Audit Quality and Subsidiary Audits

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Jeremiah Bentley and Dr. Steven Glover, Accounting

International and national accounting standard setters have spent significant amounts of time discussing and making rules about the consolidation of company’s financial statements (ASB 2009; PCAOB 2008, 2010; IAASB 2007; FASB 2010). One of the focuses of these discussions is how auditors should respond to the consolidation process when performing group audits (Glover et al. 2008). A group audit is an audit performed on an entity with multiple locations or components, with separately audited financial information included in consolidated or group financial statements (Glover et al. 2008). While previous research has examined how the consolidation process affects the financial statement quality of the consolidated entity as a whole (e.g., Okuda and Shiiba 2010; Wiedman and Wier 1999), no academic research has investigated if the consolidation process impacts the accounting risk of subsidiary companies (accounting risk is the risk that clients’ financial statements contain misleading or fraudulently reported numbers (Price et al. 2010)). In this study, we begin to fill this void by examining if the consolidation process impacts the accounting risk of a subsidiary company that also issues its own stand-alone financial reports.

Given the competing theoretical arguments for how a group setting will affect subsidiary accounting risk, we evaluate how the consolidation process impacts accounting risk using two-tailed tests with archival data.

We use data from Audit Analytics, Compustat, and Audit Integrity, LLP to model the relationship between accounting risk and subsidiary status (i.e. when a company’s financial statements are consolidated into those of another company). We proxy for accounting risk by using a commercially developed measure called Accounting and Governance Risk (AGR) developed by Audit Integrity, LLP. We combine this measure with control variables from both Audit Analytics and Compustat from 2001-2008. To measure subsidiary status, we use the “parent” variable in Audit Analytics to identify companies that are subsidiaries but issue stand-alone audit opinions. We also include control variables common in the archival literature and cluster our results by firm and year.

Our archival analysis reveals that subsidiary companies that also issue stand-alone financial statements have significantly lower accounting risk than do non-subsidiary companies. However, this archival analysis does not reveal the causal driver of the relationship. We have begun work on an experiment that we plan to administer to professional auditors to help us understand what causes the archival results.
We have conducted pilot versions of this experiment with MAcc students and hope to pilot and then administer the experiment to professionals within the next year. We will then submit the results to an academic journal in accounting.

Work co-authored with David Wood and Steven Glover.

References

  • American Institute of Certified Public Accountants (AICPA) Auditing Standards Board (ASB). 2009. Audits of Group Financial Statements (Including the Work of Component Auditors). Proposed Statement on Auditing Standards. 4 September 2009. New York, NY: AICPA.
  • Child, J., D. Faulkner, and R. Pitkethly. 2000. Foreign direct investment in the UK 1985-1994: The impact on domestic management practice. Journal of Management Studies 37 (1): 141-166.
  • Financial Accounting Standards Board (FASB). 2010. Board Meeting: Consolidations. April 20. Available at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176156915753.
  • Glover, S. M., D. F. Prawitt, J. T. Liljegren, and W. F. Messier Jr. 2008. Component materiality for group audits. Journal of Accountancy. 206 (6): 42-47.
  • International Auditing and Assurance Standards Board (IAASB). 2007. ISA 600, Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors). New York, NY: International Federation of Accountants.
  • Okuda, S. and A. Shiiba. 2010. An evaluation of the relative importance of parent-only and subsidiary earnings in Japan: A variance decomposition approach. Journal of International Accounting Research 9 (1): 39-54.
  • Price III, R. A., N. Y. Sharp, and D. A. Wood. 2010. Detecting and predicting accounting irregularities: A comparison of commercial and academic risk measures. Working Paper. Rice University, Texas A&M University, and Brigham Young University.
  • Public Company Accounting Oversight Board (PCAOB). 2008. Order Instituting Disciplinary Proceedings, Making Findings, and Imposing Sanctions In the Matter of Christopher E. Anderson, CPA. October 31. Washington, D.C.: PCAOB. Accessed from http://pcaobus.org/Enforcement/Decisions/Documents/10-31_Anderson.pdf.
  • Public Company Accounting Oversight Board (PCAOB). 2010. Staff Audit Practice Alert No. 6 Auditor Considerations Regarding Using the Work of Other Auditors and Engaging Assistants from Outside the Firm. July 12. Washington, D.C.: PCAOB.
  • Wiedman, C. I. and H. A. Wier. 1999. Management of note disclosures: The case of unconsolidated subsidiaries Prior to FAS No. 94. Journal of Accounting, Auditing & Finance 14 (1): 73-94.