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In audits of SMEs, the audit team normally consists of very few persons and their audit firm and audit office are typically much smaller than those that audit large private firms and public firms. This influences auditor behavior in different ways and impacts audit quality. The incentive to provide audits of sufficiently high quality decreases for SMEs because the reputational capital at risk and the risk of litigation is reduced when auditing small clients with low publicity. Additionally, in small audit firms, the pool of colleagues to consult is smaller, the internal controls are less thorough and the internal monitoring mechanisms are weaker. The risk of social bonding between auditor and client due to long-term relationships, local anchoring and familiarity is higher compared to public firms, which is a potential threat to independence. As an auditor’s reputation risk falls, when going from public to private firms, impaired independence due to economic bonding may also increase. On the other hand, the small size of the audit team makes potential synergies and spillovers gained from providing non-audit services (NAS) more easily transferable to the audit and thereby may increase audit quality.
The differences that exist between private and public firms are so large that we cannot rely on findings for public firms without careful consideration when we want to understand auditing in private firms, whether auditing is statutory or not.
REVIEW OF THE LITERATUREIn order to increase the reliability of financial statements and reduce agency costs, the audit has to be performed with high quality. Audit quality is much debated but, despite two decades of research, there is little consensus about how to define and measure audit quality (Knechel, Krishnan, Pevzner, Shefchik, and Velury 2012).
DeAngelo (1981) defines audit quality in terms of the likelihood that the auditor discovers material misstatements in a firm’s reporting system and the likelihood that misstatements are reported. Even though audit quality is more multi-faceted than DeAngelo’s two-dimensional model suggests (Knechel et al. 2012), the model is useful because much research into auditing in private firms fits how DeAngelo modeled audit quality. We therefore use that model as a point of departure.
Ability to detect misstatements The first dimension in the audit quality definition is the likelihood of discovering misstatements, which depends on the auditor’s competence and level of effort. Few studies have analyzed how observable variables relate to competence and level of effort, and most of the research has been conducted at the audit firm level, using data from listed companies. However, during the last few years researchers have started to investigate how audit quality relates not only to audit firm factors, but also to audit offices, audit teams and the individual partner (see Francis 2011; Knechel et al. 2012;
Sundgren and Svanström 2012b). These new approaches are relevant and necessary since complex auditing decisions are ultimately judgmental and taken by individuals or groups of individuals, and the evidence suggests that audit quality varies within and across each level of analysis whether being firm, office, team or partner.
Competence/expertise The resources needed to obtain reasonable assurance that the financial statements are free from material misstatements vary across engagements, and depend on the personnel, the abilities and expertise of the audit team, the audit technology and the audit methodology being used (De Angelo 1981; Knechel et al. 2012). To put it simply, “audits are of higher quality when undertaken by competent people” (Francis 2011: 134). To some extent we might assume that auditors are competent based on general education requirements and CPA licensing, but individual auditor performance varies due to demographic, physiological and cognitive characteristics (Francis 2011).
The expertise needed to detect material misstatements can be divided into i) general knowledge, ii) domain-specific knowledge and iii) client-specific knowledge. Work experience, participation in courses, seminars and other training activities are positively associated with an auditor’s ability to detect misstatements in general. Daily exposure to input from colleagues and to external expertise via internal reviews of on-going and completed audit work, and attendance at seminars with experts who present new or updated standards, laws, techniques and programs on a regular basis are also activities that aim at improving the general competence level. There are significant differences between large and small audit firms with regard to participating in such activities which we discuss in greater detail below.
Prior experience of auditing companies in the same industry generates domain-specific knowledge that improves auditor judgment. Evidence from public firms supports that industry experts outperform non-specialists in error-detection, in performing analytical procedures, in assessing components of audit risk and disclosing internal control deficiencies (Knechel et al. 2012). The potential relationship between industry expertise and audit quality has not gained much attention in private company research. Hope and Langli (2010) used industry expertise as a control variable in their audit fee regressions. They found a positive association between industry expertise and fees from provision of non-audit services (which may indicate that industry experts sell more non-audit services and/or charge higher fees for non-audit services), but no relationship between fees from auditing and industry expertise (if industry experts deliver audits of higher quality one might have expected them to earn higher fees).6 Client-specific knowledge is of vital importance when conducting private firm audits, given the strict time budget for these assignments. Client-specific knowledge, such as knowledge of the client's accounting system and internal control structure, gives auditors comparative advantages in detecting errors, creates a significant learning curve for new auditors and significantly reduces start-up costs (DeAngelo 1981; Johnson, Khurana, and Reynolds 2002). The literature that studies the relationships between audit quality, non-audit services (NAS) and auditor tenure acknowledges the importance of client-specific knowledge. Auditors gain knowledge from providing both auditing and NAS and they are able to utilize the same client-specific information for both services (Arruñada 1999). An auditor who consults on improvements to the client’s internal controls learns how the business operates and can draw upon that knowledge when conducting appropriate tests of internal controls during the audit process. Beck and Wu (2006) argue that auditors enrich their knowledge accumulation by performing NAS, which allows the auditor to anticipate and learn about changes in the client’s earnings dynamics. During long auditor-client relationships, the auditor learns about the client’s operations and systems which allows him or her to more easily identify areas with increased risk of material misstatements.
Svanström (2012) studied private companies in Sweden and found positive associations between provision of NAS and measures of audit quality, thus suggesting that knowledge about the client is crucial in detecting and correcting material misstatements in financial statements of private companies. The importance of client specific knowledge in driving demand for services is documented by Svanström and Sundgren (2012), who found that the purchase of NAS from the incumbent auditor was positively associated with the length of the auditor-client relationship and the perceived quality of the audit services. However, there were negative associations between both audit firm tenure and perceived audit quality and the purchase of NAS from an audit firm other than the incumbent one. These findings suggest that, in private companies’ audits, client-specific knowledge is strongly related to the demand and quality of auditing and non-auditing services.
Level of effort Competence must be accompanied by effort for the audit program to be properly planned and executed. Several factors influence how thoroughly the audit program is planned and executed, among them the auditor’s judgments about how agency conflicts influence the risk of material misstatements in financial statements, the size of the auditor’s portfolio, the incentives facing the auditor and the auditor’s working environment.
The International Standards on Auditing (ISA) require auditors to assess several agency conflicts when assessing risk of material misstatements, for instance agency conflicts related to the firm’s ownership and governance structures (e.g. ISA 315 paragraph 11, 14, A17, A30). For instance does the presence of large shareholdings reduce the need for an external auditor to monitor the CEO since such shareholders have incentives and ability to monitor management on their own? In firms with dispersed ownership, however, the need for external auditing is likely to be higher since an individual shareholder lacks the incentives to carry the monitory costs because he receives only his fraction of the benefits of increased monitoring. As another example: the board becomes less independent if the CEO has family members on the board. Reduced independence means weaker board monitoring and, to compensate for a less independent board, the auditor should increase effort in order to “obtain reasonable assurance about whether the financial statements as a whole are free for material misstatements, whether due to fraud or error” (ISA 240, paragraph 5).
Hope et al. (2012) develop and test six hypotheses about how auditors should respond in the presence of agency conflicts. The results document that auditors adjust their level of effort as predicted by agency theory and the ISAs. Audit effort is negatively related to concentrated ownership and the presence of a second large shareholder, consistent with these shareholders’ incentives and ability to monitor management. Auditor effort relates negatively to CEO ownership, consistent with CEO-ownership aligning conflicts of interest between the CEO and owners. Family relationships between major shareholders and the CEO, and between the CEO and board members, are positively associated with effort, consistent with kinship and marriage resulting in reduced monitoring by owners and board members who belong to the same family as the CEO. Finally, they find that audit effort is negatively associated with the proportion of board members from the largest family, consistent with there being fewer agency conflicts between owners and the board, and positively related to family relationships between board members and the CEO (suggesting a less independent board, as explained above). Two additional findings are worth noting since we return to related topics below. The first is that audit fees increase with leverage, consistent with auditors increasing effort in order to ensure the interest of debt holders. The second is that there is a Big N premium, consistent with Big N auditors being more sophisticated since they respond more strongly to agency conflicts.7 Overall the results show that auditors pay due attention to potential agency conflicts in firms’ ownership and governance structures and adjust their audit effort correspondingly.
Portfolio size and career stage The size of an engagement partner’s portfolio is related to effort since one engagement partner has a fixed number of hours available per period. Therefore, having too many clients may force the engagement partner or members of the audit team to cut corners and simplify test procedures in order to meet time and budget constraints. Thus, being busy may increase the risk of material misstatements and/or erroneous audit reports. From other fields than studies of board effectiveness (i.e. nursing, supermarket cashiers and bank employees), research has shown that being more busy influences work performance negatively. Evidence from the auditing field, though not private company specific, shows that tight reporting deadlines following from time and budget pressure have the potential to compromise the auditor skepticism and professional judgment which are critical to audit quality (Coram, Ng, and Woodliff 2004). López and Peters (2012: 140) document that "compressed workloads impair audit quality and increase management’s ability to manipulate reported earnings" for US public firms. The documented behavioral outcomes from complying with time budgets are: i) premature signing off on an audit program step (one or more of required audit procedures are not completed), ii) reducing the amount of work performed on an audit step below what the auditor would normally consider reasonable, iii) failing to research an accounting principle, iv) making superficial reviews of client documents, and v) accepting weak client explanations (Kelley and Margheim 1990). We expect being busy to have at least similar consequences in private firm audits as the auditors are less exposed to risks of litigation and loss of reputation.
The level of effort may also depend on where the engagement partner is in his or her career (Sundgren and Svanström 2012b). Young persons may be more willing to put in effort in order to achieve promotions and wage increases, while persons approaching retirement may lack the incentives and the desires that are necessary to deliver the same effort and performance as in previous years. For instance, an auditor close to retirement has much less to lose economically if involved in an audit failure, since the negative consequences in terms of promotions and wage increases may be negligible compared to an auditor who recently entered the job market. The incentives to learn and implement improved audit test methodology may also be lower for auditors approaching retirement since the costs, which are born when learning new methods, may outweigh the expected benefit due to the period for collecting future audit fees being too short. Thus, career stage may impact audit quality.