How Small Audit Firm Membership in Associations, Networks, and Alliances Can Impact Audit Quality and Audit Fees

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1 Volume 9, Issue Pages P29 P35 American Accounting Association DOI: /ciia PRACTITIONER SUMMARY How Small Audit Firm Membership in Associations, Networks, and Alliances Can Impact Audit Quality and Audit Fees Kenneth L. Bills and Lauren M. Cunningham SUMMARY: This article summarizes Small Audit Firm Membership in Associations, Networks, and Alliances: Implications for Audit Quality and Audit Fees (Bills, Cunningham, Myers 2015), which examines the association between small audit firm membership in an association, network, or alliance (collectively referred to as an association ), audit quality, and audit fees. We find that small audit firm association members provide higher-quality audits and charge higher fees than small audit firms that are not members of an association. When compared to similarly sized clients audited by the Big 4, we find that member firms provide audit quality similar to the Big 4 firms, but member firms charge lower fees than their Big 4 counterparts. We caution that these results may not be generalizable to the largest Big 4 clients for which there is not a similarly sized client audited by our sample of small audit firms. We infer audit quality from Public Company Accounting Oversight Board inspections, restatement announcements, and discretionary accruals. Our findings should be of interest to audit committees in charge of auditor selection and to small audit firms interested in the benefits of association membership. Keywords: associations; networks; small audit firms; audit quality; audit fees. INTRODUCTION In 2008, the Advisory Committee on the Auditing Profession to the U.S. Department of the Treasury (ACAP) reported that small audit firms face difficulties in performing large public company audits because companies with operations in multiple countries need auditing firms with global resources and technical and industry expertise to deal with an increasingly complex Kenneth L. Bills is an Assistant Professor at the University of Arkansas and Lauren M. Cunningham is an Assistant Professor at The University of Tennessee. We thank Linda Myers, the Garrison/Wilson Chair at the University of Arkansas, who coauthored the Bills et al. (2015) paper with us. We also thank Dorsey Baskin and J. Gregory Jenkins for helpful suggestions and comments. Submitted: August 2015 Accepted: September 2015 Published Online: September 2015

2 P30 business and financial reporting environment (ACAP 2008, VIII: 2). Also in the report were several recommendations to assist small audit firms in overcoming these barriers such as encouraging cooperation among regulators and the establishment of a national center to facilitate the sharing of fraud prevention and detection methodologies. Of particular interest to our study (Bills, Cunningham, and Myers 2015) is the recommendation that accounting association, network, or alliance membership (which we collectively refer to as association membership) can assist small audit firms in overcoming these barriers (ACAP 2008; GAO 2008). 1 Accounting firm associations (e.g., AGN International, BDO Seidman Alliance, IGAF Worldwide, Nexia International, Praxity, PrimeGlobal) differ from the accounting networks of the Big 4 and other large accounting firms in that they are made up of independent members that are distinct in legal name and in legal structure. They also do not establish association-wide standards for all members. Accounting firm associations do, however, provide their members with benefits such as joint training opportunities, recommendations about best practices and benchmarking data, as well as access to a network of reliable audit firms that can be used to outsource audit work, while allowing the member firms to remain independent in legal name and legal structure. Association membership is subject to a preapproval process, typically based on peer recommendations and AICPA peer review and PCAOB inspection reports, and requires payment of annual dues. In addition to access to association resources as described previously, association membership provides member audit firms with a brand that can be used for marketing purposes. In our Bills et al. (2015) study, we tested the ACAP recommendation that association membership can benefit small audit firms by examining whether audit quality is higher for small audit firm association members, as compared to other small audit firms that are not association members, and also how that audit quality compares to Big 4 audits of similarly sized clients. We then examined whether small audit firm members can charge higher audit fees than nonmember firms (a fee premium ), and whether that fee premium is comparable to the fee premium charged by Big 4 audit firms. In this paper, we discuss the research design used in our Bills et al. (2015) study, we summarize the empirical findings, and we provide practical implications of our results. BENEFITS PROVIDED BY ACCOUNTING ASSOCIATIONS AND MEMBERSHIP DATA USED IN THE STUDY To better understand the types of services available to accounting firm association members, we obtained a list of association-provided benefits from CCH, which publishes an annual listing of industry associations, along with details about membership counts and the services they provide. More than 75 percent of associations provided the following services in 2011: 2 Member conferences and meetings Members only intranet Networking and information exchanges within specific peer groups Continuing professional education for technical proficiency and for soft skills (e.g., leadership, marketing) 1 According to the U.S. Government Accountability Office, [F]irms that do want to audit large public companies continue to face challenges to expanding their public company practices. Some firms are taking actions to reduce certain challenges, such as increasing their geographic reach by joining networks and affiliations (GAO 2008, 37). 2 See Bills et al. (2015, Table 1) for a summary of all services covered in CCH (2011) and the percentage of associations offering each service.

3 P31 Special interest group podcasts, webcasts, and teleconferences International referrals These benefits provided by associations can help small audit firms overcome some of the barriers described in ACAP (2008), such as technical and industry expertise, and servicing clients with international operations. We collected association membership data using the association listings in the Annual Directory of CPA Firm Associations and Networks, published annually by CCH and CPA Practice Management Forum, and used the Top 30 Accounting Networks and Associations, published annually by Accountancy Age, for the years 2010 through We began by contacting each of the associations to obtain a copy of that year s membership list, and for those that did not provide membership lists, we retrieved the publicly available lists of members from the association websites. 3 DEVELOPMENT OF PREDICTIONS In Bills et al. (2015), we proposed that association members provide higher-quality audits than other small audit firms for two primary reasons. First, associations prescreen firms for membership and reject audit firms that do not meet their standards. Therefore, association membership acts as a signal of a higher-quality audit firm. Second, associations provide members with access to numerous resources that, if utilized, are expected to help improve audit firms audit quality. So, while members of associations may be, on average, of higher quality than nonmember associations to begin with, we predicted that there would also be post-membership improvements in audit quality. As it relates to audit fees, we predicted that association members would charge, and audit clients would be willing to pay, higher fees because of the additional access to resources (particularly, access to industry expertise and expansion of geographic reach), and because of the signal provided by the brand recognition of association membership. RESEARCH DESIGN Audit Quality To determine whether audit quality differs between member firms, nonmember firms, and Big 4 firms, we assumed that audit quality would be indicated by these three separate measures: (1) PCAOB inspection deficiencies (Gunny and Zhang 2013); (2) misstatements as subsequently revealed by restatements of annual financial statements (Cao, Myers, and Omer 2012); and (3) discretionary accruals (Reichelt and Wang 2010) reported by audited companies. We first compared audit quality for small audit firms that are members of an association to small audit firms that are not members of an association. We then took each client audited by a small audit firm member and matched it with a client of a Big 4 auditor of similar size (measured using total assets), and compared the audit quality of the small audit firm members clients to the size-matched Big 4 auditors clients. Our samples for these tests were limited to audit firms that audited public companies available in the Audit Analytics database. In each of our tests, we controlled for other factors that likely affect the respective measures of quality, including the size of the auditor, the 3 We retrieved information from association websites between October and December of each year to ensure consistent collection of annual memberships.

4 P32 size of the client, the profitability of the client, the complexity of the client operations (including the client s number of business segments and whether the client had foreign operations), and whether the auditor was in the early years of tenure. We also controlled for differences between years and industries. For full model specifications, refer to Bills et al. (2015). Audit Fees To determine whether audit fees differ between member firms, nonmember firms, and Big 4 firms, we followed the same method as in the audit quality test, where we first compared audit fees for member small audit firms clients to nonmember small audit firms clients, and then compared audit fees of small audit firm members clients to the size-matched Big 4 auditors clients. We controlled for other factors that likely affect the audit pricing process, including the size of the client, the profitability (or financial risk) of the client, the complexity (or inherent risk) of the client operations (as described above), whether there was an audit of internal controls (which requires additional audit effort), whether the auditor was in the early years of tenure, and the auditor s market share and relative importance of the client as a percentage of the auditor s portfolio (which affect bargaining power). For full model specifications, refer to Bills et al. (2015). Sample Construction In all of our primary tests comparing member small audit firms and nonmember small audit firms, we removed audit firms that were annually inspected by the PCAOB (BDO Seidman LLP, Crowe Horwath LLP, Deloitte & Touche LLP, EY, Grant Thornton LLP, KPMG LLP, MaloneBailey LLP, McGladrey LLP, and PricewaterhouseCoopers LLP). We also removed audit firms that were the parents of their own associations, such as Baker Tilly International, because these firms are large enough to start their own associations and our intended focus was on the benefit of membership for small audit firms. We then manually matched the remaining audit firms in Audit Analytics to our hand-collected sample of association membership for 2010 through We used Audit Analytics for audit fee and restatement data, we hand collected PCAOB inspection data from publicly available PCAOB inspection reports, and we used Compustat to calculate discretionary accruals. For tests using discretionary accruals and audit fees, we followed the prior literature and removed observations in financial industries. RESULTS We found that approximately 49 percent of small audit firms that audit public companies are a member of an association. Consistent with our expectations, we found that the probability of receiving a PCAOB inspection deficiency, the probability of a restatement, and the clients discretionary accruals are all lower for member small audit firms than for nonmember small audit firms. Thus, we concluded that audit quality is higher for member small audit firms than nonmember small audit firms. We also found that audit fees are higher for member small audit firms than for nonmember small audit firms. When compared to the size-matched sample of Big 4 clients, we found that discretionary accruals are similar for clients of member small audit firms and the size-matched Big 4 clients (in other words, there is no statistical difference between the two groups), but audit fees are lower for the clients of member small audit firms. Thus, we concluded that audit quality is similar between member small audit firms and Big 4 audit firms with similarly sized clients, but member small audit firms charge less to their clients. It is important to note that

5 P33 the size of clients in this size-matched sample ranges from $75 million to $2.7 billion in market capitalization, with a median market capitalization of $156 million. Thus, the size-matched sample represents many large, but not the largest, Big 4 audit clients. These results are summarized in Table 1. In order to determine whether there were improvements in audit quality after audit firms became members of an accounting association, we employed two techniques (changes analysis and a difference-in-differences design) that allowed us to control for the audit quality of an audit firm prior to becoming a member of an association. In the changes analysis, we used a sample of audit firms that either joined or left an association in our sample period. We then compared these firms clients audit quality during association membership to the time period without association membership. For the difference-in-differences analysis, we used the same sample of firms that joined an association, but matched them to firms for the same time period that were never association members, and compared changes in audit quality between the two groups. This ensures that our results are not driven by general time trends in audit quality (i.e., audit quality improves over time). Using these alternative tests, we found evidence that audit quality did increase after audit firms joined an association, suggesting that it is not only the prescreening activities that allow member firms to have higher audit quality than nonmember firms, but that the resources of the association contribute to the improved audit quality. CONCLUSION AND PRACTICAL APPLICATIONS Audit committees are tasked with the difficult decision of finding an auditor that is well equipped to handle the complexity of a public company s operations. Despite having hundreds of audit firms registered with the PCAOB, the majority of public company audit work continues to be provided by the Big 4 or Second-Tier firms (e.g., BDO, Grant Thornton, McGladrey). 4 In ACAP (2008), the advisory committee recommended that regulators find ways for small audit firms to compete in this market. In Bills et al. (2015), we investigated one of the primary suggestions for small audit firms to successfully compete for public company auditing clients: membership in an association, network, or alliance. In this paper, we summarize the results of those findings. Specifically, we found that member small audit firms provide higher-quality audits than other nonmember small audit firms, and that the level of quality is comparable to the Big 4 when using a size-matched sample of clients (specifically, we compared a member small audit firm client with a Big 4 client that has approximately the same total assets). Further, we found that clients value association membership, because the member small audit firms are able to charge more than nonmember small audit firms, but they do not charge as much as the Big 4 audit firms. Our findings should be of particular interest to audit committees tasked with auditor selection, because they suggest that, on average, membership in an accounting association, network, or alliance provides audit firms additional resources that enable the firm to provide a higher-quality audit. However, those companies considering employing an association member have several things they should consider. As described further in Bills et al. (2015), not all associations are created equal, such that associations offer various types of services and have various sizes of membership. Here are some questions that audit committee members could ask their auditors or potential auditors that are members of an association to better understand how the association membership could affect their specific audit engagement: 4 Among the 1,500 largest public companies with revenues greater than $1 billion, the Big 4 accounting firms audit about 98 percent (GAO 2008).

6 P34 TABLE 1 Summary of Results Panel A: How Do Member Small Audit Firms Compare to Nonmember Small Audit Firms? Member Firms Have Statistical Significance PCAOB Inspection Deficiencies Higher Quality þþ Misstatements (Restatements) Higher Quality þþþ Discretionary Accruals Higher Quality þþ Audit Fees Higher Fees þþþ Panel B: How Do Clients at Member Small Audit Firms Compare to Size-Matched Clients at Big 4 Audit Firms? Member Firms Statistical Significance Discretionary Accruals Are Not Different NA Audit Fees Have Lower Fees þþþ Source: See Bills et al. (2015) for full results. þ indicates that audit quality (audit fees) are statistically different between the two groups. More þ in the cells indicate a stronger statistical association. NA indicates no statistical difference between the two groups. What work do you plan to outsource to other members within the association? How will you monitor the quality of work performed by other association members? Do you have previous experience with the association member that you are recommending to assist with this engagement? What types of technical expertise does the association offer specific to the industry or unique accounting issues faced on this engagement? How does association membership affect quality control at your accounting firm, particularly as it relates to this specific engagement? Our findings should also be of interest to audit firms considering membership in an association to expand their resources or enhance their brand reputation. Just like finding the right match between auditors and clients, auditors must find the right match with an accounting association. Based on our conversations with audit partners at firms that are currently association members, here are some things that an audit firm may want to consider before selecting a specific association: How many members are currently in my geographic region? Does the association offer geographic exclusivity? How will the size of my audit firm compare to other members (i.e., are there similarly sized firms facing similar issues, or will I be significantly larger or smaller than the other member firms)? How much time (workload capacity) can my firm offer to assist with client referrals from other members? Does that align with the needs or expectations of the association? Note: Referrals are common for jurisdictional tax questions, inventory observations, etc.

7 P35 Does my firm need assistance servicing existing clients or expanding to a specific industry or a specific geographic region? What are my firm s growth plans for the coming years? Can the association s membership base help us achieve those goals? What type of in-person conferences and trainings are available to help me network with other member firms, and does that align with my interests? How does the training offered by the association compare with the training offered by other associations in terms of options, availability, duration, breadth of topics, flexibility, and expertise? What instructional methods of CPE are offered (in-person, conference calls, etc.), and does that meet my needs? Does the association offer its own quality control or mentorship programs, such as peer reviews or office visitations? Does the association offer a technical hotline or centralized technical consultation system to assist with urgent technical matters? Does the association s use of technology, for the dissemination of information, networking opportunities, and technical assistance, meet my firm s needs? Does the association provide audit programs and/or technical manuals that fit my firm s needs? What kind of benchmarking information and best practices are collected and disseminated by the association? REFERENCES Advisory Committee on the Auditing Profession to the U.S. Department of the Treasury (ACAP) Final Report of the Advisory Committee on the Auditing Profession to the U.S. Department of the Treasury. (October 6). Available at: Bills, K. L., L. M. Cunningham, and L. A. Myers Small audit firm membership in associations, networks, and alliances: Implications for audit quality and audit fees. The Accounting Review (forthcoming). Cao, Y., L. A. Myers, and T. C. Omer Does company reputation matter for financial reporting quality? Evidence from restatements. Contemporary Accounting Research 29 (3): CCH Annual directory of CPA firm associations and networks. CPA Practice Management Forum 7 (2): Gunny, K. A., and T. C. Zhang PCAOB inspection reports and audit quality. Journal of Accounting and Public Policy 32 (2): Reichelt, K., and D. Wang National and office-specific measures of auditor industry expertise and effects on audit quality. Journal of Accounting Research 48 (3): U.S. Government Accountability Office (GAO) Audits of Public Companies: Continued Concentration in Audit Market for Large Public Companies Does Not Call for Immediate Action. Report Washington, DC: Government Printing Office.