Uninvolved: Effects of Restatement-Independent Audit Oversight

Gomez, Pedro Enrique

doi:https://doi.org/10.21985/n2-13cn-em63

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Uninvolved: Effects of Restatement-Independent Audit Oversight

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Prior studies about restatements generally examine outcomes under assumed auditor responsibility. Surprisingly, however, about 20% of the restatements obtained from Audit Analytics correspond to cases where the current auditor was not engaged during the misstatement period. I refer to these cases as uninvolved. The first chapter examines current literature findings on restatements and audit firm turnover, introduces the notion of an uninvolved auditor, and provides descriptive background on this classification. The second chapter evaluates market reactions to restatements, conditional on audit firm involvement. This chapter further discusses the information structure of the setting, noting potential endogeneity issues in the involvement classification, and implements causal inference techniques to mitigate these concerns. Lastly, the third chapter investigates audit firm turnover after the restatement announcement, also conditional on audit firm involvement. Prior literature, in general, has not selectively analyzed companies that have experienced an audit firm switch prior to the discovery or announcement of a material misstatement. Many of the conclusions and implications that have been inferred from prior results, directly or indirectly, rely on the fundamental assumption that the audit firm at the time of the restatement announcement was involved during the misstatement period. The distinction of involvement has implications for studies in this stream of literature and others in which a restatement event, perhaps incorrectly, has been taken to be synonymous with audit failure or to signal impaired audit quality of the audit firm engaged at the time of restatement announcement. In the first chapter, I introduce the notion of an uninvolved auditor, referencing relevant prior literature on restatement announcements and audit firm turnover. I discuss the guidance provided for restatements and auditor turnover under the auditing standards and provide descriptive statistics for these two dimensions using the general broad sample of interest. I find that this unstudied sample corresponds, on average, to 20% of restatements every year. In the second chapter, I examine the market reaction to the announcing of a restatement by a company that currently has an audit firm that was not involved during the misstatement period. I conjecture that the market may infer three different signals based on involvement, and these signals may, a priori, lead to differential market reaction. Using a model similar to that in prior literature, I find that companies with involved audit firms have incrementally negative abnormal returns around the restatement announcement compared to companies with uninvolved audit firms. Furthermore, referring to prior literature on the determinants of audit firm turnover, I estimate the likelihood of audit firm turnover at the end of the misstatement period and implement a Heckman correction and propensity score matching procedures to mitigate endogeneity concerns arising from the involvement classification. In general, the findings of the main effects of involved and uninvolved are qualitatively similar. In the third chapter, I analyze whether there are different likelihoods of turnover for audit firms conditional on involvement and examine the respective market reactions to these departures to evaluate the market’s perception of the turnover event. I find that, following the restatement announcement, companies with uninvolved (involved) audit firms are less (more) likely to experience turnover and to have a positive (no) reaction to audit departures. These findings suggest that the market penalizes companies with involved audit firms at the restatement announcement: these companies are more likely to experience audit turnover, consistent with companies trying to reestablish reporting credibility; furthermore, involved audit firm departures are not valued by the market, but they are for uninvolved audit firm departures. Collectively, this work seeks to expand our understanding of a significant corporate and audit event, financial restatement due to a material misstatement. I seek to fill a gap in the academic literature related the market’s inferences about, and audit firms’ outcomes in regard to, financial restatement announcements when the current audit firm was not engaged during the misstatement. Prior literature has either assumed that all audit firms at the time of a restatement announcement are involved with the misstatement or has focused on instances in which such is the case. Consequently, we do not know whether the market processes the involvement classification and, if it does so, whether it acts differently according to involvement. Given documented findings about expected costs a restatement imposes on an audit firm, one would question the lack of disclosure mechanisms for audit firms to differentiate themselves concerning this classification. Moreover, this work contributes to existing literature on determinants of market reactions and audit firm turnover related to financial restatements, analyzing potential implications that involvement may have for companies and audit firms. This work highlights that companies and auditors may face different incentives during and after the restatement process depending on involvement, which may influence both the actions they might take as well as the signal the market may interpret about the restatement.

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