferroni test points Our results propose that when compared with Deloitte, EY has to significant differences for Deloitte versus EY and PWC in the the lowest likelihood of having a higher RESPONSE score. PWC has pairwise comparison test. Dunn's test for rank sums shows significant the second-lowest likelihood (e.g.,
0.912 in col 1). These results are differences between Deloitte and every other BIG4 audit firm (the dif- statistically significant in all models. We do not observe significant dif- ference between Deloitte and KPMG is significant at the 90% level). ferences between Deloitte and KPMG. The highest pseudo R2 (0.104) There is also a significant difference between EY and KPMG and is in model 2, where country dummies are included. Model 3 with between EY and PWC. The latter is significant at the 90% level. legal system dummies has a pseudo R2 of 0.048, but the coefficients We now move to an ordered logit regression to control the previ- for legal dummies are highly significant. Significant negative coeffi- ously known issues that may cause a higher RESPONSE score. Table 5 cients signify that compared with the common law legal system, audi- presents the results of the ordered logit models. Our main question tors operating in other legal environments are less likely to report a relates to the differences among the BIG4 audit companies, and we higher number of KAMs. run our models with year dummies (columns 1–3), country dummies (column 2), and legal origin dummies (column 3). Logistic models can estimate the raw coefficients for variables and evaluate the odds for 7.2 | Research questions 2 and 3 each category. In other words, we can compare the odds among auditors to get a higher RESPONSE score. The reference category for Our sample companies operate in the real estate sector, and a remark- auditors is Deloitte. We present the regression coefficients and odds able share of their assets lies in investment properties. The use of fair ratios (OR) for the categorical variables. We can interpret the results value allows management to use fair value as an instrument to adjust as follows. Regression coefficient shows that one unit change in the the results according to their own will. Therefore, we take a closer predictor means the value of coefficient times change in the log odds look at RESPONSE. We run some additional analyses for SPECIALIST in the dependent variable. Interpreting the OR means that for a one and CHALLENGE, which are the industry-related components of unit increase in predictor, that is, going from 0 to 1, the odds of high RESPONSE. In addition, these two components are not included in category of RESPONSE versus the combined middle and low catego- audit standards. ries are the value of OR times greater. For example, in a column. 1, for We first cross-tabulate SPECIALIST and CHALLENGE with the EY, the coefficient is
1.365, and we would say that for a one-unit audit groups and provide a chi-squared test for distributions (Table 6). increase in EY (going from 0 to 1 [compared with Deloitte]) we expect Again, we observe the variation among the auditors. Out of all the a 1.365 decrease in the log odds of being in a higher level of auditors, 27.66% have challenged management's opinion about fair RSPONSE, given all of the other variables in the model are held con- value. For example, Deloitte reported management challenges in about stant. That is, going from 0 to 1, the odds of 3.9 (1/0.255) of the 52% of cases, while EY reported challenges in about 14% of cases. highest response rate versus the combined lower response rates are PWC and KPMG are very close to each other, with about 22–23% of 3.9 times lower, given that all of the other variables in the model are cases. The observed differences are statistically highly significant. TABLE 6 Cross-tabulation of auditor versus CHALLENGE and SPECIALIST CHALLENGE 1 = EY 2 = PWC 3 = KPMG 4 = Deloitte 1 EY 2 PWC 3 KPMG 0 SPECIALIST 1 Total 0 1 Total 44 7 51 20 31 51 86.27 13.73 100.00 39.22 60.78 100.00 51 16 67 39 28 67 76.12 23.88 100.00 58.21 41.79 100.00 49 14 63 30 33 63 77.78 22.22 100.00 47.62 52.38 100.00 4 Deloitte 26 28 54 28 26 54 48.15 51.85 100.00 51.85 48.15 100.00 Total 170 65 235 117 118 235 72.34 27.66 100.00 49.79 50.21 100.00 χ2 22.153; p = 0.000 4.391; p = 0.222 Note: The first row presents frequencies, and the second row presents row percentages. The variable definitions are in Table 1. Frequencies, percentages, and chi-squared test statistics. 363 HONKAMÄKI ET AL. TABLE 7 Logit regression results 1. EY (1) SPECIALIST (2) SPECIALIST (3) SPECIALIST 0.367 (0.507) 0.443 (0.525) 0.495 (0.496) 2. PWC
0.327 (0.426)
0.541 (0.485)
0.326 (0.436) 3. KPMG 0.118 (0.443)
0.042 (0.550) 0.253 (0.469) LNASSETS 0.042 (0.034) 0.075* (0.041) 0.058* (0.034) FVCHANGE
1.598 (3.489)
7.546 (4.922)
0.535 (3.219) ROA
1.749 (3.713) 4.594 (4.671)
2.725 (3.661) Leverage
0.745 (1.070) 0.145 (1.396)
0.013 (1.176) TOBINQ
0.031 (0.027)
0.042 (0.034)
0.031 (0.025) Legal origin 2. FRENCH
0.565 (0.407) 3. GERMAN
1.009* (0.587)
0.413 (0.453) 4. SCANDINAVIAN _cons
0.243 (0.737)
2.079 (1.542)
0.427 (0.754) Year fixed effects Yes Yes Yes Country fixed effects No Yes No Obs. 235 223 235 Pseudo R2 0.028 0.086 0.045 Note: Robust standard errors are in parentheses. The variable definitions are in Table 1. The dependent variable is SPECIALIST. Reference categories are Deloitte for auditor and common law for legal origin. Coefficients and (standard errors). *p < 0.1. **p < 0.05. ***p < 0.01. TABLE 8 Logit regression results (1) CHALLENGE (2) CHALLENGE (3) CHALLENGE 1. EY
1.836*** (0.536)
2.908*** (0.751)
1.799*** (0.560) 2. PWC
1.171** (0.508)
1.725** (0.720)
1.194** (0.519) 3. KPMG
1.365*** (0.528)
1.654*** (0.551)
1.362*** (0.511) LNASSETS
0.001 (0.036)
0.006 (0.049) 0.024 (0.037) FVCHANGE 2.842 (3.786) 2.738 (5.045) 2.558 (3.483) ROA
3.579 (5.433)
3.849 (6.324)
3.379 (4.729) Leverage
1.200 (1.612)
2.152 (1.850) 0.111 (1.554) TOBINQ 0.181* (0.100) 0.434*** (0.113) 0.151* (0.083) Legal origin 2. FRENCH
1.241** (0.540) 3. GERMAN
0.829 (0.620)
0.861 (0.547) 4. SCANDINAVIAN _cons 0.545 (0.956) 1.375 (1.447) 0.295 (0.923) Year fixed effects Yes Yes Yes Country fixed effects No Yes No Obs. 235 202 235 Pseudo R2 0.116 0.240 0.146 Note: Robust standard errors are in parentheses. The variable definitions are in Table 1. The dependent variable is and CHALLENGE. Reference categories are Deloitte for auditor and common law for legal origin. Coefficients and (standard errors). *p < 0.1. **p < 0.05. ***p < 0.01. 364 HONKAMÄKI ET AL. with those of common law origin, have a lower possibility of using a When it comes to valuation specialist use, about 50% use a valua- specialist. tion specialist out of all the auditors. EY has the highest rate of using In terms of CHALLENGE (Table 8), Deloitte challenges manage- a specialist (about 61%). The observed differences among the BIG4 audit companies are not statistically significant. ment more likely than the others (significant negative coefficient for Finally, we use the logit model to analyse the differences among other BIG4 dummies in all columns). Compared with Deloitte, EY has the auditors (Tables 7 and 8), using the same controls as in the earlier the lowest probability of challenging management opinion. For exam- ordered logit model. Again, the control group is Deloitte in the BIG4 ple, the coefficient for EY is
1.836 in column 1 and
2.908 in col- auditor group and common law legal origin in the legal origins. We do umn 2. Auditors operating in French legal origin, here compared with not find significant differences in using valuation specialists among common law origin countries, have a lower possibility of challenging the BIG4 auditors. This is in line with our earlier observations in the management. Compared with the models for the use of specialists cross-tabulations. As a whole, it is difficult to predict the use of valua- (Table 7), the values of pseudo R2 are relatively higher, between 0.116 2 tion specialists. First, the pseudo R for our models is between 0.028 and 0.240. The and 0.086. Second, we find only a couple of 90%-level significant results of the challenge are clearer than using coefficients. A positive coefficient for firm size indicates that the valuation specialists. When it comes to separating RESPONSE higher the client company, the higher the probability of using a spe- components, cialist. Auditors operating in French legal origin countries, compared differences. 1 1 CommonLaw Mean 2 3 Mean rank 139.60 2 French Mean
0.69** 4.339 (n = 56) Mean rank Mean (n = 37) Mean rank 4 Scandinavian Mean CHALLENGE 2.54*** 110.08
1.14***
0.45 3.892 3.85*** 1.50* 90.04
0.69** 0.01 0.46 4.347 2.87*** 0.39
1.11 106.02 (n = 49) Mean rank (n = 235) ANOVA F = 7.84*** Kruskal–Wallis χ 2 = 17.750*** can explain the observed T A B L E 9 Pairwise comparison statistics for RESPONSE by LEGAL origins 4 5.032 (n = 93) 3 German only Note: Group means, mean ranks, Bonferroni (italics) and Dunn's (bolded and italics) statistics. Variable definitions are shown in Table 1. *p < 0.1. **p < 0.05. ***p < 0.01. TABLE 10 Ordinal logit results 1. EY (1) CommonLaw (2) French (3) German (4) Scandinavian
0.459 (0.646)
2.178** (0.851)
4.609*** (1.133) 0.335 (0.843) 2. PWC
1.891*** (0.581)
1.461* (0.817)
2.557** (1.1) 0.574 (1.356) 3. KPMG
0.758 (0.713)
2.12 (1.517)
2.302*** (0.861)
0.324 (0.813) LNASSETS 0.067 (0.053)
0.111 (0.119) 0.07 (0.119) 0.13* (0.068) FVCHANGE 1.913 (4.616) 9.759*** (3.709) 17.804** (8.401)
38.092* (20.8) ROA
3.979 (8.276)
7.415 (8.242) 13.064 (12.204) 60.219** (26.802) Leverage
1.778 (1.935)
0.073 (3.666) 16.198** (7.636)
2.556 (1.882) TOBINQ
0.013 (0.065)
0.027 (0.023)
6.003 (4.989) 3.114** (1.229) Year fixed effects Yes Yes Yes Yes Obs. 93 56 37 49 R2 0.058 0.089 0.281 0.134 Note: Dependent variable is RESPONSE. Robust standard errors are in parentheses. *p < 0.1. **p < 0.05. ***p < 0.01. 365 HONKAMÄKI ET AL. 7.3 | Additional analysis legal origins. The highest mean value (5.032) of RESPONSE is in Common law countries and the lowest (3.892) in German legal origin coun- We found earlier that the legal environment has strong explanation tries. Both the Bonferroni and Dunn's statistics state that the power when analysing variation in reported KAMs. This is especially Common law countries differ from others. the case of RESPONSE. This raises the question of variation of KAMs In the ordered logit results (Table 10), we find that in the Com- between legal origins. Therefore, we run additional analysis, starting mon law countries, PWC auditors report fewer KAMs than Deloitte with comparing RESPONSE mean values between legal origins and auditors. EY and PWC report fewer KAMs than Deloitte in the French ending with sub-sample regression analysis. The regression models legal origin countries. In the German legal origin countries, every three are the same as used in our primary analysis. auditors report fewer KAMs than Deloitte, while in Scandinavian legal Table 9 presents the mean values of REPONSE by each legal origin. We find that there are statistically significant differences between TABLE 11 Logit regression results origin countries, we do not find any significant differences between BIG4 auditors. (1) CommonLaw (2) French (3) German (4) Scandinavian 1. EY a
1.848* (1.074) 0.338 (1.701) 1.117 (1.282) 2. PWC
0.527 (0.632)
1.666** (0.815) 0.841 (1.698) 0.364 (1.055) 3. KPMG 0.061 (0.766)
0.769 (1.242)
0.227 (1.288) 0.271 (1.041) LNASSETS 0.051 (0.062)
0.054 (0.086) 0.311 (0.216) 0.125* (0.068) FVCHANGE 1.801 (8.62)
8.278 (6.738) 13.968 (25.689)
6.932 (17.822) ROA
7.618 (12.147) 2.665 (7.144) 18.484 (23.905)
12.686 (25.442) Leverage
4.79 (2.931) 1.969 (2.108) 12.015 (7.968)
2.801 (3.568) TOBINQ 0.021 (0.081)
0.095* (0.05)
1.054 (4.887) 5.604** (2.603) _cons 1.323 (1.261) 1.379 (2.115)
11.839 (7.394)
5.921* (3.327) Year fixed effects Yes Yes Yes Yes Obs. 79 56 37 49 R2 0.081 0.151 0.208 0.174 Note: Robust standard errors are in parentheses. Dependent variable is SPECIALIST. a EY is excluded due to lack of variation of SPECIALIST within EY auditors in the Common law countries. *p < 0.1. **p < 0.05. ***p < 0.01. TABLE 12 Logit regression results (1) CommonLaw (2) French (3) German (4) Scandinavian 1. EY
2.464*** (0.831)
2.617* (1.488) a
1.143 (1.746) 2. PWC
2.229*** (0.691)
2.381* (1.261) a 1.025 (1.673) 3. KPMG
2.325*** (0.731)
2.363 (2.811)
0.992 (2.042)
2.791 (1.923) LNASSETS 0.04 (0.059)
0.195 (0.19) 0.121 (0.182) 0.096 (0.141) FVCHANGE 0.006 (6.812) 6.728 (6.928) 4.455 (33.545)
21.079 (18.594) ROA
3.873 (10.028)
10.235 (7.512)
38.225 (39.388) 72.755*** (27.714) Leverage
5.01* (2.708)
2.203 (2.414)
9.807 (10.685) 6.788 (5.705) TOBINQ 0.05 (0.046) 0.934** (0.441) 1.725 (7.49) 5.314** (2.531) _cons 2.689** (1.36) 3.687 (2.62) 1.711 (13.088)
15.474*** (4.978) Year fixed effects Yes Yes Yes Yes Obs. 93 56 20 49 R2 0.193 0.369 0.297 0.381 Note: Robust standard errors are in parentheses. Dependent variable is CHALLENGE. a EY and PWC are excluded due to lack of variation of CHALLENGE within EY/PWC auditors in the German legal origin countries. *p < 0.1. **p < 0.05. ***p < 0.01. 366 HONKAMÄKI ET AL. Table 11 presents results for the use of a valuation specialist. This legal system, EY, KPMG, and PwC have statistically significantly less sub-sample analysis shows that it is the French legal origin where the audit reported audit procedures than Deloitte. Our results indicate BIG4 auditors differ in using a specialist. Namely, in the French legal that BIG4 audit companies are not reporting the same audit tasks origin countries, compared with other BIG4 auditors, EY and PWC relating to the fair value of investment properties in their audit auditors use less likely valuation specialists. This finding is statistically reports. significant at a 95 (90) percent level in the case of PWC (EY). We found that the reported audit procedures differ among the Finally, Table 12 presents the results of the subsample analysis BIG4 audit companies. A statistically significant difference among the for CHALLENGE. We find that the differences between BIG4 auditors BIG4 audit companies was found in reporting the challenges of man- exist in the Common law countries. Compared with other BIG4 audi- agement estimates. Deloitte statistically significantly more often tors, Deloitte challenges management opinion more likely (significant reports challenge management estimates when compared with the negative coefficients for EY, PWC, and KPMG in column 1). other BIG4 audit firms in the common law legal systems. There were also statistically significant differences between Deloitte and EY and PwC of French origin. In French legal origin, Deloitte report challenges 8 | C O N CL U S I O N the management more often than EY and PwC. In challenging management valuations regarding fair values, about 28% of audit reports The current study aimed to determine whether BIG4 audit companies include a sentence relating to a challenge of management estimations. could be treated as a homogenous group related to audit reporting. EY's reporting on management valuation challenges was statistically Previous studies have shown that audit report quality indicates audit significantly less frequent than the other BIG4 audit firms. The legal quality (Francis, 2004; Francis & Krishnan, 1999; Financial Reporting system affects the result overall. The differences between legal sys- Council [FRC], 2008; Lennox, 1999; Weber & Willenborg, 2003), and tems impact the results. In Common Law countries, auditors reported the BIG4 audit firms have been considered a homogenous group in challenging management estimations more often than in other legal relation to audit quality (DeAngelo, 1981; Defond et al., 2000; systems. Ferguson et al., 2003; Francis, 2004; Francis & Krishnan, 1999; Francis & Wilson, 1988; Simunic & Stein, 1987). We also examined the use of valuation specialists. Valuation specialists were mentioned in 50% of the audit reports, but we did not KAMs in audit reports have been a mandatory requirement since find statistically significant differences among the BIG4 audit firms. the ISA audit-related audit report (ISA 701.11) of publicly listed com- The legal origin itself does not impact the auditor's reporting. How- panies (ISA 701.5) after December 2016, but there is no standard ever, in the French legal origin, Deloitte has used valuation specialists model for auditors' reports. This means that the content of the audit statistically significantly more often than EY and PwC. report (which also serves as an indicator of audit quality) may differ Although our study reports significant differences among the between the audit companies; thus, KAMs provides an excellent BIG4 audit companies, we cannot reject the existing BIG4 audit com- opportunity to investigate the differences between auditors' panies and audit quality evidence. In the case of challenging manage- reporting. ment opinion, there are two types of errors in auditing. Type 1 errors We explored this issue by using hand-collected KAM data from (false positive) suggest that an auditor challenges the opinion, even audit reports. In addition, our research setting of real estate compa- though they are correct. Type 2 errors (false negative) suggest that nies allowed us to compare auditor behaviour, particularly in terms of auditors do not challenge the opinion, even though they should. We the total number of reported issues, valuation specialist use, and chal- have not studied whether complement or supplement audit activities lenging management opinion. can cover these issues. Our findings provide some indication that BIG4 audit companies We also found that a country's legal origin plays a role when audi- do not harbour the same issues when reporting KAMs on audit tors report KAMs. Auditors operating in common law-origin countries reports. There is a wide range of explanations describing what the tend to report more audit procedures in KAMs. In contrast, auditors auditor has done. The range listed on the audit report and fair value of operating in German legal origin countries report the most minor investment properties KAMs were 0 to 8, with the average being number audit procedures in KAMs. Although we do not find differ- 4.55. ences among the BIG auditors when using valuation specialists overall, We found some statistically significant differences in the number we find little evidence that auditors operating in German legal origin of audit procedures reported by BIG4 audit companies. Assessed by countries are less likely to use valuation specialists than other legal probabilistic calculations, Deloitte has the highest probability of origins. However, we found out that the Deloitte report uses special- reporting the audit report with the most audit activities. Although ists more often than PwC and EY in the French legal origins. Finally, legal origin will affect the results, our findings showed statistically sig- auditors operating in French and German legal origin countries are nificant differences between BIG4 audit companies with different less likely to challenge management opinions. legal origins. For example, PwC has statistically significantly fewer The current study contributes to the audit literature. However, it reported audit procedures than Deloitte in common law legal origin. also has implications for regulators who frequently require auditors to In the French legal system, EY and PwC have statistically significantly pay attention to management estimations of fair value estimations less audit reported audit procedures than Deloitte, and in the German and auditors' responses to management discretion around fair values 367 HONKAMÄKI ET AL. (FRC, 2020; Joe et al., 2017; Public Company Accounting Oversight PERMIS SION TO REPRODUCE MATERIAL F ROM OTHER Board [PCAOB], 2014). Real-life evidence about auditors' responses SOURC ES to fair value estimations could provide a new aspect for future audit This is an original article, and this has not been published or request reporting requirements and a response to highly estimated for publishing of any other sources. information. Further investigation could also focus on why auditors do not DATA AVAILABILITY STAT EMEN T report management challenges more often. Another area for investi- The data that support the findings of this study are available from the gation could be whether the BIG4 audit companies report using a val- corresponding author upon reasonable request. uation specialist in litigation for risk mitigation purposes or for meeting supervisors' needs. One answer may also be a challenge to OR CID the fair value verification is true. One possible future research area Tuomas Honkamäki https://orcid.org/0000-0001-7026-2768 could be the difference between legal systems related to the content of KAM. 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Grezov and Drazin (1997) state that equifinality depends on functional organizational demands and the options available to managers to deal with those demands. Based on our findings in audit reports, in terms of equifinality, the audit quality of BIG4 audit companies depends on (1) the differences in functional demands (challenges in estimation of fair values, role of management in fair value estimations, reputation of audit firm, and risk of litigation, demands of supervisors, and demands of investors) and (2) the options available to auditors to deal with those demands (audit standards, use of valuation specialists, audit reports, and KAMs). When the premise is that BIG4 audit firms strive to maintain high-quality audits, our results show that different strategies can achieve this. In this way, we can say that different auditing strategies in different contexts may lead to similar results, that is, to the equifinality of audit quality (cf. Child, 1972; Grezov & Drazin, 1997). ACKNOWLEDGEMEN TS Open access funding enabled and organized by Projekt DEAL. Open access funding enabled and organized by Projekt DEAL. CONF LICT OF IN TE RE ST We are not aware of any issues relating to the conflict of interest. E TH I CS S T A TE M E N T This study does not contain material that raises ethical issues. AUTHOR CONTRIBUTIONS Tuomas Honkamäki: develop the original idea, gather data, drafting the manuscript. Markus Mättö: Statistical analysis. Henri Teittinen: Critical revision of manuscript for adding Equifinality to the contexts. 368 Behavioral Research in Accounting, 32(2), 15–40. https://doi.org/10. 2308/BRIA-19-064 Botez, D. (2017). Updates regarding audit reporting. Studies and Scientific Researches. Economics Edition, 25(2017), 71–76. Brown, J. O., Brenier, J. H., Pyzoha, J. S., Rewffelt, A., & Zielinski, N. (2020). When does utilizing valuation specialists reduce auditors litigation risk? 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Evidence from auditors in microcap IPOs. Journal of Accounting Research, 41(September), 681–720. https://doi.org/10. 1111/1475-679X.00120 AUTHOR BIOGRAPHIES Tuomas Honkamäki, CPA, MBA (Econ.), works at independent auditor. He is a PhD student at the University of Tampere, and he works as a part-time lecturer of Eastern Finland in accounting and auditing. His research interests are accounting and auditing. Markus Mättö, D.Sc. (Econ.), works at the University of Eastern Finland as a university lecturer in accounting and finance. His research interests are corporate finance and auditing. Henri Teittinen, D.Sc. (Econ.), works at the University of Eastern Finland as an assistant professor in accounting and finance. His research interests are management accounting, control systems, performance measurement systems, and accounting systems. How to cite this article: Honkamäki, T., Mättö, M., & Teittinen, H. (2022). The homogeneity of BIG4 audit reports after the implementation of key audit matters in the context of fair value accounting. International Journal of Auditing, 26(3), 354–370. https://doi.org/10.1111/ijau.12285 It’s not a secret anymore! – People's Republic of China company and audit firm collide Kathleen Rankin,* Dina El Mahdy,** and Stephen Rau*** University of St. Bonaventure,* Morgan State University,** University of Duquesne*** ABSTRACT This case is fictitious but draws upon facts from actual occurrences. It requires students to apply auditing concepts and professional standards in an international setting. An affiliate of a U.S. accounting firm, Loxon Shanghai CPA Ltd., has received a request from the SEC for the audit workpapers of one of their Chinese clients, Great Lead Software. If Loxon complies with the SEC, they may violate Chinese State Secrecy Laws. After revelations of fraud by Great Lead Software surface, Loxon’s decision regarding the workpapers becomes more perilous. The case provides an opportunity for students to achieve multiple learning objectives including: Identify audit deficiencies in a globalized setting, identify auditor’s responsibility in the U.S. versus China, describe the benefits of International Standards on Auditing (ISA), describe how culture may affect financial reporting systems including transparency and regulatory issues, and identify potential conflicts between U.S. regulatory requirements and the Chinese state secrets laws. Keywords: Audit Workpapers; Sarbanes-Oxley Act; PCAOB; fraud; SEC Section 10A; Chinese State Secrecy Laws. The Case Based in Shanghai, China, Great Lead Software (GLS) provides software solutions for many types of industries including manufacturing, banking, and insurance. While GLS offers many types of software, supply chain management, inventory management, and accounting solutions software provide the three largest sources of revenue. GLS began operations seven years ago and had been very successful in terms of income and sales growth. Mr. Cheng Lin is the Chairman of GLS and has been with the company since its inception. Within just five years after GLS began operations, Mr. Lin was successful in having GLS listed on the New York Stock Exchange (NYSE). However, in the same year that it was listed on the NYSE, GLS abruptly changed auditors. This change occurred amid rumors of a confrontation between Mr. Lin and GLS’s Audit Committee over fraud allegations. The catalyst of the 1 allegations were financial analysts’ observations that GLS’s cash balances and profitability ratios were high relative to industry averages. Upon the resignation of its auditor, GLS filed a form 8-K with the SEC citing the resignation. The 8-K indicated the resignation was the result of scope limitations and loss of confidence in GLS’s Board of Directors. The report also indicated that prior to their resignation, the auditor encountered difficulties in authenticating cash confirmations received from GLS’s banks. The 8K also reported GLS’s Audit Committee had approved the appointment of a new auditor, Loxon Shanghai Ltd. (Loxon). Loxon is a professional services firm that provides audit, consulting, IPO support, and financial advisory services to clients in the Peoples’ Republic of China (PRC). Within the PRC, Loxon services multi-national enterprises as well as a rapidly growing number of Chinese business entities. The transition from GLS’s predecessor auditor to Loxon was accelerated as to not jeopardize GLS’s listing on the NYSE. One of Loxon’s engagement partners, Mr. Frank Harrison, performed a cursory review of the predecessor auditor’s workpapers, but had no direct correspondence with the former auditor. Mr. Harrison also reviewed GLS’s financial statements and met with the Audit Committee. Despite some lingering concerns, Mr. Harrison recommended that GLS be approved as a new client for Loxon. Loxon is among the leading firms providing services to clients in the PRC. Loxon is an affiliate of a large US audit firm which employs thousands of professionals worldwide. Loxon itself employs over 100 employees, including staff accountants, senior accountants, managers, senior managers, and partners, along with administrative staff. Many of Loxon’s staff and senior accountants have less than five years’ experience, which is common among many CPA firms. The managers and partners usually have at least seven years of experience. Besides ensuring 2 audits are in compliance with applicable laws and standards, engagement partners are also responsible for evaluating potential clients. Upon recommending GLS’s approval as a new client, Loxon assigned Mr. Harrison as its engagement partner. Mr. Harrison had been a partner with Loxon for just over four years when he was assigned to the GLS account. Prior to his time at Loxon, Mr. Harrison had lived in Washington, D.C. where he worked for Loxon’s parent firm. Loxon had been experiencing difficulty retaining employees at the partner level, so Mr. Harrison was asked to transfer from the parent firm’s D.C. office to the Loxon office in Shanghai. Along with his wife and son, Mr. Harrison decided to make the move as it would be a great experience for the entire family. In the two years since GLS was listed on the NYSE and hired Loxon as its auditor, their market valuation continued to grow, but some financial analysts were still questioning several of GLS’s financial statement items. Specifically, when compared to industry norms, GLS’s reported sales and cash balances were excessively high while several expense accounts, including cost of goods sold, were low relative to sales. Analysts were also beginning to question some of the debt information in GLS’s most recently published financial statements. Fueling these suspicions were persistent rumors regarding the abrupt resignation of GLS’s former auditor. These rumors suggested that GLS refused to provide the former auditor with original invoices that supported the growing sales and cash balances and that GLS management interfered with third-party confirmation processes. The growing suspicions over the legitimacy of GLS’s financial statements prompted the Securities and Exchange Commission (SEC) to request GLS’s audit workpapers from Loxon. The SEC’s request for GLS’s workpapers is in part guided by The Sarbanes-Oxley Act (SOX). SOX has had a profound effect on both U.S. and foreign issuers that are listed on the U.S. 3 markets, as well as their auditors. For instance, foreign public accounting firms1 that perform audit work for any public issuers listed on the U.S. markets are subject to SOX. Specifically, Title 1, Section 106 of SOX states that Foreign Public Accounting Firms that issue an audit opinion are deemed to have consented: (A) to produce its audit workpapers for the Board or the Commission in connection with any investigation by either body with respect to that audit report; and (B) to be subject to the jurisdiction of the courts of the United States for purposes of enforcement of any request for production of such workpapers.2 Responding to the SEC’s request for the GLS workpapers created a dilemma for Loxon. While Loxon was under the jurisdiction of SOX, they were also under the jurisdiction of Chinese law. Of particular concern to Loxon was the fact that by providing the GLS workpapers to the SEC, they could be in violation of China’s “State Secrecy Laws.” According to the Criminal Law of the People’s Republic of China3, Chinese companies are prohibited from disseminating information that are deemed to be state secrets. In addition to the State Secrets Law, other Chinese laws overlap and provide more protection for private data including the Criminal Law, Tort Liability Law, and the Anti-Unfair Competition Law. Companies conducting business in China are required to comply with these laws as together they provide legally binding protection against data infringement. For example, the Chinese State Secrecy Law has criminal implications for “whoever steals, spies into, buys, or unlawfully supplies state secrets or intelligence for an organ, organization or individual” based on Article 111 of the Criminal Law and Security Law in China. Unauthorized sharing of state secrets subjects individuals as well as firms to penalties 1 Foreign Public Accounting Firm is a public accounting firm that is subject to the laws of a foreign government or jurisdiction. 2 https://www.congress.gov/bill/107th-congress/house-bill/3763/text 3 http://english.court.gov.cn/2015-12/01/content_22595464_9.htm 4 ranging from public surveillance and deprivation of political rights to imprisonment and even the death penalty for severe cases that involve violations of National Security Act of the People’s Republic of China.4 Although the scope of information that is considered a state secret is mostly limited to specific categories such as national defense, foreign affairs, and energy resources, the law also includes a broad category “other matters” that are classified by the State Secrets Bureau. This provision gives Chinese authorities the right to retrospectively classify any matter as a state secret. This ambiguity gives lawmakers in China the ultimate discretion to classify information as state secrets, thus creating significant compliance and risk management challenges for any company conducting business in China. In considering the conflicting expectations of the SEC and the PRC, Loxon decided to withhold GLS’s workpapers from the SEC. Loxon’s partners were concerned that turning the workpapers over to the SEC was too risky considering China’s State Secrecy Laws. While Mr. Harrison agreed with the other partners about this decision, he was concerned that noncompliance with the SEC could cause detrimental harm to Loxon. Loxon’s decision to withhold the workpapers was not unusual. Indeed, the SEC has had difficulty in getting PRC firms that are listed on the U.S. stock exchanges to comply with the SOX and PCAOB requirements. This issue was recently brought to the attention of the U.S. Senate by former SEC Chairman Jay Clayton. As a result, the Holding Foreign Companies Accountable Act was passed in 2020 that would authorize the SEC to remove any PRC firm from the U.S. 4 https://cmkwmlive.kwm.com/en/uk/knowledge/insights/china-investigations-handling-state-secrets-and-privacydata-20150910 5 stock exchange if its auditor is not inspected by the PCAOB. The Act is expected to bolster the SEC’s efforts to enforce PRC firms’ compliance with the U.S. laws and regulations.5 The SEC’s request, coupled with the continuing questions from financial analysts’ regarding the legitimacy of GLS’s financial statements, prompted several investors to voice their concerns to both GLS’s Board of Directors and to Loxon. According to GLS’s most recent balance sheet, cash accounted for more than half of the company’s total assets. Investors were questioning why the amount was so high and whether it existed at all. In addition, Loxon had recently received additional information that proved to be troubling. As Mr. Harrison described, “[i]t was strongly suggested that we re-confirm the bank balances.” He continued, “[i]t was not until we sent a few of our auditors to several of the banks when evidence of cash fraud surfaced. Several of the bank’s employees confirmed they had known that the bank confirmations were misstated.” With these concerns and the revelation of potential fraud, Mr. Harrison requested a meeting with GLS’s Chairman, Mr. Lin. Mr. Lin was aware of the rece...