ESSAYS ON THE SUPPLY AND DEMAND FOR AUDITING SERVICE

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The market for auditing service is shaped by the demand side and supply side forces. For audit firms and the overall profession, human capital is the most important asset because auditing service is delivered by auditors. The first paper in this book highlights the salience of leadership ability for auditors’ career success, and the second paper examines recent years’ trajectory of gender salary gap in the Swedish auditing profession.

The demand for auditing service arises when owners are separated from managers of a firm. Due to the rapid rise of index funds in recent years, the ownership pattern of the stock market has changed greatly. The third paper in this book examines the impact of passive investors on audit quality.

The fourth paper of this book focuses on regulatory intervention to the auditing market and examines the consequence of relaxing the mandatory audit requirement on small firms’ tax avoidance behaviour.

TING DONG received her bachelor’s degree (Accounting) and master’s degree (Economics) from Xi’an Jiaotong University in China. Ting’s research interest is auditing, financial accounting, and corporate social responsibility. Ting is currently a researcher at Stockholm School of Economics.

Ting Dong

ESSAYS ON THE SUPPLY AND DEMAND FOR AUDITING SERVICE

Ting Dong ESSAYS ON THE SUPPLY AND DEMAND FOR AUDITING SERVICE

ISBN 978-91-7731-186-75

DOCTORAL DISSERTATION IN BUSINESS ADMINISTRATION STOCKHOLM SCHOOL OF ECONOMICS, SWEDEN 2020

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ESSAYS ON THE SUPPLY AND DEMAND FOR AUDITING SERVICE

The market for auditing service is shaped by the demand side and supply side forces. For audit firms and the overall profession, human capital is the most important asset because auditing service is delivered by auditors. The first paper in this book highlights the salience of leadership ability for auditors’ career success, and the second paper examines recent years’ trajectory of gender salary gap in the Swedish auditing profession.

The demand for auditing service arises when owners are separated from managers of a firm. Due to the rapid rise of index funds in recent years, the ownership pattern of the stock market has changed greatly. The third paper in this book examines the impact of passive investors on audit quality.

The fourth paper of this book focuses on regulatory intervention to the auditing market and examines the consequence of relaxing the mandatory audit requirement on small firms’ tax avoidance behaviour.

TING DONG received her bachelor’s degree (Accounting) and master’s degree (Economics) from Xi’an Jiaotong University in China. Ting’s research interest is auditing, financial accounting, and corporate social responsibility. Ting is currently a researcher at Stockholm School of Economics.

Ting Dong

ESSAYS ON THE SUPPLY AND DEMAND FOR AUDITING SERVICE

Ting Dong ESSAYS ON THE SUPPLY AND DEMAND FOR AUDITING SERVICE

ISBN 978-91-7731-186-75

DOCTORAL DISSERTATION IN BUSINESS ADMINISTRATION STOCKHOLM SCHOOL OF ECONOMICS, SWEDEN 2020

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Essays on the Supply and Demand for Auditing Service

Ting Dong

Akademisk avhandling

som för avläggande av ekonomie doktorsexamen vid Handelshögskolan i Stockholm

framläggs för offentlig granskning tisdagen den 15 december 2020, kl 15.15,

sal Ragnar, Handelshögskolan, Sveavägen 65, Stockholm

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fDissertation Title

Essays on the Supply and Demand for

Auditing Service

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Essays on the Supply and Demand for Auditing Service

Dissertation Subtitle Lorem Ipsum Dolor Sit Amet Consectetur Adipiscing Elit

Ting Dong

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ii

Dissertation for the Degree of Doctor of Philosophy, Ph.D., in Business Administration

Stockholm School of Economics, 2020

Dissertation title : Essays on the Supply and Demand for Auditing Service

Back cover photo:

BrandFactory, Gothenburg, 2020 Keywords:

Auditing, audit quality, leadership, gender gap, passive investment, corporate governance, tax avoidance

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To

My mom († 2015)

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Foreword

This volume is the result of a research project carried out at the Accounting Department at the Stockholm School of Economics (SSE).

The volume is submitted as a doctoral thesis at SSE. In keeping with the policies of SSE, the author has been entirely free to conduct and present her research in the manner of her choosing as an expression of her own ideas.

SSE is grateful for the financial support provided by FIRE (Forskarskolan i Redovisning), Torsten Söderberg Foundation, the Swedish Auditing Acad- emy, the Swedish Bank Research Foundation, the Iwar Sjögrens Foundation, Handelsbanken, and the Jan Wallanders and Tom Hedelius Foundation which has made it possible to carry out the project.

Göran Lindqvist Kalle Kraus

Director of Research Professor and Head of the

Stockholm School of Economics Accounting Department

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Acknowledgements

I have been extremely lucky to have the opportunity to work on my PhD at Stockholm School of Economics, and I am grateful to everyone around me during this journey. My advisor, Henrik Nilsson, is my role-model in research. I want to thank him for guiding me masterfully over the PhD process, for all the encouraging words, and for helping me whenever I need. Henrik has been a mentor, a teacher, and a friend to me. I am deeply grateful to him.

I am also indebted to Kenth Skogsvik who was my advisor in the begin- ning of my PhD study. The advice that Kenth gave me has been very important for my PhD work, and I want to thank him for always being there to listen to me, help me, and give me wise advice in the past six years.

I also want to thank Ann Vanstraelen and Edward Lee who are on my supervisor committee. They have helped me greatly in improving the papers.

More importantly, they gave me invaluable advice on making career and life decisions. I am also deeply grateful to my professors during my master and bachelor study. I thank Hung-Jen Wang, Wanli Li and Qizhe Ren for their guidance and help over the past many years. They are the reason why I de- cided to pursue a career in research.

I also wish to thank everyone with whom I have worked together on research. Thanks to Florian Eugster who helped me greatly in my first paper.

He taught me how to conduct empirical analyses and write good Stata code.

Thanks to Milda Tylaite for all the discussions and arguments late in the nights and on vacations. Thanks to Juha-Pekka Kallunki and Ryan Wilson for mentoring me on the papers with great patience and all the insightfull comments. Thanks to Antonio Vazquez for lending your help whenever I needed. Thanks to Mariya Ivanova, Torkel Strömsten, Marek Reuter and Tinghua Duan for all the support and hard work together, I look forward to more fruitful research with you.

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viii

My research has benefited immensely from discussions, seminars, and courses at the Department of Accounting. I thank Martin Walker, Peter Jennergren, Henrik Andersson, Stina Skogsvik, Katerina Hellström for sharing your research experience, insights, and your kindest advice to me whenever I ask. I thank Ebba Sjögren, Walter Schuster, Lukas Goretzki, Martin Carlsson- Wall, Tomas Hjelström for your valuable comments on my research at various occasions.

Research would not have been so fun without my fellow PhD students.

Thanks to Peter Aleksziev for educating me on European geography and your help in my research. It has been a great pleasure to share office with you for almost five years. Thanks to Ingolf Kloppenburg for the nice talks about life and research, our pingpong time downstairs, and the toy trains you bought to my son’s birthday. Thanks to Anna-Stina Gillqvist, Emilia Cederberg, Liwei Zhu, Zeping Pan and Noor Alshamma who have shared office with me, it’s great to have you guys around!

Teaching has been a very important part of my PhD. I gratefully thank Niclas Hellman for your guidance and advice to improve my teaching, Kalle Kraus and Johnny Lind for your encouragement, trust, and support. My teaching has also benefited greatly from all the guest speakers who have par- ticipated in our Auditing course. Their practical insights have inspired my research too. In particular, I want to thank Anna-Karin Brusk Rönnqvist, Björn Irle, Eric Bergheden, Helena Nilsson, Charlotte Söderlund, Wayne Haydon, Hedvig Jonzon, Nils Romberg, and Stefan Lundberg. I must also say a big “Thank You” to Christina Ekelin and Anne Bengtsdotter for your magic in solving all problems with admin!

I thank all present and former colleagues at the Department of Accounting who are the most helpful, inspirational, creative, and skillful in conducting high quality research. Your advice, comments, and insights have shaped my research mindset.

My research in this dissertation would not have been possible without the generous scholarship from FIRE (Forskarskolan i Redovisning), Torsten Söderberg Foundation (Torsten Söderbergs Stiftelse), the Swedish Auditing Academy (Svenska Revisionsakademin), the Swedish Bank Research Foundation (Bankforskningsinstitutet), the Iwar Sjögrens Foundation (Iwar Sjögrens stipendie- fond⁾, Handelsbanken, and the Jan Wallanders and Tom Hedelius Foundation

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ix

(Jan Wallanders och Tom Hedelius stiftelse). I also wish to thank Christer Petersson at the Swedish Inspectorate of Auditors (Revisorsinspektionen) for providing crucial data for my research. I thank Per Johansson, Anders Ahlgren, Carin Rytoft Drangel, Ulf Westergren, Philip Lagerling and all the colleagues at Revisorsinspektionen who gave invaluable comments to my paper.

Finally, I thank my family for their unconditional love and support.

I dedicate this book to my mother, who passed away too early to witness me finishing the PhD. She would have been so proud and happy to see this day.

Stockholm, October 30, 2020 Ting Dong

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Chapter 1

1. Introduction

This dissertation consists of four independent papers in Auditing. The uni- fying theme of the four papers is to better understand some key elements in the two market forces that together shape audit outcome: the supply of the audit work and the demand for auditing service.

The value of auditing has been documented in ample studies. By assuring the faithfulness of the auditee’s reported financial information, auditing reduces information risk and helps improve resource allocation efficiency (De- fond and Zhang 2014). As with the markets for other commodities, the auditing market is shaped by the demand and supply forces (Wallace 2004).¹ The demand for auditing service stems from agency conflicts between managers and outside stakeholders. Hence, the incentives and competency of these stakeholders play a significant role in the demand side of the auditing market. On the supply side, suppliers of the auditing service are auditors and audit firms. Their competency and incentives for independence, which arises from reputation and litigation concerns (Dye 1993), together shape the driv- ing forces to supply higher quality audits (Watts and Zimmerman 1990).

Prior to the notorious corporate scandals in the early 2000s, auditing markets were self-regulated in most jurisdictions. However, the trend in recent years is toward more regulation with governmental intervention. In the U.S., for example, self-regulation was eliminated with the establishment of the

1 The mandate for audited financial reports by regulation is not the only explanation for the presence of the demand for auditing. The free market for auditing existed prior to governmental regulation.

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2 ESSAYS ON THE SUPPLY AND DEMAND

FOR AUDITING SERVICE

PCAOB in 2002. In Sweden, which is the focus of my research, the auditing market is also subject to European Union (EU) regulations. As Defond and Zhang (2014) noted, the regulatory intervention has substantial impacts on both the supply side and the demand side of the auditing market. In this chapter, I will review, based on Defond and Zhang (2014), the main archival research streams that pertain to the demand and the supply side of the auditing market. The discussions will follow the framework shown in Figure 1 below. Specifically, the focus will be on the research frontier in each area and the link to the four papers in this dissertation.

Figure 1.

1.1. The supply of the auditing service

Prior literature on the supply of auditing service mainly focuses on auditors’

incentive for independence (Defond and Zhang 2014), but recent years have

Litigation risk Industry specialization Agency cost Corporate governance

Reputation risk Auditor office size

Regulation risk Audit process Gap in literature: Emerging research on:

Endogeneity Audit committee

Internal audit function Emerging research on:

Emerging research on:

Auditing in private firms Paper II (on gender)

Supply Demand

Auditing Market

Auditors' competency

Individual auditor effect on audit quality Paper I (on auditors' leadership ability)

Paper III (on passive investors)

Paper IV (on audit regulation change for small private firms)

Client incentive to demand higher audit quality Auditors' incentive

for independence Client competency

Latest changes in capital market

Regulation

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CHAPTER 1 3

also witnessed a surge in research on auditor competence. I first discuss the incentive for independence.

1.1.1. The incentive for independence

Auditors strive for high quality audits because they are exposed to engagement risks including litigation risk, reputation risk, and regulation risk (Knechel and Salterio 2016). Earlier studies that examine reputation risk focused on the adverse market reaction of Anderson’s clients after the Enron scandal (e.g., Chaney and Philipich 2002; Krishnamurthy, Zhou, and Zhou 2006). More recent studies, no longer limited to the Enron setting, found further evidence on the real effects of reputational damage following audit failures. For example, Saito and Takeda (2014), using data from Japan, show evidence indicating that global audit firm networks have created a “network- wide reputation” which is susceptible to audit failures of both the U.S. Big Four and also those of non-U.S. affiliates. Nagy (2014) uses PCAOB inspection disclosures to show that audit firms that received quality control criti- cisms lose a significant amount of market share. Likewise, audit firms that receive PCAOB deficiency reports are more likely to be dismissed by their clients (Daugherty, Dickins, and Tervo 2011). The latest advancement in this line of research has found new evidence on the plus side of good reputation.

For example, Shroff (2019) shows that companies benefit from their auditors’ deficiency-free PCAOB inspection report through issuing additional external capital and increasing investment.

In terms of litigation risk, the consequence of lawsuits against auditors can be large enough to bring down a global audit firm. Ample evidence show that such threat affects audit fees and auditors’ decision on audit planning (exert more effort) and client acceptance/retention. Habib, Jiang, Bhuiyan, and Islam (2014) provides a comprehensive review of the extant literature on this area, and they note that major challenges remain. For example, further research is needed for understanding the causes and consequences of litigation against auditors and proper measurement of litigation risk. Along this line, Abbott, Gunny and Pollard (2017) use reverse merges to provide evidence on the litigation risk premium. The study by Cassell, Drake and Dyer (2018), on the other hand, improves our knowledge about auditor’s sensitiv- ity to factors that increase litigation risk. As the number of institutional

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investors increase litigation exposure, they find a positive association between audit fees and the number of institutional investors holding stock in the company. Recent experimental study by Alderman and Jollineau (2020) also provide new evidence on the relation between auditors’ exposure to liability and audit committee members’ perceived independence and financial expertise. Another challenge in this field of research pointed by Defond and Zhang (2014) is to address whether higher audit fees are due to increased effort or risk premia. In this respect, Bronson, Ghosh, and Hogan (2017) provide new evidence that the higher fees paid by cross-listed firms can indeed be attributed to, at least partly, incremental efforts associated with the U.S. institutional environment.

Regulatory intervention aimed for enhancing auditor independence in- clude, for example, restrictons on non-audit services (NAS) and tightened scrutiny on factors that regulators perceive to impair auditor independence.

Church, Jenkins, and Stanley (2018) contends that, as regulatory intervention could only focus on auditors’ independence in appearance - because “independence of mind”/auditor’s mindset is impossible to be observed - regulators’ goal for auditor independence is impossible to fulfill. Empirical findings on whether NAS compromise audit quality is mixed (Tepalagul and Lin 2015), and Knechel (2016) discusses potential negative consequences that are unintended by regulation. New evidence on this topic are emerging in recent years. For example, Meuwissen and Quick (2019) show that, from the Ger- man supervisory board members’ perspective, NAS is perceived as imparing auditor independence. Castillo-Merino, Garcia-Blandon, and Martinez- Blasco (2020), on the other hand, do not find a significant association between tax and audit-related service fees and audit quality. Rather, they find that future other NAS fees are negatively associated with audit quality. Hence the effect of NAS on audit quality may depend on the service type, and regulators do not necessarily have to ban all of them. In assessing the impact of NAS on audit quality, one should also take into account the fact that academic audit quality measures are noisy and, in general, could only explain a very minor part of practitioners’ assessment of audit quality (Aobdia 2019).

Therefore, further studies are needed before we could conclude on the relation between NAS and audit quality.

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CHAPTER 1 5

The auditor rotation rules in EU audit reform (effective 2016) have also attracted much attention in recent years. The relation between auditor te- neure and auditor independence has been examined in numerous studies, and findings are not conclusive (Defond and Zhang 2014). The latest studies have provided new evidence from practitioiners’ point of view in Europe (Aschauer and Quick 2018, Quick and Schmidt 2018), which shows some positive effect of mandatory rotation on perceived audit quality. However, Canadian evidence seem to suggest that audit committee members hold a negative view towards mandatory audit firm rotation (Fontaine, Khemakhem and David N. Herda 2017). Evidence in the U.S. also shows a negative (positive) stock market reaction upon events that increased (decreased) the likelihood of rotation (Reid and Carcello 2017). Analytical work also shows that mandatory audit firm rotation may have unintended consequences (Bleibtreu and Stefani 2018). To summarize, current research on the consequence of mandatory audit firm rotation is not conclusive; the effect of mandatory auditor/audit firm rotation may also depend on country-specific institutional factors that need to be further explored.

1.1.2. Auditor competence

As Defond and Zhang (2014) noted, archival research on auditor competencies is recent and relatively small. In their review article, Defond and Zhang (2014) summarizes the three main streams of literature in this area: auditor industry specialization, auditor office size, and the audit process. Specifically, they remarked that, besides audit firm competence, “individual auditor’s competencies are also likely to play a role in providing high quality.” Indeed, auditing research in recent years has witnessed a shift of focus from the level of audit firm to that of the office and individual audit partner (Lennox and Wu 2017). Recent empirical studies have documented the heterogeneity of audit partners. For example, Gul et al. (2013) use the auditor fixed effect approach to separate the effects of individual auditors on audit quality from those of clients, audit firms, and audit offices and find that individual effects not only exist but also vary in magnitude. Auditor individual effects have been documented both for large and small audit firms. In another study, Cameran et al. (2018) distinguish audit firm control mechanisms at the organizational, office, and partner levels and attempt to clarify the

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interrelationships among and relative importance of these layers. They find that audit firm, office, and partner fixed effects are all significant, but the most considerable effect is inter-partner variation. Further, there is evidence that the individual auditor effect impacts the capital market. For example, Aobdia, Lin, and Petacchi (2015) employ the methodology of Bertrand and Schoar (2003) to document a positive association between the quality of an individual partner’s audit quality and clients’ earnings response coefficients.

The market further reacts positively when an audit client switches from a lower quality partner to a higher quality one. Numerous archival studies of audit partner heterogeneity have also looked at various styles and characteristics of auditors. Knechel, Vanstraelen and Zerni (2015) report that a con- servative or aggressive reporting style persists for individual partners over time. Other characteristics found to be associated with audit outcomes are auditors’ age (Goodwin and Wu 2016; Sundgren and Svanström 2014), gender (Ittonen, Vähämaa, and Vähämaa 2013), expertise (Zerni 2012; Goodwin and Wu 2014), risk tolerance (Amir, Kallunki, and Nilsson 2014), cognitive ability (Kallunki et al. 2018), and Dark Triad traits (Hobson, Stern, and Zim- belman 2020). Nevertheless, this emerging line of research on individual auditors (characteristics) is relatively small with mixed findings, and more work is needed to gain better understanding of the audit process (Lennox and Wu 2017; DeFond and Zhang 2014).

The first two papers in this thesis are rooted in this stream of auditing research and attempt to provide new knowledge about individual auditors.

Outside academia, one primary concern often raised by auditing profession- als is the long-term sustainability of the whole industry, due to the intense human capital challenges that potentially could severely affect audit quality.

According to the most recent CPA Firm Top Issues Survey (AICPA, 2019), the top two concerns of large audit firms are finding qualified staff and re- taining qualified staff.² As human capital serves as the primary factor input of public accounting firms (Lennox and Wu 2017), I examine in Paper I the importance of auditors’ leadership ability and in Paper II, I focus on the gender gap within the auditing profession.

2 Similar voices are also communicated by PCAOB (2013), the Association of Chartered Certi- fied Accountants (ACCA 2018), the Financial Reporting Council (FRC 2006) and the Ministry of Finance of China (MFC 2015).

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CHAPTER 1 7

1.1.2.1. Paper I: auditors’ leadership ability

Studies that attempt to identify the determinants of a high-performing auditor (see, for example, Bonner and Lewis (1990), Libby and Tan (1994), Abdolmohammadi, Searfoss and Shanteau (2004) and McKnight and Wright (2011)) focused on technical competence in the early days (Abdolmoham- madi and Shanteau 1992), and are diverting more attention on tacit knowledge, client interaction skills and professional attitudes or behaviour (Tan and Libby 1997; McKnight and Wright 2011; Siriwardane, Kin Hoi Hu, and Low 2014). As audit partners do not do “accounting for accounting’s sake”, it is more important to be a “relationship person” with whom clients want to spend time (Carter and Spence 2014). More recent studies find, for example, tacit knowledge – in helping auditors to manage themselves and others better when performing socially interactive tasks – benefits even in- experienced auditors as audit firms are now assigning more socially interactive tasks to them (Bol et al. 2018). Further, Peecher et al. (2019) argue that proactive auditing behaviour is critical in delivering high quality audits.

However, a key talent that is actively pursued by leading audit firms is leadership ability, which is rarely studied in archival research (please see de- tailed discussion in Paper I). Motivated by the profession’s recent concern for human capital challenges, the first paper of my thesis titled “Is leadership ability rewarded by the auditing profession?” aims to investigate whether and how leadership ability is compensated in the industry. This paper is co-authored with Henrik Nilsson, Juha-Pekka Kallunki, and Ann Vanstraelen. We present evidence that leadership ability is a strong predictor of CPAs’ job- related income and career success. We also find that that the labour market return to auditors’ leadership ability is related to revenue generating activities rather than audit quality, especially in non-Big Four firms. Further analyses show that the reward to leadership ability is not impartial: younger CPAs’

leadership ability does not seem to be rewarded, and for those who depart the auditing profession, the return to leadership ability is significantly higher after leaving. Our findings are especially salient given the concerns on the attractiveness and sustainability of the auditing profession. The implications of this study on talent management should be of interest to audit firms and the profession.

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1.1.2.2. Paper II: Gender salary gap

Human capital is almost without doubt the most important asset for the auditing profession (AICPA 2013, Aobdia, Srivastava, and Wang 2018). Hence the access to a deep pool of both female and male talent is essential to the success of audit firms (Cohen et al. 2018). Prior literature has shown evidence that female auditors provide higher audit quality than their male counterparts (Ittonen, Vähämaa, and Vähämaa 2013), and that female auditors can charge an audit fee premium (Ittonen and Peni 2012). In explaining the female audit fee premium, Ittonen and Peni (2012) provide a potential explanation: female auditors are more diligent, have lower overconfidence, and are better pre- pared. In another study, Ittonen et al. (2013) find evidence that female audit engagement partners are associated with lower abnormal accruals, consistent with female auditors constrain earnings management better than male auditors. Such findings support the notion that the behavioral differences between men and women may have substantial implications for audit quality and financial reporting quality.

Despite the above mentioned evidence found in prior research, the supply of female and male talents on the auditing market is not balanced: gender gap in the auditing profession has long existed (Eastman 1929, AICPA 1984, Collins 1993, Anderson-Gough, Grey, and Robson 2005) and still remains as a serious concern (Haynes 2017; Cohen et al. 2018). In recent years, leading firms in auditing have exerted strong efforts to promote greater gender equality (Kornberger, Carter, and Ross-Smith 2010). But despite such efforts and the heightened public attention to gender equality in recent years (Giannetti and Wang 2019), it is not clear in prior literature how the auditing profession’s gender gap has developed recently.

Kornberger, Carter, and Ross-Smith (2010), for example, conducted a field study on one Big Four firm’s flexibility initiative aimed to create “the best professional workplace for women”, and to enhance the progression and retention of senior level talented female staff. However, the main prac- tices promoted by the flexibility initiative subverted the program: “flexible working ended up being widely perceived as reflecting a part-time commit- ment towards Sky (the audit firm) on the part of the employee.” Designed strategically by the top management team of the firm, such initiative to bring about gender equality in audit firms ultimately undermined. Carter and

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CHAPTER 1 9

Spence (2014), also based on interviews, noted that “barriers to entry and ascension appear to be all but insurmountable for females and ethnic minor- ities,” (977) showing little confidence in the status quo.

It is, therefore, an important research question to know the development of the gender gap within the auditing profession in recent years. In the second paper titled “Gender salary gap in the auditing profession: trend and explanations,” I examine the trajectory of gender salary gap in the auditing profession from 2007 to 2015 in Sweden. Studying auditing profession’s gender salary gap in Sweden is of particular interest. As the world’s forerunner of gender equality, the Swedish government initiated some of the most important reforms to promote gender equality as early as the 1970s. The three major reforms were: (1) separate income taxation for wife and husband (1971), which made women’s income independent from their husbands’ (2) development of public child care (1974), which made affordable public child care facilities available to all – a prerequisite to a large proportion of women’s gainful employment, and (3), introducing gender-neutral paid parental leave benefit (1974), which aims to support a dual-earner family model – the cornerstone for the development of a gender equal society. The third policy (gender-neutral paid parental leave policy) started in 1974 and was revised a few times. In 1995, 2002, and 2016, for example, reserved parental leave months were introduced, so that each parent was entitled to a non-transfer- able month of paid parental leave.³ As of today, women and men in Sweden are entitled to 480 days of paid parental leave per child.

According to the World Economic Forum’s Global Gender Gap Report 2020, Sweden ranks first in the EU gender equality index. Prior literature has also shown that human capital investment in women and men is equal and that they are equality represented in the Swedish labour market. Therefore, in the Swedish setting, female and male differences are arguably lower than in most other countries. Hence the gender gap observed in my sample is more specific to the auditing profession per se. Besides, since the major re- forms on gender equality initiated by the government were implemented as early as the 1970s, there were no major regulatory changes initiated by the

3 The first reserved month was introduced in 1995, and was expanded to two months in 2002.

In 2016, it was extended to three months.

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government during recent years. Thus, the empirical findings from this study are less susceptible to confounding factors outside the auditing industry.

Using Swedish administrative data from 2007 to 2015 for all CPAs, I find that the overall gender salary gap in the auditing profession has substantially declined: the gap in 2015 is about half the size of 2007. More female auditors have moved up to the top earnings group during this period, with an evident lessening of the glass ceiling phenomenon. Oaxaca-Blinder analysis shows that auditor’s clientele size is the most important factor to explain the salary gap, and the increase in female auditors’ clientele size during this period ac- counts for half of the decrease in total salary gap. I also find that the rise of female leadership in Big Six firms is positively associated with the increase in female auditors’ clientele size. Consistent with Kunze and Miller (2017), such

“women help women” effect in the auditing environment is more pronounced in the middle and lower half of the firm hierarchy, suggesting that female representation at the top of the firm has spillover benefits to lower ranked female auditors. The implications of this study may help audit firms in closing their gender gap and better cope with the talent challenge faced by the overall auditing industry nowadays.

In summary, the supply side of auditing is co-determined by auditor incentive and competence. Prior literature on the latter is relatively scarce but there is a recent boom in this research field. The first two papers of my thesis aim to provide new evidence from a labour economics oriented perspective on the supply of human capital in the auditing profession.

1.2. The demand for auditing service

Similar to the supply side, the demand for auditing service is also co-determined by two factors: client incentive to demand higher quality audit and client competence (Defond and Zhang 2014).

1.2.1. Incentives to demand higher audit quality

As moral hazard arises from information asymmetry between managers and outsiders (Jensen and Meckling 1976), the need for third party’s independent monitoring of firm’s financial performance is thus evident. Most studies in this line of research use agency theory to explain the demand for auditing

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CHAPTER 1 11

service, and research findings are mostly consistent with agency costs increase the demand for high quality audits (see, for example, Defond and Zhang 2014).

1.2.1.1. Paper III: Passive investors

An important determinant of agency conflict is ownership structure, which should have considerable impact on firms’ demand for auditing (Chow 1982). One crucial type of ownership that has largely been ignored in auditing research is passive investors. They are quietly changing the ownership structure of U.S. listed firms by gaining massive scale in recent years. Fichtner et al. (2017) report that, when combined, the largest three money managers dominating the index fund industry constitute the single largest shareholder in at least 40% of all listed companies in the U.S. in 2015, with mean ownership of 17.6%. The incentive and behavior of passive institutional investors are intriguing due to the growing importance of passive investing in the capital market as well as the controversial views towards it in both academia and practice. By mimicking a particular index, passive investors do not have much choice on the stocks to hold (i.e., they are unable or are reluctant to “vote with their feet”); hence, they may have higher motivation to be engaged owners and adopt activist positions (Carleton et al., 1998). However, their “passive” way of investing may also mean that they take a passive role in monitoring the firm managers.

The rise of index fund, or passive investing, in the past decades has caused heated debates over the efficacy of passive investors’ stewardship role in corporate governance. The third paper of my thesis, “Passive institutional investors and audit quality: empirical evidence from the Russell index recon- stitution,” will add to this emerging line of literature by examining whether passive investors enhance the quality of financial statement audits, a key as- pect of the corporate governance mechanism. This paper is joint work with Antonio Vazquez and Florian Eugster. We exploit the yearly Russell index reassignment which provides us with an ideal setting to study the causal rela- tion between passive institutional investors (i.e. index trackers) and firms’

audit quality. Examining firms closely surrounding the Russell 1000/2000 cutoff line, we find that higher passive ownership leads to (1) higher audit fee payment, (2) lower propensity to restate financial statements, (3) lower

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propensity to meet or beat the zero earnings threshold and (4), less internal control weaknesses. We also find that such positive effect on audit quality is more pronounced in firms with higher agency costs. To investigate the chan- nel through which passive investors exert their impact on audit related governance issues, our evidence from auditor ratification voting records suggests that passive investors do “voice” their opinion on low-quality audits. Such effort, potentially coupled with private engagement initiatives, also leads to higher likelihood of auditor turnover in the following year. Our paper thus lends support to the view that passive investors do take an active role in improving corporate governance.

1.2.1.2. Other factors affecting the incentive for high quality audits Besides agency cost, other factors may also play an important role in affecting client incentive. Francis, Inder, Xiumin and Raynolde (2011) noted that, while agency theory suits well for the U.S. setting where public firms typically have dispersed ownership and the quality of investor protection is high, it may not be universally true in other parts of the world. Using data from 3,829 private firms in 62 widely diverse countries and economies, they provide ev- idence that firm level incentive and country characteristics are both important determinants for the demand of auditor assurance. Importantly, this may ap- ply not only to financial statement auditing but also to the broader realm of the demand for assurance services, as shown by Dalla Via and Perego (2020).

The study by Wieczynska (2016) reinforces the findings in Francis et al.

(2011) by showing that a country’s regulatory regime affects the likelihood of auditor replacement around IFRS adoption.

Recent advancement in the audit demand literature also benefits from richer data at audit office and individual level.⁴ For example, Swanquist and Whited (2015) find that audit offices experience a loss in local market share following client restatements, especially in high competition markets. For audit clients that dismissed their auditors, they tend to select less contaminated audit offices. Similar effect is found at partner level by Chi et al. (2019).

4 This line of literature is not independent from the individual auditor research mentioned in previous discussion about auditor competency.

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CHAPTER 1 13

While previous studies mainly focus on public firms’ demand for audit service, recent literature has seen more studies on private firms’ demand for auditing services. In private firms, which are substantially different from public firms in various dimensions, the demand for auditing service origins from different sources (Langli and Svanström 2014) than in public firms (where agency conflict is the main reason). In their review paper, Vanstraelen and Schelleman (2017) confirms the value of audits to private companies in, for example, reducing the cost of capital, better financial reporting quality, and an increased level of debt, investment, and operating performance (e.g., Min- nis 2011; Kausar, Shroff, and White 2016; Downing and Langli 2019). In this line of studies, one advantage of the private firm setting is that researchers could utilize shifts in the mandatory/voluntary audit regimes to exploit the value of auditing. Lennox and Pittman (2011) and Kausar et al. (2016), for example, both employ the UK regulation change that removed mandatory audit requirement for small sized companies.

1.2.1.3. Paper IV: Auditors’ role in constraining tax avoidance

An underlying assumption in the studies mentioned above is that audit assurance is the same in mandatory and voluntary audits. For example, Lennox and Pittman (2011, page 1657) noted: “In particular, when a company voluntarily chooses to remain audited, there is no change in audit assurance”.

My fourth paper, “Mandatory vs. voluntary audit: the role of auditing in constraining corporate tax avoidance”, is co-authored with Milda Tylaite and Ryan Wilson. In this paper, we argue that, under voluntary audit, the client- audit relationship dynamic is not the same as under mandatory audit, hence the level of assurance may be different. This is mainly because under the voluntary audit regime, auditees maintain the option to opt out of financial statement audits – they no longer have to bear a sizable auditor switching cost in case they fall out with their incumbent auditor.

In private firms’ financial reporting process, tax considerations play an important role because there is not as much public interest in such firms and the pressure to report favourable accounting numbers is low. In this paper, we examine the difference between firms’ tax avoidance behavior under voluntary versus mandatory audit. In our empirical setting of Swedish micro sized private companies, the demand for auditing is present - as we observe

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the large number of firms that voluntarily purchased financial statement audits – but we show that auditors’ role in constraining tax avoidance is substantially different when the audit service is voluntarily purchased. More specifically, we find that firms that are voluntarily audited exhibit higher levels of conforming tax avoidance than firms subject to mandatory audit. The former shows similar tax avoidance levels as firms that opted out of audits. We also present evidence that the more aggressive tax avoidance behavior among voluntarily audited firms is, at least partially, due to impaired auditor independence under the voluntary audit regime.

In line with Defond and Zhang (2014), this paper illustrates that incentives and competence on the supply and demand side of auditing are not independent of regulatory intervention. For example, in this paper we present evidence that voluntarily audited firms with external debt financing do not exhibit higher tax avoidance levels than firms under mandatory audit.

This finding suggests that creditors’ demand for higher quality monitoring constraints tax avoidance behavior. But for those without external financing, when the set of institutional rules governing the hiring and firing of auditors is relaxed, auditor assurance level is lower. From the auditors’ perspective, those auditors who are more sensitive to the audit regime shift (those whose revenue inflow is more affected due to potential loss of clients that opt out of an audit) may have less incentive to maintain their independence and hence their clients exhibit higher levels of tax avoidance.

1.2.2. Client competency

In terms of client competency, prior literature generally finds consistent re- sults that show (1) strong corporate governance is positively associated with high quality audits and (2) certain mechanisms, such as audit committee characteristics, internal control, and internal audit function, are important factors that help auditees to achieve the desired level of audit quality (Defond and Zhang 2014). Client incentives and competency are not independent of each other. Their interactive relation can be inferred from Paper III of this dissertation. That is, passive investors have the incentive to monitor the firm, which accordingly improves corporate governance and audit quality. In terms of the specific mechanisms that enhance client competency, archival research on the internal audit function is relatively new (Abbott et al. 2016). Besides,

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CHAPTER 1 15

studies on audit committee members’ characteristic and social ties/identities are also emerging in recent years.

1.2.2.1. The internal audit function

Internal audit function is an important part of the corporate governance mechanism because it provides ongoing assessments of the company's risk management processes and system of internal control to management and the audit committee (Harrington 2004). The importance of internal audit function in deterring management misconduct is documented by Ege (2015).

To achieve effective monitoring, the joint presence of internal audit function’s competence and incentive for independence is needed (Abbott et al.

2016). With regard to the incentive perspective, the latest international evidence from Jiang, André, and Richard (2018) shows that firm complexity, board monitoring, audit committee diligence are important determinants for internal auditors’ independence. Environmental factors such as industry competition and country-level corporate governance code are also important for high internal audit quality. Consistent with Abbott et al. (2016) regarding internal auditor independence, Jiang et al. find that CEO power reduces internal audit quality, and Chris et al. (2015) show that when internal audit function’s staffing model diminishes internal auditors’ objectivity, financial reporting quality is significantly lower.⁵ Chris et al. (2015) also show that several monitoring mechanism - including audit committee oversight and the consistency of internal audit function’s leadership or supervision – can miti- gate the negative effect of such staffing models.

Recent evidence on internal auditor competence focuses mainly on its impact on the internal audit quality as well as the interaction with external auditors. For example, Pizzini, Lin, and Ziegenfuss (2015) document that internal audit competence and fieldwork quality drives down (external) audit delay. Lee and Park (2016) find evidence that internal auditors’ accounting and legal expertise is utilized by external auditors to improve audit efficiency, and the availability of internal auditors increase their contribution to external audit work. Oussii and Taktak (2018) find new evidence on the impact of the

5 Please see Carcello et al. (2018) for the positive effects of using the internal audit function as a management training ground.

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internal audit function’s characteristic on internal control quality in emerging markets.

Recent developments in internal audit research also focus on internal au- dit quality per se. For example, Trotman and Duncan (2018) investigate the concept of internal audit function (IAF) from practitioners’ view, and find that various stakeholder groups evaluate internal audit quality differently by focusing on different dimensions. The multi-stakeholder IAF quality framework developed by Trotman and Duncan (2018) contributes important insights about the internal audit function.

1.2.2.2. The audit committee

Based on a burgeoning literature that documents the influence of social network on economic agents’ behavior, recent research in auditing has provided new evidence on the social ties of audit committee members. He, Pittman, Rui, and Wu (2017) find evidence suggesting that social ties between auditor and audit committee members impair audit quality. Further, Ittonen, Myl- lymäki and Tronnes (2019) focus on bank audit committees and report significantly lower audit fees when the audit committee chair is an alumnus of the incumbent audit firm. This finding suggest that the external auditor exert less effort in such relations. On the other hand, Christensen, Omer, Shelley and Wong (2019) base their prediction on psychology’s social identity theory and find evidence supporting improved audit quality when companies have an affiliated partner on their audit committee. They also find that such quality improvement is accompanied by a reduction in audit fees and time spent on fieldwork, suggesting efficiency.

Several recent work also examine the competence of audit committee members and its effect on audit quality. For example, Lisic, Myers, Seidel, and Zhou (2019) find that audit committee accounting expertise helps to promote audit quality measured by internal control audit opinions. Ghafran, Chaudhry and O’sullivan (2017) use audit fee as proxy for quality; they also find that audit committee expertise help enhance audit quality. Across corporate boards around the world, female participation has significantly increased recently. The implication of such development on auditing has also been studied, but the findings are not conclusive. Lai, Srinidhi, Gul and Tsui (2017), for example, find that firms with gender-diverse boards pay higher

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CHAPTER 1 17

audit fees and are more likely to hire industry expert auditors. Still, Nekhili, Gull, Chioui and Radhouane (2019), using French data, find that higher female board (audit committee) participation reduces audit fees because of the reduced risk assessed by auditors. As mentioned before, the gender perspective in auditing is relatively under-researched, and further work is needed.

1.3. Concluding remarks

In this chapter, I conduct a focused overview of the major developments of archival auditing research in recent years and discuss how the existing gap is linked to my Ph.D. work. The four papers in the following chapters attempt to answer some important questions in the current auditing market. On the supply side, prior literature on auditor competence is relatively scarce, and studies on individual auditor characteristic are in its infancy. To contribute to this line of research, I provide new evidence in Paper I on auditors’ leadership ability and in Paper II on the gender salary gap. On the audit demand side, research on agency conflicts and ownership structure is relatively ma- ture. However, this area faces an acute endogeneity issue; fast developments in the capital market, such as the emergence of passive investors, also means that this area of research needs further investigation. Paper III in my dissertation thus examines how passive owners affect the demand for audit quality.

Regulatory intervention is also a key factor affecting both audit demand and supply. Although ample studies have examined the impact of regulation (such as SOX, EU audit reform) for large, listed companies, we know relatively little about private firm audits. In my fourth paper, I attempt to fill in the gap in this area.

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ESSAYS ON THE SUPPLY AND DEMAND FOR AUDITING SERVICE

ESSAYS ON THE SUPPLY AND DEMAND FOR AUDITING SERVICE

ESSAYS ON THE SUPPLY AND DEMAND FOR AUDITING SERVICE

Essays on the Supply and Demand for Auditing Service

Ting Dong

Akademisk avhandling

fDissertation Title

Essays on the Supply and Demand for

Auditing Service

Essays on the Supply and Demand for Auditing Service

Dissertation Subtitle Lorem Ipsum Dolor Sit Amet Consectetur Adipiscing Elit

Ting Dong

Foreword

Acknowledgements

Contents

Chapter 1

1. Introduction

1.1. The supply of the auditing service

1.2. The demand for auditing service

1.3. Concluding remarks

References