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Summary Introduction to Auditing and International Standards
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- Katholieke Universiteit Leuven (KU Leuven)
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PART 1: INTRODUCTION TO AUDITINGLECTURE 1: INTRODUCTION TO THE ECONOMICS OF AUDITING
1. WHAT IS AUDITING?
What is an auditing service?
• Auditors sell an ‘opinion’. About what?
• Offer reasonable assurance
• There is always some audit risk left no matter how good the audit service is
What is an auditing service?
The audit service has attributes of an ‘experience good’ or even a ‘credence good’. An experience good is a product or
service where product characteristics, such as quality or price, are difficult to observe in advance, but these characteristics
can be ascertained upon consumption for instance restaurants. On the other hand, credence goods are goods for which it
is difficult for consumers to ascertain the quality even after they have consumed them, such as vitamin supplements for
example or legal services, and some medical services. Hence: Auditor reputation is crucial for the audit service to be
valuable.
Auditor Reputation
• Fee premium: Auditors with better reputation can charge higher audit fees
• Return on investing in higher quality
• Reputation damage can negatively impact an audit firm’s portfolio of clients.
Auditor Reputation: The story of Enron
Established in 1985, It was as a US corporate energy giant that employed 20,000 staff and earned $101 billion in 2000.
Fortune awarded Enron as "America's Most Innovative Company" for 6 consecutive years. However, at the end of 2001,
it was revealed that its reported financial condition was sustained substantially by institutionalized, systematic, and
creatively planned accounting fraud. Restated earnings back to 1997, resulted in losses of $591 & debt of $628 by 2000.
Enron filed for bankruptcy protection in 2001 and became a symbol of corporate fraud and corruption (greedy, arrogant &
foolish management). As a consequence, the credibility in corporate reporting was lost/damaged. This led to introduction
Sarbanes-Oxley Act of 2002 and the dissolution of the audit company Arthur Andersen. Enron case has negatively impacted
reputation of accountancy profession.
Arthur Andersen (then part of the Big 5) seized operations worldwide after the scandal the Big 5 become the Big 4. Arthur
Andersen was convicted for obstruction of justice (later overruled) and surrendered their licenses on August 31, 2002 as a
result 85,000 employees lost their jobs. Other scandals that affected the reputation of the accountancy profession where
Carillion (UK), Wirecard (Germany), Parmalat (Italy), Lernout & Hauspie (Belgium) and also the Global Financial Crisis.
All these events triggered more Audit Regulation.
What is an Audit?
Merriam-Webster: “a complete and careful examination of the financial records of a business or person.”
Arens et al.: “The accumulation and evaluation of evidence about information to determine and report on the degree of
correspondence between the information and established criteria.”
Knechel: “An economically motivated professional service designed to reduce information risk (usually in the form of
financial statements) that relies on the knowledge and skills of experts used in a systematic process that considers the
idiosyncratic needs of a client where the outcome is unobservable and subject to market forces and regulatory constraints.”
Characteristic Concept
An economically motivated professional service designed to reduce information risk that Incentives and
relies on the … Economics
knowledge and skills of experts used in a … Judgement and
Cognition
systematic process that considers the … Process
idiosyncratic needs of a client where the … Client Environment
outcome is unobservable and subject to … Uncertainty
market forces and regulatory constraints. Externalities
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, 2. WHY IS THERE AUDITING?
• Because it is mandatory: For many companies auditing is mandatory. In Belgium, for firms exceeding certain
size thresholds (art. 15 W. Venn) and in the USA only for Publicly listed firms.
• Because it is valuable to shareholders and stakeholders: Costs of auditing < Benefits of auditing
• Reasons for voluntary audit demand:
1. Information demand
2. Agency / contracting demand
3. Insurance demand
(1) Information demand
Stakeholders want to make rational investment decisions. From a capital markets perspective, financial reporting has a role
to play in the efficient allocation of savings to investment opportunities/entrepreneurs. Such an allocation is not trivial
for two reasons:
1. First, entrepreneurs have better information than savers/investors about the value and quality of the business
opportunities they engage in (Information Asymmetry).
2. Second, the information that entrepreneurs provide to savers is not fully credible because savers know that
entrepreneurs have an incentive to present their projects as more optimistically than in reality (Moral hazard
problem).
Consequence: Investors cannot sufficiently distinguish between good and bad investment opportunities because of lack
of credible information; the bad firms will claim to be good firms and consequently all firms will be considered average or
equal “the lemons problem”: markets will break down due to asymmetric information. Information intermediaries, such as
auditors, can prevent a market breakdown: mitigating adverse selection and moral hazard problems.
(2) Agency / contracting demand
Auditing has a monitoring role. When ownership and control are separated, shareholders are aware of the likelihood that
managers could act in their own interest and provide them with misleading information. Rational shareholders will take
that into account when they decide on managerial compensation. Managers thus have an incentive to hire an auditor to
demonstrate their effort and performance to existing or potential shareholders. This is called the agency rationale for audit
demand. Related to agency theory is the contract monitoring role of auditing; in this context auditing is improving the
efficiency of various types of contracts in which the firm engages (Ball, 1989). For instance: Hiring a higher quality auditor
decrease the cost of debt (Pittman/Fortin JAE 2004).
(3) Insurance / Deep pocket demand
Audit demand derives from management's liability exposure for losses attributable to defective financial statements. The
auditor's professional liability exposure creates incentives for managers and professional participants in financial activities
to insure themselves against bankruptcy risk via the auditors' participation. By providing society with deep pockets relative
to bankrupt companies, auditors are in the position to offer at least some protection from an otherwise uninsurable business
risk. By requiring that companies be audited by auditing firms, who bear the liability burden, government regulators can
shift some of the bankruptcy risk to auditors. One of the main theories used to explain the existence of the Big 4.
3.AUDIT SUPPLY AND PRODUCTION
Audit is supplied by certified auditors and their audit teams. Audit supply is regulated (cfr. IBR in Belgium). Audit
production is labor intensive and also regulated.
Types of audit firms:
• Big N audit firms
• Second tier audit firms
• Small audit firms / sole practitioners
The “Big 8” The “Big 6” (after 1989) The “Big 5” (after 1998) The “Big 4” (after 2001)
• Arthur Andersen • Arthur Andersen • Arthur Andersen • Arthur Andersen
• Arthur Young • Deloitte & Touche • Deloitte & Touche • Deloitte & Touche
• Deloitte Haskins and Sells • Ernst & Young (EY) • Ernst & Young (EY) • Ernst & Young (EY)
• Ernst & Whinney • Peat Marwick Mitchell • Peat Marwick Mitchell • Peat Marwick Mitchell
• Peat Marwick Mitchell • Price Waterhouse • Price Waterhouse • Price Waterhouse Coopers
• Price Waterhouse • Coopers & Lybrand Coopers (PWC) (PWC)
• Touche Ross
• Coopers & Lybrand
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, 4.AUDIT MARKETS
Audit demand and supply meet each other at the audit market.
How do firms compete? Two effects and streams of empirical evidence:
• Differentiation strategy: e.g., Craswell et al. (1995); Mayhew & Wilkins (2003); Ferguson et al. (2003); Francis
et al. (2005); Numan and Willekens (2012). Higher quality leads to higher audit fees / more market share.
• Cost leadership strategy: Ettredge & Greenberg (1994); O’Keefe et al. (1994); Deis & Geroux; Dekeyser et al.
(2016). Cost efficiency leads to lower audit fees / more market share. Industry specialization as differentiation
strategy.
Characteristics of audit markets
• High market concentration
• Perfect competition in audit markets? No: Audit markets are more likely ‘oligopolistic’.
• Each audit firm can impact market conditions.
• Audit firms’ competitive actions are interdependent.
• There are costs and benefits to competition.
• Firms do not necessarily actively collude.
• However: different market segments could have different type of competition: e.g., the market for small versus
large audit clients
• Could even differ between clients = idiosyncratic nature
• Product differentiation in audit markets
• Large and small auditors
• Industry specialist vs. non-specialist auditors
• (Worldwide) empirical evidence suggest that product differentiation is associated with higher audit quality and is
priced (price premium)
Audit Market Evidence from Belgium
• Big 4 and Industry Specialist premiums; positive association between concentration and fees but no quality effects
(Dutillieux and Willekens, Review of Business and Economics 2009)
• Is perfect competition possible?
• Evidence of price premiums in private client segment when market share distance to closest competitor is larger;
no clear quality effects of market share distance (Numan, PhD dissertation KU Leuven 2012).
• Big 4 expand market share by offering discounts to non-Big 4 clients that are fast growing (experience good
arguments; Dutillieux, Stokes and Willekens, Accounting & Finance 2013)
• Strategically targeting clients by offering discounts to have the Big 4 experience
• Evidence of production efficiencies for industry specialists which are passed on to the client (lower fees) unless
there is market power (Dekeyser, Gaeremynck and Willekens 2019, Contemporary Accounting Research)
Regulators: Worried about “audit market aspects”
Regulators worry about whether there is sufficient competition among audit suppliers in the audit market. Why this
concern? Because of “given” demand, barriers of entry and market concentration. The audit market is characterized
by a high level of concentration and this has been a concern for policymakers for many years. Why? Because lack of
auditor choice for (mainly) large public firms may potentially lead to auditor market power Resulting in pricing effects and
audit quality effects. Alleged lack of competition in the audit market based on the argument of high concentration which
is often seen as a synonym of market power with potentially negative consequences.
EU: In Europe the economic crisis put the issue of concentration back on top of the regulatory agenda: Green paper (2010);
EU Regulation (2014): lack of auditor choice and concentration tackled via mandatory audit firm rotation. EU Regulations
still allow each country to make different choices giving variation in the implementation of the EU Regulation and therefore
no uniform cross-national approach.
U.S.: GAO Report (2008) was much milder as there were no recommendations formulated to address auditor market
concentration.
GAO Report (2008): “The overall market continues to represent a tight oligopoly, which is a concentrated market in
which a small number of firms have large enough market share to potentially use their market power, either unilaterally
or through collusion, to greatly influence price and other business practices to their advantage” (GAO report 2008, p. 16)
3
, “While generally proposed as a means of enhancing auditor independence by periodically bringing in a new auditor for a
“fresh look” at a company’s financial statements, mandatory rotation could potentially reduce concentration to the extent
that it provided more opportunities for midsize and smaller firms to compete to provide audit services to public companies”
(GAO report 2008, p. 52)
“The level of market concentration also does not appear to be affecting audit quality as many of our survey respondents
and those we interviewed said that audit quality had improved, which some attributed to the Sarbanes-Oxley Act.” (GAO
report 2008, p. 5)
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