Auditing: A Journal of Practice & Theory Vol. 31, No. 1 February 2012 pp.

1738

American Accounting Association DOI: 10.2308/ajpt-10192

Investors Perceptions of Audit Quality: Effects of Regulatory Change

Jason L. Smith
SUMMARY: In an experiment using M.B.A. students as proxies for individual investors, I examine the effects of two important regulatory changes on investors perceptions of audit quality. The first change examined is from a bottom-up coverage-based approach for auditing internal controls to a more top-down risk-based approach. The second change is litigation reform further limiting auditor liability exposure following an alleged audit failure. I find that investors perceive a reduction in audit quality following each of the two regulatory changes. These observed effects are mediated by a perceived focus on efficiency for the new auditing standard and by a perceived change in the auditors economic incentives following the proposed litigation reform. I also find that investors believe the perceived reduction in audit quality will lead management to invest fewer resources in internal controls. Keywords: audit quality; investor perceptions; internal control; auditor liability. Data Availability: Contact the author.

Perceptions of audit quality vary amongst stakeholders depending on their level of direct involvement in audits and on the lens through which they assess audit quality . . . This implies that a broader and deeper understanding of the complexities and nuances of the topic needs to be developed through studying audit quality more holistically. It also implies that individual stakeholders should consider more carefully whether actions they endorse might have detrimental effects on others perspectives of audit quality. Therefore, understanding each others views and how ones actions may impact on others perceptions of audit quality is critical to efforts to enhance audit quality. (International Auditing and Assurance Standards Board [IAASB] 2011)
Jason L. Smith is an Assistant Professor at the University of Nevada, Las Vegas.
I express gratitude to my dissertation committeeWilliam L. Felix, Jr. (chair), Jeffrey Schatzberg, and William S. Wallerfor their guidance and support. I am also grateful to Ken T. Trotman and two anonymous reviewers for their helpful suggestions during the review process. I also appreciate helpful comments by Bill Messier, Kristian Mortenson, Lisa Ordo nez, Lisa Sedor, Chad Simon, Nate Stephens, Rick Warne, David Wood, Arnie Wright, and workshop participants at The University of Arizona, Georgia State University, University of Houston, University of Nevada, Las Vegas, Northeastern University, The University of Texas at Arlington, and Virginia Polytechnic Institute and State University for their valuable comments. I also thank the M.B.A. students who participated in the experiment described in the paper. All errors are my own. Editors note: Accepted by Ken Trotman.

Submitted: November 2010 Accepted: September 2011 Published Online: January 2012

17

18

Smith

INTRODUCTION uditors provide a critical service to the worlds capital markets. Without high-quality audits, managers would face a higher agency cost (Jensen and Meckling 1976), and investors would be less condent in corporate disclosures (Libby 1979; Hodge 2001). Because actual audit quality is an unobservable state, investors perceptions of audit quality become their view of reality and likely affect their judgments and decisions (Smith and Minter 2005; SEC 2001). These perceptions of audit quality are developed, in part, by considering auditors incentives (Lowe and Pany 1995). Regulators and other governance stakeholders have long argued that investors perceptions of auditor independence and audit quality are vitally important and, in some cases, tantamount to reality (e.g., IAASB 2011; SEC 2001; Chenok 1994). As such, policy makers who enact changes affecting auditors incentives should also consider the effects of those changes on investors perceptions of audit quality. In an experiment using 101 Executive and Evening M.B.A. students as proxies for individual investors, I examine the effects of two heavily debated regulatory changes on individual investors perceptions of audit quality. The rst change I examine is from a bottom-up coverage-based standard (i.e., Auditing Standard No. 2) to a top-down risk-based standard (i.e., Auditing Standard No. 5) for conducting the audit of internal control pursuant to Section 404 of the Sarbanes-Oxley Act (SOX; U.S. House of Representative 2002).1 The second change examined is the proposed passage of legal reform that reduces auditors liability exposure following an alleged audit failure. I examine individual investors because they represent an important set of nancial reporting users whose protection and advocacy is charged to oversight bodies like the Securities and Exchange Commission (SEC) and because international regulators have recently called for research to enhance our understanding of various stakeholdersincluding investorsperceptions of audit quality (IAASB 2011).2 I study the effects of the two aforementioned regulatory issues because they both represent signicant changes in the auditing environment that affect auditors incentives and loss function for an integrated audit engagement. The rst regulatory changereplacing Auditing Standard No. 2 (AS2) with Auditing Standard No. 5 (AS5)deals with the audit of internal control, which has been shown in prior research to affect investors perceptions of rm value (Lopez et al. 2009). In this study, I manipulate the regulatory environment in which that audit is performed. Although the change in auditing standards has been enacted since this experiment was conducted, liability reform reducing the auditors liability exposure continues to be discussed and debated in the United States and abroad (U.S. Treasury 2008, C: 46; E.U. Commission 2008). Given the relatively uid nature of legislation and regulation surrounding the auditing environment, an examination of investors reactions to regulatory changes not only provides useful feedback on evolving standards, but it may also provide important evidence for policy makers to consider when developing future regulatory changes. In a 2 3 2 experimental design where each of the two regulatory changes is (not) enacted by policy makers, I nd that both regulatory changes cause signicant reductions in investors perceptions of audit quality. In the case of the change in auditing standards, I nd evidence suggesting that the perceived reduction in audit quality is driven by a perceived focus on efciency in the new standard. The results also suggest the perceived reduction in audit quality following the
1

Although AS2 (PCAOB 2004) does not contain language requiring a bottom-up approach, the PCAOB indicates that auditors approached the audit of internal control from the bottom up in their Report on the Initial Implementation of Auditing Standard No. 2 (PCAOB 2005). To ensure a different approach was taken pursuant to AS5, the PCAOB explicitly prescribes a top-down approach in the replacement standard (PCAOB 2007). According to the Investment Company Institutes 2008 survey, more than 47 percent of U.S. households, representing over 90 million Americans, own individual stocks or shares of mutual funds.

Auditing: A Journal of Practice & Theory February 2012

Investors Perceptions of Audit Quality: Effects of Regulatory Change

19

auditor liability reform is driven by a perceived reduction in the auditors cost of an audit failure. Interestingly, I nd that the perceived reduction in audit quality following both regulatory changes leads investors to expect a reduction in managements investment in internal control. Finally, I nd that investors signicantly reduce their equity investments following the liability reform, but the effect of a change in auditing standards appears to be conditional on investors experience. Specically, investors who purchased individual stocks within the past three years appeared more likely to increase their investment allocation following the change from AS2 to AS5 while individuals who had not purchased individual stocks were more likely to reduce their equity investment allocation. Implications of these ndings are threefold. First, contrary to regulators intent that AS5 would improve efciency without sacricing effectiveness of the audit of internal controls, investors appear to believe the new standard will achieve the improved efciency by sacricing audit quality.3 Second, investors appear to believe that economic incentives to reduce audit quality outweigh auditors reputation concerns following auditor liability reform. Third, individuals are likely to reduce their equity investments if shareholder recourse is further limited by additional liability reform. The remainder of the paper is organized as follows. In the next section, I discuss the regulatory background and prior literature in developing my hypotheses. The third and fourth sections respectively describe the research method and results. The nal section concludes with a summary and discussion of limitations and future research implications. BACKGROUND AND HYPOTHESIS DEVELOPMENT A Change in Auditing Standards Following several years of SOX 404 compliance under AS2, some public registrants and other interested parties (e.g., institutional shareholders) expressed concerns that the costs of compliance with the stringent regulations outweighed the benets of the internal control audit and accompanying auditor opinion. Advocates for change claimed that reforms to ease the burden of SOX 404 would reduce the cost of compliance for public companies and would free up time and resources that could be used by management to add value to the organization (Scannell 2007). Some argued that AS2 caused auditors to spend hours questioning issues that [had] little relevance to nancial statements (Johnson 2007a) and that a new standard would permit auditors to perform more effective and efcient audits by utilizing a top-down risk-based approach to the internal control audit that would primarily focus on high-risk areas (PCAOB 2007). In contrast to those who argued for a new auditing standard, other parties (e.g., investor advocate groups) pointed to the restored investor condence and historic market performance during the three years following the implementation of SOX 404 and AS2 as benets of the regulation (Scannell 2007). Others expressed concern that AS5 represented a [backing]-off of the objectives that [the PCAOB] set with AS2 that could lead to pre-Enron reporting quality (Johnson 2007b). Ultimately, the PCAOB and the Securities and Exchange Commission (SEC) both approved AS5 for integrated audits with year endings of November 15, 2007, or later. AS5 was introduced to repeal [its] unduly expensive and inefcient predecessor: AS2.4 The PCAOB claimed AS5
3

Although I observe a reduction in perceived audit quality following the change from AS2 to AS5, it is important to note that both auditing standards require an independent audit of internal control over nancial reporting. As such, both standards represent signicant efforts to enhance audit quality relative to the pre-SOX environment (i.e., no audit of internal control). Per SEC Chairman Chris Cox, as quoted in Johnson (2006). Also, see PCAOB (2006).

Auditing: A Journal of Practice & Theory February 2012

20

Smith

was designed to both increase the likelihood that material weaknesses in companies internal control will be found before they cause material misstatement of the nancial statements and steer the auditor away from procedures that are not necessary to achieve the intended benets (PCAOB 2007). DeZoort and Lee (1998) provide evidence relevant to the question of investors perceptions following a change in auditing standards. In an experiment examining auditors perceptions of newly passed SAS No. 82 (AICPA 1997), they show that the intent and perceived effect of a new auditing standard may not be the same. Although regulators intent in enacting SAS No. 82 was simply to clarify the auditors responsibility to detect fraud, participants consistently perceived an increase in the auditors responsibility as a result of the new standard.5 Although the PCAOBs intent in passing AS5 was to promote efciency without sacricing effectiveness, the effect of the change on investors perceptions is an empirical question. If individual investors agree with the regulators intent and believe AS2 was unduly expensive and inefcient, then a change to the revised auditing standard should not adversely affect their perceptions of audit quality. Conversely, if individual investors disagree with regulators and prefer the additional testing of the bottom-up coverage-based approach of AS2, then a change to the new standard may result in a perceived reduction in audit quality. Because individual investors generally hold under-diversied portfolios and are subject to more idiosyncratic risk (Goetzman and Kumar 2008; Polkovnichenko 2005), I expect them to be more concerned about audit effectiveness than efciency. Because public discussion of the new standard largely focused on improving audit efciency, I predict that investors perceptions of audit quality will be adversely affected as a result of the change. H1: Investors perceptions of audit quality decrease with the change from AS2 to AS5. Auditor Liability Reform Because the public auditing industry has become increasingly concentrated over the past twenty years and because the industry is crucial to the functioning of the worlds capital markets, the risk of catastrophic damages stemming from an alleged audit failure poses a serious threat that domestic and international regulatorsled by the U.S. Treasury Department, the SEC, the U.S. Chamber of Commerce, and the European Commissionhave taken under serious consideration (e.g., U.S. Treasury 2008; E.U. Commission 2008). Proposals to reduce auditor liability have ranged from contractual (i.e., fee-based) liability caps, client-based (i.e., market value-based) liability caps, statutory liability caps, proportionate liability laws, nancial reporting insurance policies, and securitization of nancial reporting risk through bond issuances. In each case, the objective of the proposed reform is to limit or reduce auditors liability following an alleged audit failure. Although some countries have recently enacted auditor liability reform (e.g., United Kingdom, Germany, Austria), the debate is currently ongoing in the United States and the European Union. While some interested parties (e.g., institutional investors, investor advocate groups) argue that further limiting auditor liability may introduce economic incentives for auditors to accept higher levels of audit risk and to reduce the quality of public audits (Reilly 2006; E.U. Commission 2006, 155), auditors, legislators, and corporations have indicated that the audit rms reputation concerns
5

Although DeZoort and Lee (1998) use auditors for participants, their ndings that users perceptions are not always consistent with regulators intent are pertinent to a setting where investors interpret the effect of a new standard.

Auditing: A Journal of Practice & Theory February 2012

Investors Perceptions of Audit Quality: Effects of Regulatory Change

21

would outweigh any economic incentives introduced by possible litigation reform (E.U. Commission 2006, 154155).6 Schwartz (1997), Dopuch et al. (1994), and Gramling et al. (1998) all provide evidence consistent with auditors exerting less effort and providing lower quality audits in settings where auditor liability is reduced. In addition, Lee and Mande (2003) and Geiger et al. (2006) provide evidence that audit quality may have diminished following the passage of the Private Securities Litigation Reform Act (PSLRA) of 1995. Burton et al. (2009) nd that the size, distribution, and probability of penalties for an audit failure affect auditor effort and audit quality. Each of these studies focuses on a measure of actual audit quality and on auditors judgments and decisions as a result of changes in liability reform. In contrast, my study attempts to expand our knowledge with respect to liability reform by examining its effect on investors perceptions of audit quality and on their related investment allocation decisions. Given that the prior research in this area has not focused on investors perceptions, their reaction to a reduction in auditor liability exposure is an empirical unknown. Although prior ndings suggest that actual audit quality is likely to be reduced following such a reform, individual investors may not expect a reduction if they believe auditors incentives to maintain a strong reputation or to adhere to professional norms are paramount to other economic incentives to reduce audit quality (see Barton 2005; Mayhew 2001; Craswell et al. 1995). Consistent with prior research on actual audit quality following a reduction in auditor liability, I propose the following hypothesis with respect to perceived audit quality. H2: Investors perceptions of audit quality decrease with the passage of litigation reform limiting auditor liability exposure. Implications for Investments in Internal Control A survey of corporate executives in 2004 revealed that 79 percent of respondents reported having stronger internal controls as a result of complying with SOX 404 under the AS2 regime (Oversight Systems 2004). The same report, however, nds that only 13 percent of respondents felt the benets of SOX compliance outweighed the costs of compliance. These resultsalong with experimental ndings by Wu and Tuttle (2011)suggest that the audit of internal controls encourages management to focus time and resources on maintaining controls in order to avoid an adverse or disclaimer opinion. Given the opportunity, however, the survey also suggests that managers might welcome the chance to reduce their investment in internal controls. Consistent with prior research examining the strategic interactions of auditors and managers (Bloomeld 1995, 1997; Zimbelman and Waller 1999; Bowlin 2010), managers may respond to reductions in auditors testing of controls by reducing their investments in maintaining effective internal controls.7 This perceived reduction in testing may result from either a change in auditing standards (i.e., AS2 to AS5) or from a reduction in the cost of an audit failure (i.e., liability reform). Because I assume the auditor and manager are both viewed by investors as economically rational agents attempting to minimize the costs associated with SOX 404 compliance, I predict investors will expect a reduction in managements investment in internal control given changes in either the auditing standard or the auditor liability laws.
6

In their nal report, the U.S. Treasurys Advisory Committee on the Auditing Profession stated: The effect of private litigation on auditing rms has been contentious for decades and it is not surprising that it continued to defy a consensus solution, but the Committees dialogue nonetheless has laid the groundwork for continued and constructive effort in the future (U.S. Treasury Department 2008). Management may choose to reduce investment in controls for nefarious purposes (i.e., to commit fraud) or to divert funds to activities viewed as more likely to add value to the rm.

Auditing: A Journal of Practice & Theory February 2012

22

Smith

H3a: Investors perceive that management will invest less in internal controls with the change in auditing standard. H3b: Investors perceive that management will invest less in internal controls with the passage of litigation reform limiting auditor liability exposure. Implications for Investing Decisions Perceived reductions in audit quality (H1 and H2) and in managements internal control investment (H3) are likely to lead to a perceived increase in uncertainty regarding the reliability of future nancial reporting. As such, I expect investors to allocate fewer resources to equity investments as a result of these regulatory changes and the predicted increase in nancial statement risk. H4a: Investors will allocate fewer resources to equity investments under AS5 than under AS2. H4b: Investors will allocate fewer resources to equity investments under a lower auditor liability setting. EXPERIMENTAL METHOD Design I implement a 2 3 2 between-subjects repeated measures design. A repeated measures design is used to create an environment analogous to a natural setting wherein participants all begin in the same regulatory environment and are then faced with a change (or no change) to one or two regulatory issues. The independent variables I manipulate are the applicable auditing standard (AS2/ AS5 ) and the relevant auditor liability law (higher liability/lower liability).8 Participants The participants in this study are 101 Executive and evening M.B.A. students from a large, public university.9 Participants have an average of 11.57 years of full-time work experience. Most of them have previously invested in mutual funds (85 percent), have purchased individual stocks within the past three years (57.4 percent), and plan to invest in individual stocks within the next two years (71.3 percent). On a post-experimental questionnaire with a scale from 1 (Not at all Familiar) to 9 (Very Familiar), participants self-assessed their familiarity with nancial statements (5.9), investing options (5.33), and Section 404 of the Sarbanes-Oxley Act (3.71). Participants were randomly assigned to one of the four treatment conditions.10 Procedures At the beginning of the experiment, participants were asked to assume the role of an investment advisor charged with investing $5,000 on behalf of an established client.11 The client asked that the
8

10 11

All participants begin in a setting similar to the regulatory environment contemporary to the date of the experiment. After making their assessments and investment decision in the contemporary setting, the participants viewed the independent variable manipulations and were asked to revise their assessments. One hundred sixteen M.B.A. students participated in the experiment. Fifteen participants who failed one or both of the manipulation checks were not included in the analyses. Including these participants does not change any reported inferences. Experimental conditions do not vary signicantly along any of the demographic factors (i.e., p-values . 0.10). Participants were asked to serve as an investment advisor instead of being asked to invest their own money in order to mitigate differences in individual risk preferences due to individual wealth differences. Although random assignment to conditions should theoretically control for these differences, this design choice was used as an additional control to mitigate any potential systematic differences between conditions.

Auditing: A Journal of Practice & Theory February 2012

Investors Perceptions of Audit Quality: Effects of Regulatory Change

23

participant allocate the funds with a 12-month horizon between two investment options: (1) shares of a publicly traded corrugated container manufacturing rm and (2) a 12-month FDIC-insured certicate of deposit account (CD) at a local bank.12 The participant was told that the client would close all positions at the end of one year and would realize any gains or losses at that time. Participants were instructed that their objective was to maximize their clients wealth at the end of the one-year period.13 Participants rst viewed background and nancial information for both investment options. To increase the level of mundane realism in the experimental setting, all information was taken from actual companies web sites and SEC lings; the names of the bank and manufacturing company were both changed to avoid recognition.14 In addition to investment-specic information, all participants also read a section that described a current auditing standard governing audits of internal control (i.e., AS2) and a description of the applicable laws governing auditor litigation exposure. After reviewing the information about the investments and the regulatory environment, participants were asked to provide their assessment of the companys performance, future earnings potential, perceptions of the amount of testing performed by the auditor, three perceived levels of audit quality, the perceived level of management ICFR investment, and the perceived costs of an audit failure. Participants then predicted the stock price in 12 months and made an investment allocation decision to invest the $5,000 between the CD account and the individual stock.15 The three measures of perceived audit quality mentioned above are measures of the respective likelihoods that (1) a material weakness would go undetected by the auditor, (2) an intentional material misstatement would be present in future nancial statements, and (3) an unintentional material misstatement would be present in future nancial statements. DeAngelo (1981) denes audit quality as the likelihood that an auditor will both discover and report a breach in the clients accounting system. Each of these three events represents a failure to identify or report a material breach in the clients system. In the next stage of the experiment, participants viewed an e-mail from their client prior to locking in their investment allocation decision. In the e-mail, the client asked the participant to review two articles that might be relevant to an investment decision; the articles discussed the possible changes to the auditing standard and to the auditor liability laws. The news articles were compilations of actual articles and press releases that appeared on regulator web sites, in the Wall Street Journal and in other popular business news outlets.16 The article discussing AS5 summarized the PCAOBs actual proposed changes (PCAOB 2007), whereas the article discussing litigation
12

13

14

15

16

The CD account is included to provide participants with a productive benchmark alternative investment. This use of two possible investments mitigates the possibility of investing all the money in the stock due to the lack of a reasonable alternative. The annual percentage yield (APY) on the CD represents the national average for 12month CDs during the time the experiment was conducted per BankRate.com. The experimental sessions were conducted in October 2007. The Chicago Board Options Exchange Volatility Index (VIX) averaged $19.11 during the month, with a low of $16.12 and a high of $22.96. The VIX index average from January 1, 2000, to December 31, 2008, was $21.08, with a low of $9.89 and a high of $80.86. Thus, market volatility during the time of the experiment was likely not a signicant factor for participants. The public company had an assets-to-debt ratio of 1.56, a current ratio of 1.79, and a gross prot margin of 20 percent. Net sales showed monotonic growth over a three-year period. Five-year stock performance data were provided and showed a non-monotonic price increase of 22.37 percent (from $19.94 to $24.40). The current P/E ratio was 81.33. Participants were permitted to allocate their investments between the two investment options in any manner they chose. The mean investments in the stock and CD were $1,785.50 and $3,214.50, respectively. Thirteen percent of participants chose to invest all $5,000 in the stock, and 32 percent of participants chose to invest all of their money in the CD. The decision to invest all or none of the money in the stock is not signicantly associated with either of the independent variable manipulations (p-values . 0.10). News outlets included: WSJ.com, BusinessWeek.com, ComplianceWeek.com, and CFO.com.

Auditing: A Journal of Practice & Theory February 2012

24

Smith

reform presented a hypothetical change in the legal environment that reduces auditor liability exposure.17 To provide assurance that the compilation articles provided unbiased information in a clear manner representative of what might be found in a popular news publication, 47 Masters of Accountancy students enrolled in advanced auditing courses at two large U.S. universities previewed the auditing standard and auditor liability compilation articles. Masters of Accountancy students were specically chosen to preview the articles because of their exposure to and understanding of the details of the existing and impending auditing standard, their understanding of auditor litigation issues, and their relative freedom from bias compared to other potential reviewers (e.g., audit partners, regulators). These students rated the articles in terms of clarity, freedom from journalistic bias, length, and likelihood of appearing in a popular business publication. Reviewers also indicated their level of exposure to and knowledge of the topics discussed in the articles. As shown in Table 1, the reviewers were knowledgeable about the regulatory changes, and they indicated that the articles were clearly written, free from journalistic bias, and were generally representative of articles commonly found in popular business news publications. After participants in the experiment read the news articles discussing the two possible changes, they viewed two short press releases announcing that each of the two changes discussed in the articles had (or had not) been approved and implemented. In the section following the news articles, participants were asked to revisit their preliminary judgments, stock price prediction, and investment allocation decision. They were asked to answer the same questions while considering the information provided in the news articles. After making these revised judgments, the participants completed a post-experimental questionnaire that included independent variable manipulation checks and appropriate demographic questions.18 RESULTS Descriptive Statistics Because this study focuses on the effects of regulatory changes on investors perceptions, I use the changes between pre- and post-manipulation measures as my dependent variables. Descriptive statisticsincluding pre- and post-manipulation valuesand correlations of the change variables are shown in Panel A and Panel B of Table 2, respectively.19 Tests of H1 and H2: Perceptions of Audit Quality My rst two hypotheses predict that investors will perceive a reduction in audit quality with each of the two regulatory changes included in this study. Each participant provided a judgment of the likelihoods of three undesirable events: (1) the likelihood of a material weakness going undetected by the auditor, (2) the likelihood of an intentional material misstatement (i.e., fraud) being present in future nancial statements, and (3) the likelihood of an unintentional material misstatement (i.e., error) being present in future nancial statements. Participants were asked to
17

18

19

The auditor liability manipulation introduces an abstract representation of legal reform that would limit the auditors liability exposure by removing the possibility of punitive damages. Although the manipulation is an abstraction, it was designed to be easily understood and to have the same directional effect as the actual reform alternatives being considered in practice. The two manipulation checks presented in the post-experimental questionnaire asked participants whether the proposed auditing standard and proposed liability reform law were accepted and implemented. Fifteen participants failed one or both of the manipulation checks and were dropped from the analysis. Including their responses does not change any reported inferences. Results from alternative analyses using the post-manipulation measure as the dependent variable and the premanipulation measure as a covariate are qualitatively the same for all reported hypothesis tests (i.e., no inferences change due to variations in statistical signicance).

Auditing: A Journal of Practice & Theory February 2012

TABLE 1 Characteristics of Compilation News Articles

Descriptive Statistics (Mean, (Standard Deviation), n Sample Size)

Length of Article Tone of Article Likely to Appear in WSJ . . . Familiarity with Subject Matter

Clarity of Writing

Auditing: A Journal of Practice & Theory February 2012

1 Too Short 3 About Right 5 Too Long 3.13 (0.341) n 16 3.00 (0.000) n 15 1 Negative Bias 3 No Bias 5 Positive Bias 2.88 (0.680) n 24 3.27 (0.703) n 22 1 Very Unlikely 3 Equally Likely/Unlikely 5 Very Likely 3.06 (1.237) n 16 3.47 (0.916) n 15 1 Not at all Familiar 3 Somewhat Familiar 5 Very Familiar 4.25 (0.856) n 16 4.60 (0.507) n 15

Article Discussing Auditing Standard

Investors Perceptions of Audit Quality: Effects of Regulatory Change

Article Discussing Auditor Liability Law

1 Very Unclear 3 Not Labeled 5 Very Clear 4.31 (0.704) n 16 4.20 (1.373) n 15

The table provides descriptive statistics for independent reviewers perceptions of the two compilation articles summarizing publicly available information about proposed changes in auditing standards and auditor liability settings. Forty-two Masters of Accountancy students from two large U.S. universities previewed the news articles used to introduce the independent variable manipulations in the experimental case. At one university, students were only asked to rate the tone of the articles to determine the articles freedom from bias. At the other university, students were asked to answer all ve questions concerning the two articles. Four students at the rst university viewed both articles. The remaining 38 students viewed one of the articles. The articles tone measures whether or not the article presents information regarding the proposed change in a balanced and unbiased manner. The question posed to those asked to rate the tone is as follows: Please indicate below the degree of bias with regards to the proposed change, if any, present in the article. Respondents indicated their response on a Likert scale where 1 indicated Negative Bias and 5 indicated Positive Bias; the mid-point (3) was set as No Bias. A t-test around the No Bias response for the article introducing the auditing standard (t-stat 0.9010, p-value 0.3769) provides evidence that the information is free from perceived bias. A similar t-test for the article discussing the auditor liability law (t-stat 1.8209, p-value 0.0829) is not signicant at the 0.05 level, but is signicant at the 0.10 level. The direction, however, suggests a positive bias, which biases against nding predicted results.

25

26

TABLE 2 Descriptive Statistics and Correlations

Panel A: Descriptive StatisticsMean (Std. Dev.)

Auditing Standard Existing Standard (i.e., AS2) Post-Manipulation 27 27 27 27 27 27 Change n Pre-Manipulation Proposed Standard (i.e., AS5) Post-Manipulation Change

Auditor Liability

Pre-Manipulation

Existing Law (Liability Reform) Amount of Testing 27

Likelihood of MW

27

Likelihood of Fraud

27

Likelihood of Error

27

ICFR Investment

27

Amount Invested in Stock

24

5.037 (1.721) 5.000 (2.000) 4.333 (1.776) 5.148 (1.657) 6.480 (1.477) 1552.08 (1618.47) 26 26 26 26 26 25

5.670 (1.144) 4.300 (1.540) 4.190 (1.594) 4.850 (1.610) 5.810 (1.241) 1787.04 (1816.99)

0.630 (1.245 ) 0.704 (1.857) 0.148 (1.231) 0.296 (1.514) 0.667 (1.664) 250.00 (1063.22) 5.185 (1.360) 4.480 (2.064) 4.074 (1.616) 4.889 (1.502) 6.300 (1.325) 1638.89 (1599.78)

4.220 (1.476) 5.590 (1.927) 4.780 (2.154) 4.780 (1.948) 4.630 (1.713) 1925.93 (1737.34)

0.963 (1.427) 1.111 (3.178) 0.704 (1.996) 0.111 (2.207) 1.667 (1.797) 287.04 (1001.69)

Proposed Law (Liability Reform) Amount of Testing 21

Likelihood of MW

21

Likelihood of Fraud

20

Likelihood of Error

20

ICFR Investment

21

Auditing: A Journal of Practice & Theory February 2012

4.640 (1.131) 4.880 (1.564) 4.790 (1.779) 4.980 (1.289) 4.400 (0.800) 1809.52 (1661.90) 0.476 (1.289) 0.095 (1.513) 0.100 (1.294) 0.350 (1.040) 1.857 (1.315) 361.11 (1257.98)

Amount Invested in Stock

18

5.119 (0.999) 4.790 (1.554) 4.600 (1.536) 4.500 (0.827) 6.260 (1.114) 1888.89 (1753.61)

5.423 (1.102) 4.620 (1.768) 4.173 (1.679) 4.808 (1.625) 6.400 (1.342) 1492.00 (1628.37)

4.040 (1.435) 5.600 (1.613) 5.480 (1.446) 5.870 (1.480) 4.250 (1.478) 1612.00 (1741.96)

1.385 (1.423) 0.981 (1.770) 1.308 (1.970) 1.058 (2.001) 2.154 (1.719) 120.00 (1218.61) (continued on next page)

Smith

TABLE 2 (continued)

Panel B: Spearman and Pearson (above/below the diagonal, respectively)

1 0.480 0.346 0.395 0.283 0.142 0.398 0.349 0.040 0.263 0.162 0.085 0.270 0.259 0.326 0.236 0.289 0.353 0.388 0.366 0.373 2 3 4 5 6 0.183 0.060 0.064 0.209 0.019

Variable

DAmount of Testing DLikelihood of MW DLikelihood of Fraud DLikelihood of Error DICFR Investment DAmount Invested in Stock

0.485 0.306 0.430 0.269 0.108

Auditing: A Journal of Practice & Theory February 2012

Italicized data are signicant at the 0.05 level (two-tailed p-values). Bolded data are signicant at the 0.01 level (two-tailed p-values).

Investors Perceptions of Audit Quality: Effects of Regulatory Change 27

Variable Denitions: Amount of Testing amount of testing to be performed by the auditor in conducting audit of internal controls (1 Too Little Testing; 5 Optimal Amount; 9 Too Much Testing); Likelihood of MW likelihood that a material weakness will go undetected by the auditor (1 Very Unlikely; 5 Equally Likely and Unlikely; 9 Very Likely); Likelihood of Fraud likelihood that an intentional misstatement (i.e., fraud) will be present in future nancial statements (1 Very Unlikely; 5 Equally Likely and Unlikely; 9 Very Likely); Likelihood of Error likelihood that an unintentional misstatement (i.e., error) will be present in future nancial statements (1 Very Unlikely; 5 Equally Likely and Unlikely; 9 Very Likely); ICFR Investment managements investment in internal controls over nancial reporting (1 Less Investment; 5 No Effect; 9 More Investment); and Amount Invested in Stock amount of money to be invested in companys stock price (money not invested in the stock price is invested in a 12-month certicate of deposit).

28

Smith

provide these judgments both before and after viewing the independent variable manipulations. Because the likelihood assessments were for three undesirable outcomes, I take the additive inverse (i.e., x) of the difference between the before and after measures (which measure the likelihood of an audit failure) as three individual measures of audit quality. Because these three measures relate to the same theoretical construct, I perform a common factor analysis and nd that all three measures load on a single factor. I extract the common factor using principal component analysis. The factor has an Eigenvalue of 1.76, and the three variables have factor loadings of 0.75, 0.76, and 0.79, respectively. The Cronbach alpha score for internal reliability of the three measures is 0.64.20 I use this extracted factorthe Change in Perceived Audit Qualityas the dependent variable when testing H1 and H2. To test these rst two hypotheses, I conduct an ANOVA with the audit quality factor as the dependent variable. Table 3 provides descriptive statistics and ANOVA results. Both the change in auditing standard (F 10.638; p 0.001, one-tailed) and the change in auditor liability exposure (F 3.963; p 0.025, one-tailed) signicantly reduce investors perceptions of audit quality.21 These results provide strong support for both H1 and H2. In addition to providing likelihood assessments for each of the three dependent variables mentioned above, participants also provided judgments of the amount of testing performed by the auditor prior to and following the independent variable manipulations. On a nine-point Likert scale where 1 equals Too Little Testing, 5 equals Optimal Amount, and 9 equals Too Much Testing, participants judged auditor testing to be near optimal (5.193, p 0.148, two-tailed) prior to the independent variable manipulations. As shown in Table 4, ANOVA results show that both the change from AS2 to AS5 (F 21.386; p , 0.001, one-tailed) and the liability reform (F 7.977; p 0.003, one-tailed) negatively affected participants perceptions of the amount of testing being performed. The post-manipulation mean assessment values for participants who were in the auditing standard change conditions (4.132, p , 0.001, two-tailed) and the auditor liability reform conditions (4.309, p , 0.001, two-tailed) were both signicantly lower than the Optimal Amount mid-point on the scale. These results provide additional support for H1 and H2 and suggest that, although the PCAOB intended for AS5 to improve efciency without sacricing effectiveness, investors perceive that the reduction in testing is one from an optimal amount to one that involves too little testing. Test of H3: Perceptions of Investment in Internal Control H3 predicts that investors will perceive a reduction by management in its investment in internal control as a result of the regulatory changes. Panel A of Table 5 presents descriptive statistics and the mean comparisons for investors perceptions of investment in internal control. Panel B of Table 5 presents results of an ANOVA using the change in investors perceptions of managements investment in internal control as the dependent variable. Consistent with H3a and H3b, I nd that both the change in auditing standard (F 3.851; p 0.027, one-tailed) and the reduction in auditor liability exposure (F 6.446; p 0.007, one-tailed) cause investors to believe management will reduce future investment in internal control.
20

21

Although the Cronbach alpha score of 0.64 is slightly below conventional levels (a . 0.70), the measure inherently underestimates the reliability of factors when few measures are used (Novick and Lewis 1967). In this case, only three variables are used in the factor analysis. ANOVA, using the average of the three audit quality measures in place of the audit quality factor, yields onetailed p-values of , 0.001 and 0.032 for the auditing standard and liability variables, respectively. MANOVA with each of the three change variables yields one-tailed p-values for the auditing standard and liability of 0.002 and 0.048, respectively.

Auditing: A Journal of Practice & Theory February 2012

Investors Perceptions of Audit Quality: Effects of Regulatory Change

29

TABLE 3 Change in Perception of Audit Quality (H1 and H2) Panel A: Descriptive Statistics (Mean, (Standard Deviation), n Sample Size)
Existing Standard (i.e., AS2) Existing Law (No Liability Reform) 0.488 (0.767) n 27 0.140 (0.505) n 20 0.340 (0.684) n 47 Proposed Standard (i.e., AS5) 0.101 (1.238) n 27 0.509 (1.004) n 26 0.301 (1.137) n 53 Totals 0.193 (1.062) n 54 0.227 (0.879) n 46 n 100

Proposed Law (Liability Reform)

Totals

Panel B: ANOVA Results

Variable Auditing Standard (AS) Auditor Liability (AL) AS AL Degree of Freedom 1 1 1 F-statistic 10.638 3.963 0.022 p-valuea 0.001 0.025 0.438

a All reported p-values are one-tailed. The Perceived Audit Quality measure results from a factor analysis of the three dependent variables dened below, which load on a single factor with an Eigenvalue of 1.76 and a Cronbach alpha score of 0.64. The factor loading score for each variable is included after its name. Panel A provides descriptive statistics, by experimental condition, for the Perceived Audit Quality measure. Panel B provides ANOVA results examining the effects of changes in the auditing standards and auditor liability settings on a factor representing participants perceptions of audit quality. Results indicate a perceived reduction in audit quality following both the change in auditing standards and the change in auditor liability.

Variable Denitions: Likelihood of MW (0.754) likelihood that a material weakness will go undetected by the auditor (1 Very Unlikely; 5 Equally Likely and Unlikely; 9 Very Likely); Likelihood of Fraud (0.756) likelihood that an intentional misstatement (i.e., fraud) will be present in future nancial statements (1 Very Unlikely; 5 Equally Likely and Unlikely; 9 Very Likely); and Likelihood of Error (0.788) likelihood that an unintentional misstatement (i.e., error) will be present in future nancial statements (1 Very Unlikely; 5 Equally Likely and Unlikely; 9 Very Likely).

Test of H4: Investment Allocation Decisions My nal hypothesis predicts that investors will adjust their investment allocations away from the public company as a result of the regulatory changes. I expect this behavior because of my predictions of reductions in perceived audit quality (H1 and H2) and perceived management investment in internal control (H3) and the increased uncertainty that would accompany such perceptions. Panel A of Table 6 includes descriptive statistics for H4 data. Panel B of Table 6 displays ANOVA results using the change in participants equity investment allocations as the dependent variable. ANOVA results indicate that investors do not signicantly change their equity allocations following the change in auditing standard (F 1.210; p 0.137, one-tailed), but they do reduce their equity investment allocations following the auditor liability reform (F 2.728; p 0.051, one-tailed). Thus, H4b is supported while H4a is not.
Auditing: A Journal of Practice & Theory February 2012

30

Smith

TABLE 4 Change in Perceived Amount of Auditor Testing (H1 and H2) Panel A: Descriptive Statistics (Mean, (Standard Deviation), n Sample Size)
Existing Standard (i.e., AS2) Existing Law (No Liability Reform) 0.630 (1.245) n 27 0.476 (1.289) n 21 0.146 (1.368) n 48 Proposed Standard (i.e., AS5) 0.963 (1.427) n 27 1.385 (1.423) n 26 1.170 (1.428) n 53 Totals 0.167 (1.551) n 54 0.979 (1.426) n 47 n 101

Proposed Law (Liability Reform)

Totals

Panel B: ANOVA Results

Variable Auditing Standard (AS) Auditor Liability (AL) AS AL Degree of Freedom 1 1 1 F-statistic 21.386 7.977 1.600 p-valuea , 0.001 0.003 0.105

a All reported p-values are one-tailed. The Change in Perceived Amount of Auditor Testing variable represents a change between the pre- and postmanipulation responses to a question asking participants to judge the amount of testing to be performed by the auditor when conducting audits of internal controls (1 Too Little Testing; 5 Optimal Amount; 9 Too Much Testing). See Table 2 for descriptive statistics. The overall mean assessment for the amount of testing (5.193) was not signicantly different from the mid-point of Optimal Amount prior to the independent variable manipulation. The post-manipulation mean assessment scores for participants in both the change in auditing standards conditions (4.132) and the change in auditor liability conditions (4.309) were signicantly lower than the scales mid-point (two-tailed p-values 0.0001, 0.0009). Panel A provides the descriptive statistics, by experimental condition, of participants perceptions of the change in auditor testing following the independent variable manipulations. Panel B provides ANOVA results examining the effects of changes in the auditing standards and the auditor liability settings on participants perceptions of the amount of auditor testing for audits of internal controls over nancial reporting (ICFR). Results indicate a perceived reduction in auditor testing following both the change in auditing standards and the change in auditor liability.

Panel C of Table 6 displays results of an ANOVA where an indicator variable denoting whether or not participants had purchased individual stocks within the past three years is included as an additional xed factor. This result is displayed because it is the only analysis where the inclusion of a demographic variable yielded signicant results. Of interest is the signicant interaction (F 9.738, p 0.002, one-tailed) observed between the change in auditing standard and investing experience.22 While more experienced investors increased the amount of money invested in the stock following the change from AS2 to AS5, less experienced investors reduced their investment allocation. Although I
22

This particular interaction is the only observed interaction that is statistically signicant (i.e., p-value , 0.10) when examining the various control variables as possible covariates or xed factors in the various reported tests. Neither an indicator variable asking if individuals planned on purchasing individual stocks within the next two years nor a nine-point Likert scale question indicating a level of familiarity with investing options yielded similar results.

Auditing: A Journal of Practice & Theory February 2012

Investors Perceptions of Audit Quality: Effects of Regulatory Change

31

TABLE 5 Change in Perceived ICFR Investment (H3) Panel A: Descriptive Statistics (Mean, (Standard Deviation), n Sample Size)
Existing Standard (i.e., AS2) Existing Law (No Liability Reform) 0.667 (1.664) n 27 1.857 (1.315) n 21 1.188 (1.620) n 48 Proposed Standard (i.e., AS5) 1.667 (1.797) n 27 2.154 (1.719) n 26 1.910 (1.760) n 53 Totals 1.167 (1.788) n 54 2.021 (1.543) n 47 n 101

Proposed Law (Liability Reform)

Totals

Panel B: ANOVA Results

Variable Auditing Standard (AS) Auditor Liability (AL) AS AL Degree of Freedom 1 1 1 F-statistic 3.851 6.446 1.133 p-valuea 0.027 0.007 0.145

a All reported p-values are one-tailed. The Change in Perceived ICFR Investment variable represents a change between the pre- and post-manipulation responses to a question asking participants to judge the current regulatory settings effect on the companys investment in internal controls (1 Less Investment, 5 No Effect, 9 More Investment). See Table 2 for descriptive statistics. Panel A provides descriptive statistics, by experimental condition, of participants perceptions of managements change in internal control investments following the independent variable manipulations. Panel B provides ANOVA results examining the effects of changes in the auditing standards and auditor liability settings on participants perceptions of the managements investment in internal controls over nancial reporting (ICFR). Results indicate a perceived reduction in ICFR investment following both the change in auditing standards and the change in auditor liability.

am unable to determine empirically the cause for this divergence in behavior, it is possible that the difference is due to experienced investors being more diversied, less risk averse, and more aware of base rates for material misstatements than their less experienced counterparts. Mediation Analysis Given the ANOVA results providing support of H1, H2, H3a, H3b, and H4b, I conduct a series of mediation analyses consistent with Baron and Kenny (1986) to better understand the mechanisms by which the manipulated independent variables impact the dependent variables. To perform this mediation analysis, I estimate three regression models as dened below: MEDIATORi b0 b1 IND: VARIABLEi : DEP: VARIABLEi b0 b1 IND: VARIABLEi : DEP: VARIABLEi b0 b1 IND: VARIABLEi b2 MEDIATOR VARIABLEi :
Auditing: A Journal of Practice & Theory February 2012

1 2 3

32

Smith

TABLE 6 Change in Equity Investment Allocation (H4) Panel A: Descriptive Statistics (Mean, (Standard Deviation), n Sample Size)
Existing Standard (i.e., AS2) Existing Law (Higher Liability) 250.00 (1063.22) n 24 361.11 (1257.98) n 18 11.905 (1176.436) n 42 Proposed Standard (i.e., AS5) 287.04 (1001.69) n 27 120.00 (1218.61) n 25 206.731 (1103.383) n 52 Totals 269.608 (1020.837) n 51 81.395 (1243.700) n 43 n 94

Proposed Law (Lower Liability)

Totals

Panel B: ANOVA Results

Variable Auditing Standard (AS) Auditor Liability (AL) AS AL Degree of Freedom 1 1 1 F-statistic 1.210 2.730 0.888 p-valuea 0.274 0.102 0.348

Panel C: Post hoc ANOVA Results with Investing Experience

Variable Auditing Standard (AS) Auditor Liability (AL) Investing Experience (IE ) AS AL AS IE AL IE AS AL IE Degree of Freedom 1 1 1 1 1 1 1 F-statistic 0.593 3.168 0.049 1.277 9.738 0.297 0.465 p-valuea 0.443 0.079 0.825 0.262 0.002 0.587 0.497

a All reported p-values are two-tailed. Panel A provides descriptive statistics, by experimental condition, for participants change in equity investment allocations following the independent variable manipulations. Panel B provides ANOVA results examining the effects of changes in the auditing standards and auditor liability settings on participants equity investment allocations. Results indicate no signicant reduction in investment following the change in auditing standards and a marginal reduction following the change in auditor liability. Panel C provides ANOVA results of post hoc analysis where investing experience is included as an additional xed factor. Fifty-four of 94 participants providing equity investment allocation data indicated they had purchased individual stocks within the past three years (Investing Experience 1). Results indicate a signicant interaction effect between investing experience and the change in auditing standards. Experienced participants increased their equity investment allocations following a change in the standard while less experienced participants reduced their investment.

Mediation exists if each of the following conditions is met: (A) the coefcient on IND. VARIABLE in Equation (1) is signicant, (B) the coefcient on IND. VARIABLE in Equation (2) is signicant, and (C) the coefcient on MEDIATOR VARIABLE is signicant in Equation (3). Full mediation exists if these three conditions are met and if (C 0 ) the coefcient on the IND. VARIABLE in
Auditing: A Journal of Practice & Theory February 2012

Investors Perceptions of Audit Quality: Effects of Regulatory Change

33

Equation (3) is insignicant. Full mediation indicates that a single mediating variable is the cause of the observed effect of the independent variable on the dependent variable. Partial mediation, which is more likely, indicates that the mediating variable is one of multiple possible mediators that are driving the observed effect. As discussed in the development of H1, I proposed that the perceived reduction in audit quality would be driven by a perceived reduction in auditor testing of controls. Although results in Table 4 already provide some evidence to this effect, mediation analysis provides a more precise estimate of the impact of the mediator variable on the observed relationship. As shown in Panel A of Figure 1, the relationship between the auditing standard and perceived audit quality is fully mediated by the perceived change in internal control testing. This suggests that investors perceptions of audit quality are primarily being determined by the reduction of internal control testing as perceived by the change from AS2 to AS5. The Sobel (1982) test statistic for the mediated relationship (Baron and Kenny 1986, 1177) is signicant (Z 3.45, p , 0.001, one-tailed).23 When developing H2, I predicted that a perceived reduction in the auditors cost of an audit failure (i.e., economic incentive) would cause investors to perceive a reduction in audit quality following the passage of liability reform. As shown in Panel B of Figure 1, the observed reduction in perceived audit quality following the passage of the auditor liability reform appears to be fully mediated by the perceived change in the cost of an audit failure (Z 1.58, p 0.057, one-tailed). In H3a and H3b, I predicted that the perceived reduction in audit quality would lead investors to expect management to reduce their investment in internal control. Panel C of Figure 1 displays the results of a pair of tests examining this proposed mediation. The perceived change in audit quality effectively mediates the relationship between each of the two independent variables and investors perceptions of management investment in internal controls. This relationship is fully mediated for the auditing standard, but not for the auditor liability law. Both mediating effects are statistically signicant (p , 0.05, one-tailed). My nal pair of hypotheses predicts that investors will reduce their equity investment allocation as a result of the perceived reduction in audit quality (H1 and H2) and the perceived reduction in internal control investment (H3a and H3b). ANOVA results provide support for H4b a reduction in equity investment allocation following the auditor liability reformbut only partial support for H4a. Panel D displays results of a pair of tests examining the effects of both proposed mediating variables on the observed relationship. The results are not consistent with a mediating effect of either the change in perceived audit quality (Z 0.353, p 0.721, two-tailed) or the change in perceived internal control investment (Z 1.066, p 0.287, two-tailed). In summary, the results of the mediation analysis provide several interesting insights. First, more evidence is presented suggesting that investors perceptions of reduced audit quality following the change from AS2 to AS5 are driven by a perceived reduction in testing. Second, investors perceptions of reduced audit quality following liability reform appear to be driven by the expected reduction in the cost of an audit failure, which suggests that investors believe auditors respond more to economic incentives than to reputation concerns or professional norms. Third, mediation results suggest that the perceived reduction in audit quality observed in H1 and H2 is the driving mechanism behind investors expectations that management would reduce investment in internal control as a result of the regulatory changes. Finally, the inability to identify a signicant mediating variable for H4a and H4b suggests that the ultimate investment allocation decision is complex and that it may not be driven by perceived changes in audit quality or internal control investment.
23

The Sobel (1982) test statistic is an additional measure to determine whether an observed mediating effect is statistically signicant. Readers are referred to Sobel (1982) and Baron and Kenny (1986) for more information.

Auditing: A Journal of Practice & Theory February 2012

34

Smith

FIGURE 1 Tests for Mediation Testsa Panel A: Test of H1

Z-test statistic: 3.45 (p , 0.001)

Panel B: Test of H2

Z-test statistic: 1.58 (p 0.057)

Panel C: Tests of H3a and H3b

Z-test statistic (1): 2.43 (p 0.008) Z-test statistic (2): 1.85 (p 0.032) (continued on next page)

Auditing: A Journal of Practice & Theory February 2012

Investors Perceptions of Audit Quality: Effects of Regulatory Change

35

FIGURE 1 (continued) Panel D: Test of H4a and H4b

Z-test statistic (1): 0.353 (p 0.362) Z-test statistic (2): 1.066 (p 0.144) Reported p-values are one-tailed. a See Baron and Kenny (1986) for more information on tests for mediation effects.

CONCLUSIONS, LIMITATIONS, AND FUTURE RESEARCH Audit quality is a critical factor in fostering the combination of transparency and trust that enables nancial markets to function properly (U.S. Treasury 2008, II:1). Given that actual audit quality is difcult to observeparticularly for outside investorsregulators have emphasized that research expanding our understanding of how ones actions may impact on others perceptions of audit quality is critical to efforts to enhance audit quality (IAASB 2011). In this study, I examine the effects of two important regulatory changes on individual investors perceptions of audit quality. Although the PCAOBs intent in replacing AS2 with AS5 was to improve audit efciency without undermining audit quality, results from this study provide evidence that investors perceptions of audit quality and of management investment in internal controls are both negatively affected by the change. This negative impact on investors perceptions of audit quality is derived from investors perceptions that reductions in internal control testing will sacrice effectiveness in order to gain efciency. Interestingly, it is possible that the effects of this change in perceived audit quality may affect experienced and inexperienced investors differently as it relates to investment allocation decisions. The results from this study should also be of interest to regulators and legislators around the world who continue to debate the potential costs and benets of auditor liability reform. Although auditors have an empirically documented incentive to maintain reputations by maintaining high-quality audits, ndings from this study suggest that auditor liability reform causes investors to perceive a reduction in audit quality as a result of a perceived reduction in the auditors cost of an audit failure. Additionally, investors expect management to reduce investment in internal control as a result of liability reform, and investors equity investment allocations may be reduced as a result of liability reform that appears to reduce the auditors cost of an audit failure. This study contributes to the literature and responds to calls from regulators by being the rst to examine individual investors perceptions of changes in audit quality that result from regulatory changes in the auditing environment. Although the results provide consistent evidence of perceived
Auditing: A Journal of Practice & Theory February 2012

36

Smith

reduction in audit quality, readers are cautioned to consider the results of this study in relation to the benets of the discussed regulatory changes. Consistent with admonitions from the IAASB (2011) and ndings from DeZoort and Lee (1998), the ndings from this study suggest that regulators should explicitly consider both the intended and perceived effects of proposed regulatory changes on investors perceptions of audit quality. The results of this study are subject to several limitations. First, the experiment employed a repeated measures design. Although the clarity and neutrality of the materials presented to participants were conrmed through statistical tests, a repeated measures design may increase the possibility of demand effects. Second, although all of the information in the experimental instrument is available to individual investors, it is possible that the average individual investor would be less informed about internal control standards or liability laws than those who participated in the study. As such, the observed reduction in perceived audit quality may not generalize to less-informed investors. Third, the investors in this study were asked to assume the role of an investment advisor, were subject to a one-year investment horizon, and were only presented with two investment choices. Although these factors are held constant across all participants, their investment decisions may not reect the same motives and incentives of investors with more alternatives and different investment horizons. Future research might further examine the effects of regulatory change on investors decisions when more investment alternatives are available and when longer- and shorter-term horizons are implicit. Fourth, the experimental instrument focused on the extent of testing between AS2 and AS5, but perceptions of changes in the nature of testing and the types of controls to be tested were not addressed. Future research may be needed to understand more fully the effects of regulatory changes that affect the nature, extent, and target of control testing. Fifth, I observe diverging investment allocation decisions from more and less experienced investors following the change from AS2 to AS5, but the current study is unable to determine the cause of this behavior. Future researchers may wish to examine how regulatory changes affect investors of varied experience levels. Sixth, the litigation reform presented in this experiment was an abstract representation of one possible reform aimed at reducing auditor liability exposure. Researchers may wish to examine the relative effects of various alternatives to this and other proposed methods of litigation reform. Finally, this study examines two regulatory changes and their effects on investors perceptions of audit quality. Consistent with the IAASBs (2011) call for more research in this area, more studies are needed to improve our understanding of various stakeholders perceptions as a determinant of overall audit quality.

REFERENCES
American Institute of Certied Public Accountants (AICPA). 1997. Consideration of Fraud in a Financial Statement Audit. Statement on Auditing Standards No. 82. New York, NY: AICPA. Baron, R. M., and D. A. Kenny. 1986. The moderator-mediator variable distinction in social psychological research: Conceptual, strategic and statistical considerations. Journal of Personality and Social Psychology 51: 11731182. Barton, J. 2005. Who cares about auditor reputation? Contemporary Accounting Research 22 (3): 549586. Bloomeld, R. 1995. Strategic dependence and inherent risk assessments. The Accounting Review 70 (1): 7190. Bloomeld, R. 1997. Strategic dependence and the assessment of fraud risk: A laboratory study. The Accounting Review 72 (4): 517538. Bowlin, K. 2010. Can Strategic Reasoning Prompts Improve Auditors Sensitivity to the Strategic Risk of Fraud? Working paper, University of Mississippi. Burton, F. G., T. J. Wilks, and M. F. Zimbelman. 2009. Audit Penalty Regimes and Audit Effort to Detect Fraud. Working paper, Brigham Young University. Auditing: A Journal of Practice & Theory February 2012

Investors Perceptions of Audit Quality: Effects of Regulatory Change

37

Chenok, P. B. 1994. Perception vs. reality. Journal of Accountancy 177 (1): 4751. Craswell, A. T., J. R. Francis, and S. L. Taylor. 1995. Auditor brand name reputations and industry specializations. Journal of Accounting and Economics 20 (3): 297322. DeAngelo, L. E. 1981. Auditor size and audit quality. Journal of Accounting and Economic 3 (3): 183199. DeZoort, F. T., and T. A. Lee. 1998. The impact of SAS No. 82 on perceptions of external auditor responsibility for fraud detection. International Journal of Auditing 2 (1): 167182. Dopuch, N., R. R. King, and J. W. Schatzberg. 1994. An experimental investigation of alternative damagesharing liability regimes with an auditing perspective. Journal of Accounting Research 32 (Supplement):103130. European Commission (E.U. Commission). 2006. Study on the Economic Impact of Auditors Liability Regimes. London, U.K.: London Economics. European Commission (E.U. Commission). 2008. Commission recommendation concerning the limitation of the civil liability of statutory auditors and audit rms. Ofcial Journal of the European Union 21 (6). Geiger, M. A., K. Raghunandan, and D. V. Rama. 2006. Auditor decision-making in different litigation environments: The private securities litigation reform act, audit report and audit rm size. Journal of Accounting and Public Policy 25 (3): 332253. Goetzman, W. N., and A. Kumar. 2008. Equity portfolio diversication. Review of Finance 12: 433463. Gramling, A. A., J. W. Schatzberg, A. D. Bailey, Jr., and H. Zhang. 1998. The impact of legal liability regimes and differential client risk on client acceptance, audit pricing, and audit effort decisions. Journal of Accounting, Auditing, and Finance 13 (Fall): 437460. Hodge, F. 2001. Hyperlinking unaudited information to audited nancial statements: Effects on investor judgments. The Accounting Review 76 (4): 675691. International Auditing and Assurance Standards Board (IAASB). 2011. Enhancing Audit Quality: An IAASB Perspective. New York, NY. Available at: http://www.IASB.org Investment Company Institute (ICI) and Securities Industry and Financial Markets Association (SIFMA). 2008. Equity and Bond Ownership in America, 2008. Washington, D.C.: ICI and SIFMA. Jensen, M. C., and W. H. Meckling. 1976. Theory of the rm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 3 (4): 305360. Johnson, S. 2006. PCAOB proposes AS2 repeal. CFO.com (December 19). Available at: http://www.cfo. com/article.cfm/8465177 Johnson, S. 2007a. AS5: Clarication or confusion? CFO.com (January 12). Available at: http://www.cfo. com/article.cfm/8512083 Johnson, S. 2007b. AS5: More exible, less effective? CFO.com (February 23). Available at: http://www. cfo.com/article.cfm/8756854 Lee, H. Y., and V. Mande. 2003. The effect of the Private Securities Litigation Reform Act of 1995 on accounting discretion of client managers of Big 6 and non-Big 6 auditors. Auditing: A Journal of Practice & Theory 22 (1): 93108. Libby, R. 1979. The impact of uncertainty reporting on the loan decision. Journal of Accounting Research 17: 3557. Lopez, T. J., S. D. Vandervelde, and Y. Wu. 2009. Investor perceptions of an auditors adverse internal control opinion. Journal of Accounting and Public Policy 28 (1): 231250. Lowe, D. J., and K. Pany. 1995. CPA performance of consulting engagements with audit clients: Effects on nancial statement users perceptions and decision. Auditing: A Journal of Practice & Theory 14 (2): 3553. Mayhew, B. 2001. Auditor reputation building. Journal of Accounting Research 39 (3): 599617. Novick, M. R., and C. Lewis. 1967. Coefcient alpha and the reliability of composite measurements. Psychometrika 32: 113. Oversight Systems, Inc. 2004. The 2004 Oversight Systems Financial Executive Report on Sarbanes-Oxley. Atlanta, GA. Available at: http://www.OversightSystems.com Polkovnichenko, V. 2005. Household portfolio diversication: A case for rank-dependent preferences. The Review of Financial Studies 18 (4): 14671502. Auditing: A Journal of Practice & Theory February 2012

38

Smith

Public Company Accounting Oversight Board (PCAOB). 2004. An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. Auditing Standard No. 2 (AS 2). PCAOB Release No. 2004-001. March 9. Washington, D.C.: PCAOB. Public Company Accounting Oversight Board (PCAOB). 2005. Report on the Initial Implementation of Auditing Standard No. 2An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. PCAOB Release No. 2005-023. November 30. Washington, D.C.: PCAOB. Public Company Accounting Oversight Board (PCAOB). 2006. Proposed Auditing StandardAn Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements. PCAOB Release No. 2006-007. December 19. Washington, D.C.: PCAOB. Public Company Accounting Oversight Board (PCAOB). 2007. An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements. Auditing Standard No. 5 (AS 5). PCAOB Release No. 2007-005A. June 12. Washington, D.C.: PCAOB. Reilly, D. 2006. Booming audit rms seek shield from suits. Wall Street Journal (November 1). Scannell, K. 2007. Softening a Sarbanes-Oxley thorn: SEC makes progress on tweaking the rules for unpopular provision. Wall Street Journal (April 7): C2. Schwartz, R. 1997. Legal regimes, audit quality and investment. The Accounting Review 72 (3): 385406. Securities and Exchange Commission (SEC). 2001. Final Rule: Revision of the Commissions Auditor Independence Requirements. Release No. 33-7919. February 5. Washington, D.C.: SEC. Smith, D. L., and F. C. Minter. 2005. Independence: Perception or reality? Strategic Finance (December): 4651. Sobel, M. E. 1982. Asymptotic condence intervals for indirect effects in structural equation models. In Sociological Methodology, edited by S. Leinhardt, 290312. Washington, D.C.: American Sociological Association. United States House of Representatives. 2002. The Sarbanes-Oxley Act of 2002. Public Law No.107-204 [H.R. 3763]. Washington, D.C.: Government Printing Ofce. United States Treasury Department. 2008. The Treasury Departments Advisory Committee on the Auditing Profession: Final Report. October 6. Washington, D.C.: Government Printing Ofce. Wu, Y., and B. Tuttle. 2011. Investor Condence in Earnings: The Interactive Effects of Internal Control Audits and Manager Legal Liability. Working paper, Case Western Reserve University. Zimbelman, M. F., and W. S. Waller. 1999. An experimental investigation of auditor-auditee interaction under ambiguity. Journal of Accounting Research 37 (Supplement): 135155.

Auditing: A Journal of Practice & Theory February 2012

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.