Discussion of “Does the Identity of Engagement Partner Matter? An Analysis of Audit Partner Reporting Decisions”

Abstract

The authors of this provocative study apply commonly used audit quality surrogate measures to a large and unique set of financial and other data on statutory audits of small private companies in Sweden. The paper has received unparalleled attention by the financial press and the PCAOB for its presumed support for regulatory intervention in standards for U.S. public company audits. In this Discussant Comment, I review the paper's content, analyze its predictive validity, and discuss its multiple implications plus, following Conference instructions, I provide constructive suggestions for improvements. Based on predictive validity analysis, I conclude that engagement partner assignment strategy is an important and acknowledged omitted variable that affects the study's internal validity via both the independent variable (partner's prior performance measure) and the dependent variable (borrower's cost of debt capital). The omission also affects construct validities and, if audit firms are applying a plausible assignment strategy, then interpretation of the study's main results would be reversed. Finally, the lack of a standards intervention noted by the authors and the extreme size and other differences between audits of Swedish private companies and U.S. public companies impair external validity and generalization to the U.S. intervention. As to improvements, I suggest that the authors (i) ask Swedish lenders to validate their presumed use of partner performance ratings in determining a borrower's interest rate, and (ii) ask Swedish Big 4 audit firms to provide a few internal partner performance ratings for comparison with the external performance measures used in the study. This two‐pronged, multimethod approach might confirm or deny critical assumptions underlying the present study and may substantively inform standards setters, evidence‐based standards, and fellow researchers about the validity of commonly applied surrogates for audit quality and the study's stated conclusion.

IQ and Audit Quality: Do Smarter Auditors Deliver Better Audits?

“…First, the number of publicly traded corporations is very limited. Thus, two out of KKNN's three samples mostly focus on small private firms, whose audits appear to be very different from the audits of publicly traded corporations (Kinney ). This difference shows in the number of engagements audited by the partners in Sweden.…”

Comments by the Auditing Standards Committee of the Auditing Section of the American Accounting Association on PCAOB Release No. 2015-004, Supplemental Request for Comment: Rules to Require Disclosure of Certain Audit Participants on a New PCAOB Form

“…The Committee believes the Board should carefully and deliberately consider Professor Kinney's discussion of Knechel et al (2015), and its relevance to the body of literature the Board has used to support firm disclosure of the engagement partner. Professor Kinney highlights several issues that significantly limit the external validity and the generalizability of the findings obtained in non-U.S. jurisdictions to a U.S. setting (Kinney 2015). Professor's Kinney's comments are necessarily focused on Knechel et al (2015), but are generally relevant to this body of literature.…”

“…These two factors suggest the research findings may be unique to the Swedish audit environment and may not generalize to the U.S. context. Kinney (2015) also points out that large accounting firms may use an engagement partner assignment strategy such as ''best partner-to-riskiest engagements.'' If this type of strategy occurs in practice, then the study's findings would have the opposite interpretation since high quality partners would be intentionally assigned to high risk audits.…”

“…However, we identified a number of studies that speak to the potential economic impact of disclosing the identities of those involved with the audit that were not incorporated in Anderson et al (2014) or referenced in Appendix 2 of Release 2015-004. One caveat-these studies should be considered in light of Kinney (2015).…”

“…They also find that greater public-client specialization is more important when the audit partner has lower overall audit experience. While these studies speak directly to the potential usefulness of identifying engagement partners, their prior audit failure rate, and experience, they may not generalize to the U.S. market due to the differing baseline conditions pointed out by the Board in Release 2015-004 as well as Kinney (2015).…”