Audit Partner Disclosure: Potential Implications for Investor Reaction

and Auditor Independence

Tamara A. LambertBenjamin L. Luippold

Chad M. Stefaniak

Conference on Regulation and the Audit Industry

2

Outline

Tamara• PCAOB

– Audit partner disclosure– Proponents / opponents

• Where disclosure occurs• Research question• Model of audit

independence– Three propositions

Ben• Hypotheses• Method

– Participants– Procedures– Design– Variables

• Results– Investment choice

• Allocation– Mediation analysis– Experience

• Conclusion

3

PCAOB: Audit Partner Disclosure

4

PCAOB: Audit Partner Disclosure

Proponents Opponents

No increased accountability

Increased legal liability

Ill-informed audit quality inferences

Independence conflicts

Increased accountability

Increased transparency

Improved audit quality

5

Where Partner Disclosure Occurs

Will disclosing the identity of the audit partner in the audit report lead to improved audit quality /

investor protection?

Research Question

7

Model:

• Audit partner disclosure may lead to independence impairment

• Three propositions

Audit Partner Identity

Disclosure

Potential Audit Partner

Independence Impairment

8

Model: Proposition 1

• No well-calibrated measures available (Francis 2004)• Accounting information transfer (Gleason et al. 2008)• Representativeness heuristic (Kahneman 2011)

Audit Partner Identity

Disclosure

Fusing of Partner

Reputation with Client

9

Model: Proposition 2

• Ill-informed partner-related inferences may lead to– Increased focus on individual reputation – Client attraction / retention concerns

• Audit / earnings quality proxies used by academics

Audit Partner Identity

Disclosure

Fusing of Partner

Reputation with Client

Audit Partner Incentive Shift

10

Model: Proposition 3

• Auditors role to reduce information risk – Conflicting investor / management incentives

• Increased prominence of individual reputation – Implicit permission for individuals to act in their own

interests (Hunton et al. 2011)

Audit Partner Identity

Disclosure

Fusing of Partner

Reputation with Client

Audit Partner Incentive Shift

Potential Audit Partner

Independence Impairment

11

Hypothesis 1

• Information transfer as a proxy for reputation fusing• Negative information is contagious– Firms within an industry (Gleason et al. 2008)– Firms audited by Arthur Andersen (Huang and Li 2009)– Firms that share a common director (Chen and Goh 2010)

• Representativeness may play a role (Kahneman 2011)

Audit partner identity disclosure will result in partner-based (reputational) information transfer

between reporting entities.

Hypothesis 1

13

Hypothesis 2

• Would partner disclosure require other changes to audit report? (PCAOB 2009)– Partner signing firm’s name is evidence that audit report is

product of the firm (PCAOB 2008, 2009)– Partner disclosure could confuse investors about what

audit opinion means

• Less knowledge = more reliance on representativeness (Gigerenzer and Goldstein 1996)

Modifying the audit report with language intended to highlight the audit firm’s responsibility for the audit will reduce the amount of partner-based (reputational)

information transfer resulting from audit partner identity disclosure.

Hypothesis 2

15

Method: Participants380 participants Investment clubs and Qualtrics

≈ 48 years

old

All have investing experience

≈ 4 years experience w/ fin. info.

16

Method: Procedure

Company Amer. Comp.

Comp. World

Elec. USA

US Tech.

Wired States

Big 4 Firm Firm ABC Firm ABC Firm DEF Firm DEF Firm DEFCurrent Ratio 2.35 2.25 2.37 2.38 2.23

Days Sales of Inventory 28 32 27 25 39

Return on Assets 12.3 9.8 12.6 12.9 8.1

Profit Margin 14.5 11.4 14.7 14.8 8.3

Market Share 8.41 6.74 8.5 8.7 5.53

Company Amer. Comp.

Comp. World

Elec. USA

US Tech.

Wired States

Big 4 Firm Firm ABC Firm ABC Firm DEF Firm DEF Firm DEFCurrent Ratio 2.35 2.25 2.37 2.38 2.23

Days Sales of Inventory 28 32 27 25 39

Return on Assets 12.3 9.8 12.6 12.9 8.1

Profit Margin 14.5 11.4 14.7 14.8 8.3

Market Share 8.41 6.74 8.5 8.7 5.53

17

Method: Procedure

Company Amer. Comp.

Comp. World

Elec. USA

US Tech.

Wired States

Big 4 Firm Firm ABC Firm ABC Firm DEF Firm DEF Firm DEFCurrent Ratio 2.35 2.25 2.37 2.38 2.23 → 1.97

Days Sales of Inventory 28 32 27 25 39 → 65

Return on Assets 12.3 9.8 12.6 12.9 8.1 → 4.8

Profit Margin 14.5 11.4 14.7 14.8 8.3 → 5.0

Market Share 8.41 6.74 8.5 8.7 5.53 → 5.22

Company Amer. Comp.

Comp. World

Elec. USA

US Tech.

Wired States

Big 4 Firm Firm ABC Firm ABC Firm DEF Firm DEF Firm DEFCurrent Ratio 2.35 2.25 2.37 2.38 2.23 → 1.97

Days Sales of Inventory 28 32 27 25 39 → 65

Return on Assets 12.3 9.8 12.6 12.9 8.1 → 4.8

Profit Margin 14.5 11.4 14.7 14.8 8.3 → 5.0

Market Share 8.41 6.74 8.5 8.7 5.53 → 5.22

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Method: Procedure

Company Amer. Comp.

Comp. World

Elec. USA

US Tech.

Wired States

Big 4 Firm Firm ABC Firm ABC Firm DEF Firm DEF Firm DEFAudit Partner

David Lastings

David Lastings

James Keaton

Thomas Edwards

Thomas Edwards

Current Ratio 2.35 2.25 2.37 2.38 2.23 → 1.97

Days Sales of Inventory 28 32 27 25 39 → 65

Return on Assets 12.3 9.8 12.6 12.9 8.1 → 4.8

Profit Margin 14.5 11.4 14.7 14.8 8.3 → 5.0

Market Share 8.41 6.74 8.5 8.7 5.53 → 5.22

Company Amer. Comp.

Comp. World

Elec. USA

US Tech.

Wired States

Big 4 Firm Firm ABC Firm ABC Firm DEF Firm DEF Firm DEFAudit Partner

David Lastings

David Lastings

James Keaton

Thomas Edwards

Thomas Edwards

Current Ratio 2.35 2.25 2.37 2.38 2.23 → 1.97

Days Sales of Inventory 28 32 27 25 39 → 65

Return on Assets 12.3 9.8 12.6 12.9 8.1 → 4.8

Profit Margin 14.5 11.4 14.7 14.8 8.3 → 5.0

Market Share 8.41 6.74 8.5 8.7 5.53 → 5.22

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Audit Opinion Note. Each audit firm stresses in its audit reports that while the audit opinion is signed by both the audit partner and the audit firm, the audit opinion represents that of the entire firm. Additionally, each firm notes that the audit involves many firm employees and includes technical guidance and other resources from its national headquarters.

Method: Procedure

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Method: Experimental Design

Firm NameFirm and Partner Name

Firm Name and

Modification

Firm Name, Partner

Name, and Modification

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Method: Variables

Main Variables• Investment choice• Investment allocation• Restatement likelihood

Supplemental Variables• Financial information importance• Fault (company, firm, partner)• Influence of restatement• Familiarity w/ financial information

& auditing• Attention checks• Investment experience• Experience w/ financial

information• Job title / employer• Gender• Age

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Results: Investment Choice

Firm Name Partner Name Report Modification

American Computers 10.1% 9.0% 14.1%

Computer World 3.4% 4.5% 3.9%

Electronics USA 14.3% 17.3% 18.8%

US Technologies 67.2% 58.6% 57.8%

Wired States 5.1% 10.5% 5.5%

(n=119) (n=133) (n=128)

Firm Name Partner Name Report Modification

American Computers 10.1% 9.0% 14.1%

Computer World 3.4% 4.5% 3.9%

Electronics USA 14.3% 17.3% 18.8%

US Technologies 67.2% 58.6% 57.8%

Wired States 5.1% 10.5% 5.5%

(n=119) (n=133) (n=128)

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Results: Investment in US Tech.

Firm Name Partner Name Modification50%

55%

60%

65%

70%

75%

24

Results: Investment in US Tech.

Variable Expected Sign Coefficient(S.E.)

Intercept + 0.916(0.519)

PARTNER - -0.561(0.310)

REPORT_MOD + -0.200(0.287)

QUAL ? -1.020(0.473)

ATTEND_PARTNER ? 0.675(0.277)

ATTEND_REPORT_MOD ? 1.051(0.519)

Variable Expected Sign Coefficient(S.E.)

Intercept + 0.916(0.519)

PARTNER - -0.561(0.310)

REPORT_MOD + -0.200(0.287)

QUAL ? -1.020(0.473)

ATTEND_PARTNER ? 0.675(0.277)

ATTEND_REPORT_MOD ? 1.051(0.519)

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Results: Allocation in US Tech.

Variable Expected Sign Coefficient(S.E.)

Intercept + 33.165(4.367)

PARTNER - -5.543(2.912)

REPORT_MOD + 1.683(2.831)

QUAL ? -3.902(3.714)

ATTEND_PARTNER ? 5.224(2.724)

ATTEND_REPORT_MOD ? 9.895(2.389)

Variable Expected Sign Coefficient(S.E.)

Intercept + 33.165(4.367)

PARTNER - -5.543(2.912)

REPORT_MOD + 1.683(2.831)

QUAL ? -3.902(3.714)

ATTEND_PARTNER ? 5.224(2.724)

ATTEND_REPORT_MOD ? 9.895(2.389)

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Results: Mediation Analysis

PARTNER

RESTATE_UST

INVEST_UST

b = 0.611(p = 0.057)

b = -0.113(p = 0.022)

b = -0.559(p = 0.041)

b = -0.509(p = 0.059)

b = -0.559(p = 0.041)

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Results: Invest. in US Tech. by Exp.

Less Experienced Investors

Firm Nam

e

Partner N

ame

Modifica

tion50%

55%

60%

65%

70%

75%

80%

More Experienced Investors

Firm Nam

e

Partner N

ame

Modifica

tion50%

55%

60%

65%

70%

75%

80%

28

Results: Invest. in US Tech. by Exp.

Less Experienced InvestorsVariable Expected Sign Coefficient

(S.E.)Intercept + 1.589

(0.871)PARTNER - -0.890

(0.481)REPORT_MOD + 0.273

(0.435)QUAL ? -1.401

(0.793)ATTEND_PARTNER ? 0.891

(0.404)ATTEND_REPORT_MOD ? 0.646

(0.871)

More Experienced InvestorsVariable Expected Sign Coefficient

(S.E.)Intercept + 0.533

(0.716)PARTNER - -0.380

(0.540)REPORT_MOD + -0.930

(0.500)QUAL ? -0.474

(0.635)ATTEND_PARTNER ? 0.542

(0.502)ATTEND_REPORT_MOD ? 1.602

(0.431)

Variable Expected Sign Coefficient(S.E.)

Intercept + 1.589(0.871)

PARTNER - -0.890(0.481)

REPORT_MOD + 0.273(0.435)

QUAL ? -1.401(0.793)

ATTEND_PARTNER ? 0.891

(0.404)ATTEND_REPORT_MOD ? 0.646

(0.871)

Variable Expected Sign Coefficient(S.E.)

Intercept + 0.533(0.716)

PARTNER - -0.380(0.540)

REPORT_MOD + -0.930(0.500)

QUAL ? -0.474(0.635)

ATTEND_PARTNER ? 0.542

(0.502)ATTEND_REPORT_MOD ? 1.602

(0.431)

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Conclusions

• Model – Partner disclosure will fuse reputation with client– Fusing will shift audit partner incentives– Shift of incentives may impair independence

• Experiment– Partner disclosure results in information transfer– Contagion not mitigated by our report

modification

Thank youTamara A. Lambert

Benjamin L. LuippoldChad M. Stefaniak

Conference on Regulation and the Audit Industry