Trinity University

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School of Business Faculty Research School of Business

3-2016

Internal Control Opinion Shopping and Audit Market Competition

Nathan J. Newton Julie Persellin

Trinity University, jpersell@trinity.edu

Dechun Wang Michael S. Wilkins

Trinity University, mike.wilkins@trinity.edu

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Repository Citation

Newton, N. J., Persellin, J. S., Wang, D., amp; Wilkins, M. S. (2016). Internal control opinion shopping and audit market competition. The Accounting Review, 91(2), 603-623. doi: 10.2308/accr-51149

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Internal Control Opinion Shopping and Audit Market Competition

Nathan J. Newton Assistant Professor

University of Missouri – Columbia

Julie Persellin Assistant Professor Trinity University

Dechun Wang Associate Professor Texas Aamp;M University

Michael S. Wilkins Jesse H. Jones Professor Trinity University

March 2015

*We would like to thank Kathleen Bentley, Cory Cassell, Chris Hogan, Brian Mayhew, Jaime Schmidt, Scott Vandervelde, and participants at the 2015 AAA Audit Midyear Meeting for helpful comments and suggestions.

Internal Control Opinion Shopping and Audit Market Competition

Abstract

This study examines whether audit clients engage in internal control opinion shopping activities and whether audit market competition appears to facilitate those activities. Regulators have long been concerned about the impact of both audit market competition and opinion shopping on audit quality. We adopt the framework developed in Lennox (2000) to construct a proxy to measure the tendency that clients engage in internal control opinion shopping activities. Our empirical results suggest that clients are successful in shopping for clean internal control opinions. In addition, we find evidence that internal control opinion shopping occurs primarily in competitive audit markets. Finally, our results indicate that among auditor dismissal clients, opinion shopping is more likely to occur when dismissals are made relatively late during a reporting period and when audit market competition is high. Our findings have implications for the current policy debate regarding audit quality and audit market competition.

Key words: opinion shopping; internal control weakness; audit opinion; audit quality; audit market competition

Internal Control Opinion Shopping and Audit Market Competition

1. INTRODUCTION

Opinion shopping has long been of concern to regulators (U.S. Senate 1976; SEC 1988; PCAOB 2011b). The Treadway Commission Report notes that differences of opinion between client management and auditors may prompt management to consult with another auditor “to obtain an opinion that coincides with managementrsquo;s interest in presenting the results in the most favorable light” (Mintz 1995). While prior research has provided evidence that clients are successful in shopping for clean audit opinions in markets outside the U.S., there is limited evidence that clients in the U.S. engage in audit opinion shopping.1 Our purpose in this paper is to broaden the traditional opinion shopping setting to include opinions related to the effectiveness of internal control over financial reporting (hereafter, internal control opinions). In so doing, we provide an alternative laboratory within which issues related to audit quality and potential compromises in auditor independence may be evaluated.

Our motivation for investigating whether companies appear to shop for favorable internal control opinions comes from two sources. First, Defond and Zhang (2014) suggest that the topic of opinion shopping is important but note that research in this area has not been particularly productive. Specifically, Defond and Zhang (2014) state that the primary limitations of opinion shopping research are that the results do not seem to be generalizable to the U.S., and that the evidence that does exist is based exclusively on the use of audit opinions as a proxy for a

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武汉理工大学毕业论文

上市公司内部控制审计问题研究

外文翻译

Internal Control Opinion Shopping and Audit Market Competition

Nathan J. Newton. Julie Persellin.Dechun Wang. Michael S. Wilkins

Abstract

This study examines whether audit clients engage in internal control opinion shopping activities and whether audit market competition appears to facilitate those activities. Regulators have long been concerned about the impact of both audit market competition and opinion shopping on audit quality. We adopt the framework developed in Lennox (2000) to construct a proxy to measure the tendency that clients engage in internal control opinion shopping activities. Our empirical results suggest that clients are successful in shopping for clean internal control opinions. In addition, we find evidence that internal control opinion shopping occurs primarily in competitive audit markets. Finally, our results indicate that among auditor dismissal clients, opinion shopping is more likely to occur when dismissals are made relatively late during a reporting period and when audit market competition is high. Our findings have implications for the current policy debate regarding audit quality and audit market competition.

Key words: opinion shopping; internal control weakness; audit opinion; audit quality; audit market competition

1. INTRODUCTION

Opinion shopping has long been of concern to regulators (U.S. Senate 1976; SEC 1988; PCAOB 2011b). The Treadway Commission Report notes that differences of opinion between client management and auditors may prompt management to consult with another auditor “to obtain an opinion that coincides with managementrsquo;s interest in presenting the results in the most favorable light” (Mintz 1995). While prior research has provided evidence that clients are successful in shopping for clean audit opinions in markets outside the U.S., there is limited evidence that clients in the U.S. engage in audit opinion shopping.1 Our purpose in this paper is to broaden the traditional opinion shopping setting to include opinions related to the effectiveness of internal control over financial reporting (hereafter, internal control opinions). In so doing, we provide an alternative laboratory within which issues related to audit quality and potential compromises in auditor independence may be evaluated.

Our motivation for investigating whether companies appear to shop for favorable internal control opinions comes from two sources. First, Defond and Zhang (2014) suggest that the topic of opinion shopping is important but note that research in this area has not been particularly productive. Specifically, Defond and Zhang (2014) state that the primary limitations of opinion shopping research are that the results do not seem to be generalizable to the U.S., and that the evidence that does exist is based exclusively on the use of audit opinions as a proxy for audit quality. The authors suggest that the importance of opinion shopping is not attributable to the mechanism itself (i.e., the audit opinion) but because the mechanism is one of many factors that may be associated with compromised auditor independence. By investigating a mechanism that

1 Lennox (2002) and Carcello and Neal (2003) provide evidence consistent with audit opinion shopping in the U.S. during pre-SOX years. We discuss potential differences between pre-SOX and post-SOX opinion shopping in Section V.

is very similar to financial statement audit opinions but that is associated with a much higher incidence of unfavorable outcomes for audit clients, we seek to shed light on potential audit quality and independence concerns that are related to the audit reporting process.

Our second reason for investigating internal control opinion shopping is based on numerous reports mentioning surprisingly low numbers of reported material weaknesses. For example, a recent Wall Street Journal article notes that Audit Analytics reported 629 material weaknesses in the first year after the Sarbanes-Oxley Act (SOX) was adopted but only 141 such weaknesses in 2011 (Chasan 2013). There is little doubt that genuine improvement in SEC registrantsrsquo; internal controls has occurred since the passage of SOX. However, Chasan (2013) cites a concern that the infrequency of reported material weaknesses may be related to a potential “lack of rigor around material weakness testing” as observed by the Office of the Chief Accountant, the SECrsquo;s Division of Corporation Finance, and the PCAOB. The PCAOBrsquo;s Staff Audit Practice Alert No. 11 (October 24, 2013) states that in 15 percent of the audit engagements occurring during a recent three-year reporting period, inspections staff found that the audit firm “had failed to obtain sufficient appropriate evidence to support its opinion on the effectiveness of internal control due to one or more auditing deficiencies identified by the inspections staff” (PCAOB 2013b). Furthermore, the Deputy Chief Accountant recently commented, “in some instances companies – managers and auditors – are not adequately evaluating the severity of [internal control] deficiencies. That may mean that some of the deficiencies are being classified as significant deficiencies, when they are really material weaknesses and investors arenrsquo;t getting the disclosures that are intended” (Mont 2015). To the extent that questionable audit rigor and/or potentially misclassified internal control deficiencies at least partially reflect acquiescence to

client preferences, the existence of internal control opinion shopping would be consistent with these regulatory findings and concerns.

Based on the above, our first research question asks whether internal control opinion shopping appears to occur

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