The impact of joint audits on audit quality and audit market structure

The European Commission issued a green paper on audit policy in 2010 to discuss lessons learned from the crisis of 2008. In order to reduce market concentration, the Commission encourages European countries to adopt joint audits. Under joint audits, two different audit firms share the audit work and jointly sign the audit report for one company. Proponents argue that four eyes are better than two or two heads are better than one. In France, any listed company, any bank or other financial institution, and any company that prepares consolidated financial statements has been required by law to appoint joint audits since 1966. Some countries mandate joint audits for a subgroup of firms. For example, India requires joint audits for state-owned enterprises and Saudi Arabia and Algeria mandate joint audits for banks. Joint audits are voluntary in Denmark, Sweden, and Germany.

In France, the joint audit law has evolved into a professional standard of practice, requiring a balanced division of the work of both auditors in order to ensure an efficient dualcontrol mechanism. However, in practice, auditors may not balance their work allocation. For example, if one Big 4 firm and one small firm conduct joint audits, it is harder to share the workload equally, because the small audit firm will have lower production capacity. In contrast, the work allocation is likely to be balanced if joint audits are conducted by two Big 4 firms. After accepting an audit engagement, the two audit firms first agree on their work allocation. Their work is usually allocated either by regions (e.g., one audits America and the other audits Europe) or by divisions. Then they start to audit the financial statements simultaneously; they typically work this way because auditors need to meet a deadline for releasing the audit report. After finishing their part of the audit, they review each other’s audit work and prepare relevant documentation.

At the end of the audit, each joint auditor signs the audit report on the whole financial statements, not just on the work they have done. However, the courts evaluate each audit firm’s responsibility based on auditing standards. Fault, if found, may not be at the same level for each audit firm. For example, if the audited inventory is materially misstated, then the auditor who is responsible for inventory could be held more responsible than the other auditor, who simply reviewed the work.

If two heads are indeed better than one, then joint audits probably would be more prevalent in the world. But single audits are still the norm in most countries, with the United States being a notable example. In 2005, Denmark did a complete about-face on joint audits—it abolished the mandate for joint audits effective since 1930. Interestingly, only 19 of 182 Danish companies had more than one auditor in 2009.

Apparently, proponents’ arguments do not form a complete picture of the benefits and costs ofjoint audits. Based on a mathematical model, Deng et al. (2014) (hereafter DLSY) identify an economic force that may work against joint audits; that is, free-riding. In joint audits, one of the audit firms may save audit resource cost by investing less in its own audit work and taking advantage of the other audit firm’s hard work.

They consider three regimes that may vary in the magnitudes of potential free-riding problems: single audits by one big firm (Regime B); joint audits by two big firms (Regime BB); and joint audits by one big firm and one small firm (Regime BS). DLSY make two assumptions to capture the differences between a big audit firm and a small one. First, a big audit firm has an advantage in its auditing technology' in the sense that it has a lower marginal cost of audit evidence precision than a small firm (Simunic 1980). Second, a big audit firm bears a larger proportion of misstatement costs (such as litigation risk and reputation loss) than a small firm (DeAngelo 1981b).

Under their model assumptions, DLSY find that Regime BB generates the same audit evidence precision as Regime B. Also, audit fees are lower under Regime BB than Regime B. Comparing Regime BS with Regime B, they find that the total precision of audit evidence under joint audits is lower than that under a single audit. In addition, the audit fees under joint audits are lower than those under single audits if the technological difference between the two audit firms is small and the big firm bears a large proportion of misstatement cost.

In other words, DLSY shows that joint audits by one big firm and one small firm may impair audit quality, because, in that situation, joint audits induce a free-riding problem between audit firms and reduce audit evidence precision.

However, empirical evidence on whether joint audits would lead to higher audit quality' is mixed. Focusing on comparing Big-Big (BB) vs. Big-non-Big (BS) joint audits, Lobo et al. (2016) document how firms audited by a BB pair have lower transparency than their counter-parties in booking goodwill impairments.

Guo et al. (2017) estimate how the introduction of a joint audit policy would affect audit market structure and consumer surplus. They find joint audit would be associated with a substantial loss of consumer surplus. The loss results from restricting clients from giving all of the audit work to their most preferred audit firm, but it is partly offset by gains in consumer surplus deriving from the opportunity to choose the best combination of auditor pairs.

André et al. (2016) examine the differences of audit fees and discretionary accruals between French companies and British and Italian companies. They find joint audits in France are associated with higher audit fees, but without significantly different abnormal accruals. In contrast, Bianchi (2017) shows there is a positive association between audit quality and auditors’ collaboration in multiple joint engagements for Italian private companies whose financial statements are jointly audited by three individual auditors. The results suggest that joint engagements facilitate knowledge transfer and increase auditor expertise. Lesage et al. (2017) find that a joint audit is associated with higher fees, but that the association between joint audit and abnormal accruals is insignificant for Danish companies. Zemi et al. (2012) suggest that while Swedish companies opting to employ joint audits have higher audit fees, they have a higher degree of earnings conservatism, lower abnormal accruals, better credit ratings, and lower perceived risk of becoming insolvent within the next year than other firms.

To summarize, existing research shows that joint audits are associated with higher audit fees, but the research has not provided consistent evidence on whether joint audits can improve audit quality. Though French professional standards require work allocation to be balanced, in practice there exists a significant portion of imbalanced joint audits. Whether joint audit work allocation should be balanced or not and the extent of its impact on market concentration and audit quality could be an interesting avenue for future research.

End-of- chapter question

What is the key objective of an audit regulator and what are the major activities an audit regulator must carry out in order to fulfill its mandate?

Notes

• 1. https://pcaobus.org/News/Speech/Pages/03202014_American.aspx.
• 2. See https://pcaobus.org/News/Releases/Pages/PCAOB-adopts-disclosure-rules-Form-AP-12-15-15.aspxfor more information.
• 3. https://pcaobus.org/Pages/AuditorSearch.aspx.
• 4. www.wsj.com/articles/kpmg-agrees-to-pay-50-million-penalty-related-to-misconduct-allegations-11560788245.
• 5. www.justice.gov/usao-sdny/pr/former-kpmg-executive-and-former-pcaob-employee-convicted-wire-fraud-scheme-steal-and.
• 6. https://pcaobus.Org/Enforcement/Decisions/Documents/105-2016-031 -Deloitte-Brazil, pdf.
• 7. www.frc.org.uk/news/june-2013/frc-issues-revised-auditing-standard-making-audit.
• 8. www.journalofaccountancy.com/news/2014/may/201410229.html.