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Review of Accounting Studies
Published in: Review of Accounting Studies 2/2020

07-03-2020

Audit partner identification and audit quality

Authors: Kyungha Kari Lee, Carolyn B. Levine

Published in: Review of Accounting Studies | Issue 2/2020

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Abstract

This paper studies the effects of disclosing the audit engagement partner’s identity on individual and partnership incentives and overall audit quality. We model a collective decision problem, incorporating individual engagement partners’ preferences with the partnership’s choice of internal quality control. In our model, disclosure of the individual engagement partner (on Form AP) influences the probability that clients observe individual partners’ past performance. While Form AP disclosure increases individual partners’ incentives to provide high-quality audits for a given level of internal quality control within the partnership, it may simultaneously decrease the partnership’s incentives to maintain good internal quality control systems, leading to a net degradation in audit quality. Our paper also demonstrates that the level of external audit oversight is critical in determining whether Form AP disclosure enhances audit quality.
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Appendix
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Footnotes
1
Two empirical studies using data from countries with partner disclosures have different conclusions. Carcello and Li (2013) find evidence suggesting that engagement partner signature requirements lead to improved audit quality, whereas Knechel et al. (2015) find that an auditor who fails to issue a timely going-concern opinion is much more likely to fail again, compared to an auditor without that history, despite being individually identified.
 
2
This definition follows the practitioners’ view of audit quality that focuses on whether an audit is conducted according to relevant audit standards. Aobdia (2019a) shows that there is significant concordance between this definition of audit quality and several academic measures of audit quality, especially the issuance of a restatement and the propensity to meet or beat the zero earnings threshold. This definition is also consistent with the definition of audit quality used by DeFond and Zhang (2014) in that it refers to not only the correctness of the audit opinion but the quality of the opinion itself.
 
3
Prior research suggests that auditor characteristics such as engagement partner’s tenure, risk tolerance, and industry specialization affect the audit process (Chen et al. 2008; Zerni 2012).
 
4
Although most people assume fees are consistently increasing, year-to-year reductions in audit fees are not uncommon. Over 1100 of approximately 6500 filers experienced fee decreases in 2015 (Allocca 2016).
 
5
Two empirical studies supporting the usefulness of individual auditor information in assessing audit quality are Gul et al. (2013), which uses Chinese data to show that audit quality varies across individual auditors, and Aobdia et al. (2015), which finds evidence from Taiwanese data that the engagement partner’s identity provides informational value to investors beyond the identity of the audit firm.
 
6
Narayanan (1995) shows how the threat of noncooperation or expulsion can mitigate the moral hazard problem in partnerships in repeated games.
 
7
Aobdia et al.’s (2015) findings are consistent with audits by a higher quality engagement partner having a greater value to the client. While the value of an audit would be determined by investors’ perception of the audit quality, to focus the analysis on the interaction between individual partners and the partnership, we abstract away from the interaction between investors and the client.
 
8
Relaxing the assumption that G-type partners always produce a high-quality audit lessens but does not eliminate partner identification’s effect on individual effort, leaving our results qualitatively unchanged.
 
9
Equivalently, we could assume that G-type partners produce high-quality audits with probability one if they exert high effort and their disutility of exerting high effort is zero.
 
10
Although unmodeled, forming a partnership provides several obvious advantages, including effective recruiting to screen bad types and economies of scale for internal quality control investments (Gu et al. 2017).
 
11
Since we assume internal quality control is observable, we constrain the internal quality control system to be held fixed throughout the two periods for consistent model logic. That is, we can view η as the average level of internal quality control within the audit firm as small marginal adjustments to internal quality control between periods might be difficult to detect.
 
12
Although we have provided an interpretation based on effort (i.e., an engagement partner that is flagged must do some further work to comply with the standards of a high-quality audit), the costs may be more implicit. That is, if performance reviews depend on the outcome of the internal quality control system, then an engagement partner would bear some real economic costs of having been identified as producing a low-quality audit in the first round. For example, according to a KPMG report, “audit partners and leaders are evaluated based on an assessment of audit quality indicators” of which the results will “directly affect compensation and advancement of KPMG personnel, including partners.” The report also notes that audit partners may receive “audit quality bonuses” (KPMG, 2016).
 
13
Green and Porter (1984) show a setting where collusion may occur in the presence of imperfect information. In their setting, firms can only observe the market price, which imperfectly reflects other firms’ past quantity choices. Anticipating the effect of their quantity choice on market price, individual firms collude which involves penalizing the industry whenever the market price drops below a trigger price. In the current paper, external oversight imperfectly reflects individual partners’ actions and affects future prices, while internal controls provide additional disincentives for partners to deviate.
 
14
Although it may seem that an audit firm could simply fire a partner who was revealed to be type B, there are two reasons we do not consider this. First, our assumption that good engagement partners always produce high-quality audits is made for tractability; it is likely that even good partners sometimes produce deficient audits, albeit with a lower probability than bad partners. Second, partnership agreements are written so that it is difficult to terminate a partner. Whether such partnership arrangements are optimal is outside the scope of our model.
 
15
For example, for case (b) in Figure 3, suppose the partnership chooses η = 0.3, which is in the shaded range. When we substitute the relevant values into (7) and (8), we find that neither condition is satisfied as the left-hand side of (7) is approximately −0.018, and the left-hand side of (8) is approximately 0.092.
 
16
If firms’ optimal levels of internal quality control can differ in periods 1 and 2, it is easier to motivate partners to exert effort in the first period when the anticipated second-period level of internal quality control is lower, and type B partners are expected to exert low effort in the second period. However, given the complex interactions between the internal quality controls in each period, the model becomes analytically intractable.
 
17
According to a speech in 2016 by a PCAOB member, the Board has recently begun to consider focusing more on assessing the audit firms’ internal control efforts (Rapoport 2016).
 
18
Examples of quality control reviews include review of the firm’s processes for monitoring audit performance, review of management structure and process, and review of partner management (Center for Audit Quality 2012).
 
19
Clients may willingly agree to a recurring contract if they have a preference for stable and predictable fees. Without them, their fees would change depending on engagement partner type in the second period.
 
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Metadata
Title
Audit partner identification and audit quality
Authors
Kyungha Kari Lee
Carolyn B. Levine
Publication date
07-03-2020
Publisher
Springer US
Published in
Review of Accounting Studies / Issue 2/2020
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-020-09533-0

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