External investigations and disciplinary sanctions against auditors: the impact on audit quality

Abstract

In this paper, we provide empirical evidence for the impact of disciplinary sanctions imposed on Spanish auditing firms and their engagement partners. The disciplinary sanctions resulted from external investigations, which revealed misapplications of auditing standards. In particular, we evaluate (a) the efficacy of the external supervisory board in identifying low-quality auditors and (b) the effectiveness of the disciplinary system in improving the quality of subsequent statutory audits performed by the sanctioned auditors. We employ two earnings management indicators as proxies for audit quality: loss avoidance through extraordinary items and abnormal accruals. And we compare these measures in the financial statements of client companies (auditees) audited by sanctioned and non-sanctioned auditors between 1995 and 2007. Our evidence is mixed. The results show that companies audited by Non-Big 4 sanctioned auditors in the pre-inspection period are less likely to avoid bottom-line losses. Additionally, we conclude that use of this earnings management tool decreases in the post-investigation period for all sanctioned auditors, whether Big 4 or Non-Big 4 firms. Contrary to our expectations, the enhancement performance on this measure of audit quality is observed only for smaller fines. The discretionary accrual approach to earnings management does not offer significant results, however. Therefore, the con- clusions are not robust, and further investigation is needed. A feasible explanation for the elusive conclusion may be based on the strong incentives for private firms to avoid bottom-line losses for financing purposes and to manipulate earnings to minimize tax payments.

Economic consequences of public oversight of the auditing profession

“…De Fuentes et al (2015) show that auditors sanctioned by the Spanish Institute of Accounting and Auditing exhibit lower average audit quality than non-sanctioned auditors. Van Opijnen (2016) finds no support that AFM inspection in the Netherlands improves audit quality.…”

Rationale and risks of non-audit services

“…As mentioned in the paper written by Fuentes et al (2009), in 2012, audit fees in retailing, metals, transportation, communication and other services industries constitute more than 85% of total fees they paid. The proportion in glass and construction industries are around 73% and 60% respectively.…”

The economic impact of audit failures

“…However, despite the emphasis placed by regulators and standard-setters on those measures, empirical evidence assessing their efficacy is scarce. Several studies address the pros and cons of the external POB as compared to the peerreview system (Lennox & Pittman, 2010;Anantharaman, 2012); the likelihood of being sanctioned according to the type of fraud (Firth et al, 2005); the efficacy of the enforcement actions in enhancing audit quality (Carcello et al, 2011;DeFond & Lennox, 2011;Gramling et al, 2011;De Fuentes et al, 2015); and the influence on accounting conservatism (Wang et al, 2011;Sun et al, 2016), among other issues. Moreover, standard setters such as the IFAC (International Federation of Accountants, 2014) and well-reputed audit researchers (Francis, 2011;DeFond & Zhang, 2014) call for contributions in this field.…”