casterella et al - 2009 - is self-regulated peer review effective at signaling audit quality

713–735 Is Self-Regulated Peer Review Effective at Signaling Audit Quality?. Inorder for peer review to impact audit quality, it must effectively identify weaknesses in lower-quality fir

2009

pp 713–735

Is Self-Regulated Peer Review Effective

at Signaling Audit Quality?

ABSTRACT: This study examines whether peer reviews conducted under the AICPA’s

self-regulatory model have been effective at signaling audit quality Prior research has

examined whether peer-review reports are associated with perceived audit quality We examine whether peer-review reports are associated with actual audit quality Using a

unique data set obtained from the files of an insurance company, we find that review findings are indeed useful in predicting audit failure (i.e., malpractice claims alleging auditor negligence), and that certain types of findings are particularly useful in this regard We also find that peer-review findings are associated with other firm- specific indicators of potentially weak quality control or risky practices within account- ing firms Taken together, we interpret our findings to indicate that self-regulated peer review as mandated by the AICPA does provide effective signals regarding audit-firm quality.

peer-Keywords: peer review; audit quality; litigation risk.

Data Availability: Accounting firm data from the insurance company files are available

subject to approval of the insurance company Summary data may

be obtained from the authors upon request.

I INTRODUCTION

This study examines the effectiveness of the AICPA’s self-regulated peer-review

proc-ess We specifically examine whether traditional peer-review reports are informativeregarding the audit quality of accounting firms Peer review has for many years been

an integral part of the AICPA’s program for enhancing quality in the auditing profession

Helpful comments were received from Eddy Vaasen, Barry Lewis, Clive Lennox, and participants at the 2006 International Symposium on Audit Research Special thanks also to the insurance company for allowing us access

to their files for our study.

Editor’s note: Accepted by Steven Kachelmeier, with thanks to Dan Dhaliwal for serving as editor on a previous version.

Submitted: February 2007 Accepted: October 2008 Published Online: May 2009

Originally adopted in the 1970s, the intent of peer review was to improve audit quality

primarily by identifying significant audit-firm weaknesses, and by communicating those

weaknesses to the reviewed firms so they could take corrective action (White et al 1988;AICPA 2004) It was clearly intended to be a forward-looking, rather than a punitive proc-ess.1 However, the AICPA has recently recognized that regulators and the general publicmight also use peer-review reports for decision-making purposes (AICPA Peer ReviewBoard 2004) This has led to a renewed emphasis on peer-review transparency, and to muchdebate regarding the information content of peer-review reports, including the disclosure

of audit-firm weaknesses to the public (e.g., Bunting 2004; Snyder 2004) Implicit in thisdebate are the assumptions that many parties value audit-firm quality, and that peer-reviewreports provide information regarding such quality Little is currently known about thevalidity of these assumptions

In this study, we focus on the information content of the peer-review report itself Inorder for peer review to impact audit quality, it must effectively identify weaknesses

in lower-quality firms and communicate this information in the report Without this, rective action cannot be taken, and related market pressure cannot be brought to bear.Recent actions by regulators imply that self-regulated peer review has not been an effectivemechanism in this regard For example, the Sarbanes-Oxley Act of 2002 now requires auditfirms with public clients to have PCAOB inspections regardless of their peer-review results(U.S House of Representatives 2002) This change was clearly a reaction to the observationthat most audit failures involved firms receiving clean (unmodified) peer-review reports

cor-At that time, few empirical studies existed to shed light on the issue In fact, little research

to date has examined whether peer-review reports credibly capture audit-firm quality.2This

is unfortunate since most audit firms continue to rely on self-regulated peer review to guidetheir quality-control efforts (Hilary and Lennox 2005).3 Moreover, understanding peer-review effectiveness is imperative to the ongoing debate about the extent to which theauditing profession should be self-regulated

Using a unique and proprietary data set obtained from the application files of an surance company that provides liability coverage to accounting firms, we examine the linkbetween peer-review reports and audit-firm quality We first examine whether the detailedinformation communicated in the peer-review report—specifically the associated letter ofcomments (LOC)—is helpful in predicting audit failure Using malpractice claims as evi-dence of audit failure, we find that the number of weaknesses identified in peer-reviewreports is associated with audit failure We also find that some types of weaknesses iden-tified in peer-review reports are helpful in predicting audit failure while others are not Wealso examine whether the information contained in peer-review reports is calibrated withother potential firm-specific indicators of risk Using information gathered by the insurance

in-1 The output from an AICPA peer review includes, (1) an overall report, which generally contains little or no specific information about quality-control weaknesses identified during the review, and (2) a letter of comments, which describes the specific quality-control weaknesses identified during the review, and which requires a written response Until recently, these were not generally available to the public.

2 Recent studies find PCAOB inspections to be associated with improved audit quality (e.g., Gunny and Zhang 2006; Hermanson et al 2007; Lennox and Pittman 2007), but say little about the effectiveness of traditional AICPA peer reviews This paper should help provide a basis for benchmarking current efforts at regulation against the strictly self-regulatory regime that existed prior to Sarbanes-Oxley.

3 Peer review remains a requirement for AICPA membership—even for firms receiving PCAOB inspections Because PCAOB inspections focus only on the audits of public clients, the AICPA allows members of its Center for Audit Quality (which replaced the SECPS in 2003) to have peer reviews that focus only on the other aspects

of a firm’s practice Most states continue to require peer review for CPA licensure Audit firms in many countries also have peer-review requirements similar to those maintained by the AICPA.

Is Self-Regulated Peer Review Effective at Signaling Audit Quality? 715

American Accounting Association

company specifically to aid in the assessment of audit-firm risk, we find that the number

of weaknesses identified in peer-review reports is associated with such firm-specific butes We interpret our results to be generally supportive of self-regulated peer review being

attri-an effective mechattri-anism for differentiating actual quality among audit firms—even amongfirms receiving clean (unmodified) peer-review reports

In the next section we discuss the background and objectives of peer review, anddevelop hypotheses regarding its ability to signal audit-firm quality In Section III, wediscuss our research method and data Section IV presents the results of our hypothesistests, followed by a summary and discussion of our results in Section V

II PEER REVIEW AND AUDIT QUALITY

The AICPA has for many years incorporated peer review as one of its primary methods

of controlling quality among CPA firms Even before mandatory peer review was adopted,the AICPA had a system of voluntary peer review that started in the 1970s This wasimplemented primarily as part of the profession’s response to a wave of audit failures thatcaused the public to question audit effectiveness The voluntary phase of peer review even-tually gave way to a form of mandatory, yet self-regulated, peer review that was instituted

by the AICPA’s membership in the late 1980s at the prodding of the SEC (Berton 1987;White et al 1988) Self-regulated peer review has remained basically intact from that time

until the present—even after the creation of the PCAOB in 2002 Although the creation of

the PCAOB implied that self-regulation had failed in terms of monitoring, the AICPArecently reasserted its commitment to peer review for its membership (AICPA 2004), albeit

in a more transparent form

The effectiveness of the AICPA’s peer-review program has often been questioned Whilesome commentators have been supportive of the program (e.g., Mautz 1984; Kaiser 1989;Felix and Prawitt 1993), critics have made reasonable arguments over the years as to whyself-regulated peer review may not work Some point to the anecdotal evidence that peerreviews identify relatively few weaknesses in reviewed firms (e.g., Wallace and Cravens1994), that almost all peer-review engagements result in unmodified reports (e.g., Hilaryand Lennox 2005), and that most audit failures involve peer-reviewed firms (e.g., Fogarty1996) Others argue that peer review cannot be effective because of the general lack ofindependence among reviewers and reviewees (Anantharaman 2007; Grumet 2005), andbecause the formality of the process allows firms to develop explicit compliance plans based

on charts and checklists that have little impact on the conduct of audits (Atherton 1989;Austin and Lanston 1981) Fogarty (1996) argues that the AICPA’s peer-review programmay be nothing more than ‘‘ceremonial logic’’ because (1) the program was created by atrade organization focused more on maintaining the profession’s image than on improvingaudit quality, and (2) reviews focus on the quality-control process and documentation ofthat process rather than on the appropriateness of audit decisions and actual audit quality.While these criticisms appear reasonable, the key to determining whether peer review

is effective is to examine whether it successfully identifies quality differences among auditfirms In other words, do peer-review reports credibly reflect audit quality? Empirical studies

have shed some light on this question, but most of this evidence is indirect For example, studies examining ex post assessments of quality find that audit firms required to undergo

peer review are associated with higher-quality audits (e.g., Deis and Giroux 1992; Giroux

et al 1995; Krishnan and Schauer 2000) On the other hand, studies using fees as a proxyfor quality are less clear on this question Francis et al (1990) find no evidence that auditorssubject to peer review are able to charge higher fees However, Giroux et al (1995) findthat such firms may indeed charge higher fees, but not on a per-hour basis Similarly, a

survey by Schneider and Ramsay (2000) suggests that while loan officers claim to havemore confidence in clients audited by peer-reviewed firms, they are not more likely toapprove loans or offer lower interest rates for those borrowers.

Wallace (1991) is the first to examine the information contained in peer-review reportsand related LOCs She finds that 90 percent of reports filed during the 1980–86 periodwere unmodified, with an average of 3.47 weaknesses identified per engagement She alsofinds that the number of weaknesses is invariant to the type of reviewer, type of reviewee,

or year of review Wallace (1991) interprets these findings as supporting the contention thatpeer review is effective in that it is not subject to moral hazard problems surrounding thechoice of the reviewing firm Hilary and Lennox (2005) examine reports filed during 1997–

2003 and find that most reports continue to be unmodified (95 percent), and that the averagenumber of weaknesses identified (1.12 per report) appears to have decreased considerablyover time Their primary contribution is to gauge the information content of peer-reviewreports by focusing on audit-market reactions to those reports Their research design makes

two assumptions: first, that audit clients perceive peer-review reports to reflect actual audit

quality; and second, that any market reaction to peer-review reports is due to audit-clients’demand for audit quality The authors find evidence that the audit market reacts to theinformation signaled by peer-review reports Specifically, firms receiving unmodified reportswithout LOCs gain clients following the review, while firms receiving modified or adversereports lose clients Shifts in the audit market also appear to be related to the number ofweaknesses identified in the LOC

Hilary and Lennox (2005) is the most complete examination to date of the informationcontent of peer-review reports They demonstrate that peer-review reports are associated

with perceived audit quality However, whether peer review provides an effective signal of audit quality ultimately depends on whether its results are well calibrated with actual audit

quality.4Unfortunately, audit quality is usually unobservable on specific audits (O’Keefe et

al 1994) Because of this, researchers generally use proxies for audit quality in their yses Such proxies often involve events suggestive of audit failure, such as restatements(e.g., Kinney et al 2004), failure to issue going-concern reports (e.g., Lim and Tan 2008),the presence of AAERs (e.g., Hilary and Lennox 2005), and audit-related litigation (e.g.,DeFond and Francis 2005; Francis 2004; Bonner et al 1998) In this vein, we believe pooraudit quality is observable with hindsight if an engagement results in litigation or a claim

anal-of malpractice against the audit firm (Palmrose 1988) That is, ceteris paribus, firms

ex-periencing legitimate malpractice claims (i.e., audit failures) are likely to provide

lower-quality audits on average It follows that if peer-review reports accurately reflect actual

audit quality, then such firms should generally have received weaker peer-review reports

prior to the events leading to the claims This leads to our first hypothesis:

H1: The likelihood of audit failure (i.e., poor audit quality) is associated with

peer-review findings

This hypothesis reflects our belief that audit failure (as proxied for by a malpracticeclaim) is a reasonable indicator of poor audit quality However, we recognize that not allaudit failures result in observable events such as lawsuits or malpractice claims We also

4 Hilary and Lennox (2005) indicate a univariate association between peer-review findings and Accounting and

Auditing Enforcement Releases (AAERs) While AAERs are a reasonable proxy for audit quality, few firms in their study had clients subject to AAERs Additionally, reviews of those firms appear to have been conducted

after the SEC investigations had begun Given the publicity surrounding SEC investigations, reviewing firms

may have felt pressure to identify weaknesses in those cases.

Is Self-Regulated Peer Review Effective at Signaling Audit Quality? 717

American Accounting Association

recognize that the existence of audit risk allows that, statistically, some claims or lawsuitsmay be associated with high-quality auditors For this reason, we also turn to insurancecompany expertise to identify other firm-specific attributes indicative of audit-firm risk and/

or lower average audit quality

During the application process, companies providing professional malpractice insurance

to audit firms collect and carefully examine firm-specific information they consider useful

in assessing the likelihood of claims or lawsuits being filed against potential clients Whilesuch information about audit-firm attributes may also reflect risks not strictly associatedwith audit quality (e.g., clientele industry or jurisdiction), it is clear that audit-firm attributesindicative of lower audit quality would be associated with increased risk to the insurancecompany, and are likely to be captured in the client-screening process It follows that ifpeer-review reports are informative about audit-firm quality, then they should also be as-sociated with the attributes identified by insurance companies as being indicative of audit-firm risk / lower audit quality This leads to our second hypothesis:

H2: Peer-review findings are associated with the presence of audit-firm attributes

in-dicative of audit-firm risk and / or lower audit quality

III RESEARCH DESIGN AND DATA COLLECTION

The data for this study are drawn from the proprietary files of an insurance company(the company) specializing in professional liability coverage for local and regional account-ing firms The company is a subsidiary of a large international professional services orga-nization and is not publicly owned It is subject to state regulation, reporting requirements,and inspection It has been in existence for more than 20 years and sells directly to itsclients, which range in size from small local firms to very large regional firms Its clientsinclude many of the largest accounting firms in the U.S In fact, our sample includes 14 ofthe largest 100 CPA firms (Public Accounting Report 1999).5 Access to the data was ob-tained through negotiations with the company, and provides us with at least three uniqueopportunities not available in prior research First, we are able to use malpractice claims

as a measure of audit failure Most of the claims in our study are the product of litigationagainst the audit firm While litigation is generally viewed as a reasonable proxy for auditquality (see Francis 2004), claims settled without litigation may represent additional inci-dents of audit failure that are generally not publicly observable In fact, aside from nuisanceclaims, these may represent relatively egregious incidents of audit failure, since the alle-gations are not even challenged in court Second, we are able to identify and use a consid-erable amount of firm-specific information not generally available to the public, includinginformation about firm histories, clienteles, structures, and services Because this data comesfrom the underwriting files of an insurance company, we are able to incorporate the com-pany’s expertise in our research design Finally, accounting firms applying for coveragewith this particular insurer are required to have peer reviews and must have received un-modified reports in their most recent review The company’s files contain copies of thesereports, including the LOCs and associated responses

In our primary analysis, we use the presence (absence) of an alleged audit failure as

an indicator of lower (higher) audit quality We first identify all audit-related claims volving accounting firms covered by the insurer during the period 1987–2000 Each ob-servation represents a unique claim for deficient audit services for which the company made

in-5 The largest accounting firms—including the Big 4 firms—are self-insured.

a nontrivial settlement (greater than $5,000).6 This process yields 79 separate audit practice claims A control group of 79 non-claim observations is constructed by matchingeach claim firm with an accounting firm having no audit-related malpractice claims Non-claim firms are matched with claim firms according to size (total billings), and are required

mal-to have been covered by the insurance company during the same period (i.e., firms werematched on application year and size) In order to be considered a non-claim firm, the firmmust have experienced no audit-related claims for the five years preceding the year of theobserved claim.7 The resulting sample includes 158 observations

An accounting firm’s underwriting application is updated once a year The applicationcontains information regarding the structure of the accounting firms, the services they pro-vide, the nature of their clienteles, the professional activities of their owners, and somedetails regarding their recent histories They contain no information about specific auditclients—including those associated with the incident leading to the malpractice claim Ourdata come from the underwriting files for the two years prior to the claim Data for thenon-claim firms are drawn from the same calendar periods Most of the data was hand-collected by a research assistant working directly under the supervision of one of theauthors The entire data set was then reviewed by a different author who had not beendirectly involved with initial data collection Discrepancies were resolved by re-examination

of the documents in the appropriate files

Descriptive data for the peer reviews in our sample are presented in Table 1 The reportsappear to be well distributed over the period 1986–1999 (see Panel A) The mean number

of weaknesses identified in the reports for the 158 firms was 1.44 (see Panel B) This falls

between Wallace (1991) and Hilary and Lennox (2005), and is consistent with a gradual

decrease in weaknesses over time since peer review was implemented The majority ofweaknesses relate to engagement performance, with 87 firms receiving such findings (al-most 1 per firm), followed by monitoring (29 firms, mean of 0.23 per firm) and personnelmanagement (17 firms, mean of 0.13 per firm) Few firms in our sample have findingsrelated to independence or client-acceptance issues.8

Table 1, Panel C presents the distribution of actual payouts on all audit-related claimsfiled with the insurance company It is noteworthy that during the sample period, 125 (59percent) of the 213 claims filed resulted in no payout, suggesting that the company doesnot simply settle claims to make them go away On the contrary, the data suggest that thecompany identifies frivolous claims and denies them The distribution of the remaining 88firms does not suggest an obvious bias toward smaller claims We are cautious, however,and eliminate the nine claims less than $5,000 from our sample Taken together, the payoutdistribution appears to support our assertion that the claims in our sample do not represent

6 We exclude claims involving small dollar amounts because they are more likely to represent frivolous claims rather than genuine audit failures We also exclude claims related to all nonaudit services The company tracks claims regardless of whether they result from litigation At least 56 of the 79 claims (71 percent) in our sample involved litigation.

7 Applications specifically request claims information only for the five years prior to the application year Matched firms were selected by insurance-company personnel who were not aware of the nature of the study.

8 The peer-review reports contained in the files represent reviews performed prior to the year the claim was filed.

Hence, it is unlikely that the reviewing firms felt pressure from these claims to identify weaknesses during their reviews (see footnote 4) In order to rule out the possibility that earlier claims may have impacted the reviews

in our study, we reviewed the applications and identified all claim firms that had audit-related claims within the five-year period prior to the claim of interest (and prior to the peer-review date) The mean number of weaknesses identified in the peer-review reports for these five firms was not unusually high (1.20 versus the 1.44 mean for all firms) Sensitivity tests performed after omitting these firms and their matched counterparts yield results that are qualitatively similar to those reported here.

Is Self-Regulated Peer Review Effective at Signaling Audit Quality? 719

American Accounting Association

TABLE 1 Descriptive Peer-Review Information

(nⴝ158) Panel A: Observations by Peer-Review Year

Panel B: Peer-Review Findings

Type of Finding b Mean Median

Range of Findings

Observations with Comments

Panel C: Distribution of Claims by Dollar Amount

Payout Range c Number of Claims

TABLE 1 (continued) Panel D: Distribution of Claims by Type

Allegation d Total Claims Claims in Sample

a Observation year represents the year of the peer review Odd numbers of observations occur because firms are matched on claim year rather than the year of their most recent peer review.

b Peer-review findings are identified directly from the letter of comments contained in the application files.

c Payouts represent the insurance company payouts rather than the amounts sought by claimants.

d Allegation categories are determined by the insurance company.

e Claims resulting in payouts of less than $5,000 are excluded from our sample as they are more likely to represent frivolous actions.

nuisance claims, but instead represent bona fide audit failures The highest concentrations

of alleged audit failure appear to involve failure to detect fraud and failure to detect stated liabilities (see Table 1, Panel D)

mis-IV PEER REVIEW AND AUDIT FAILURE Model Development

Hypothesis 1 states that peer-review findings are useful in predicting audit failure (lowaudit quality) To test this hypothesis, we estimate regression models linking peer-reviewvariables to the presence or absence of malpractice claims alleging negligent, or low-quality,

audit work The dependent variable in the models (CLAIM) takes a value of 1 if a firm is

subject to a malpractice claim, and 0 otherwise Test variables reflect the findings described

in the respective LOCs Since peer-review findings apply to different aspects of an nization’s activities, we examine them both in total (Equation (1)) and separated into thefive quality-control categories (Equation (2)) used by the AICPA (1996):

CLAIM⫽ b0⫹ b INDEP1 ⫹b ACCEPT2 ⫹b PERSNL3 ⫹b ENGAGE4

where:

TOTFIND⫽ total number of weaknesses identified in the peer-review report;

INDEP⫽ dummy variable with a value of 1 if the peer-review report identifies at

least one weakness related to independence policies, and 0 otherwise;

Is Self-Regulated Peer Review Effective at Signaling Audit Quality? 721

American Accounting Association

ACCEPT⫽ dummy variable with a value of 1 if the peer-review report identifies at

least one weakness related to client acceptance and continuation practices,

and 0 otherwise;

PERSNL⫽ dummy variable with a value of 1 if the peer-review report identifies at

least one weakness related to personnel management, and 0 otherwise;

ENGAGE⫽ dummy variable with a value of 1 if the peer-review report identifies at

least one weakness related to engagement performance, and 0 otherwise;

and

MONITOR⫽ dummy variable with a value of 1 if the peer-review report identifies at

least one weakness related to monitoring of professional practices, and 0

otherwise

Equations (1) and (2) include control variables for non-quality factors likely to beassociated with the likelihood of claims being filed with the insurance company For ex-ample, while a link has been established between the size of a CPA firm and audit quality(e.g., Stice 1991), larger firms may experience more claims simply because they have moreclients To control for this possibility, we include the natural log of total fees for the firm

in the year prior to the claim incident (LNFEES) and the percentage change in total audit firm staff in the year of the claim incident (GROWTH).9We also include the percentage of

total firm fees coming from SEC clients (SEC%) to control for the likelihood that public

audit clients are more litigious than nonpublic audit clients We next include a dummy

variable indicating whether a CPA firm is located in either Arizona or Texas (JURIS) to

control for the possibility that claims are more likely in plaintiff-friendly jurisdictions (Esho

et al 2004).10Finally, to control for the possibility that CPA firms with low deductibles aremore likely to file insurance claims, we also include a variable measuring the policy de-

ductible divided by the number of firm owners (DEDUCT).

weaknesses identified Variance inflation factors are all less than 1.5, however, so collinearity is not a problem in the data

multi-Equation (1) includes a continuous test variable representing the total number of

weak-nesses identified in the peer-review report (TOTFIND) Results from the logit estimation

are shown in Table 4, column A The model has a pseudo-R2 of 18.9 percent, and control

variables are all significant as predicted Claims are more likely for larger firms (LNFEES,

p ⬍ .001), rapidly growing firms (GROWTH, p ⫽ 044), firms with more SEC clients

(SEC%, p⫽.090), firms operating in plaintiff-friendly jurisdictions (JURIS, p⫽.004), and

firms carrying smaller deductibles (DEDUCT, p ⫽ 067) More importantly, the likelihood

9 Replacing growth in staff with growth in total fees reduces our sample size to 114 due to missing data However,

it does not qualitatively alter our results.

10 The insurance company insures accounting firms in most U.S states According to the company, legal precedent and court rules make it relatively easy to bring litigation against accountants in these states In their experience, these two states have the most plaintiff friendly courts in the U.S.

11 Nine pairs of firms (18 observations) were dropped because of missing data items for either the claim firm or the non-claim firm.

TABLE 2

Descriptive Data for Claim Firms (CLAIMⴝ1) and Non-Claim Firms (CLAIM ⴝ0)

(nⴝ140) Non-Claim Firms

nⴝ70

Claim Firms

nⴝ70 Variable Mean S.D Min Max Mean S.D Min Max.

TOTFIND (⫹) ⫽ total number of weaknesses identified in the peer-review report/LOC;

INDEP (⫹) ⫽ dummy variable with a value of 1 if the peer-review report identified at least one weakness

related to independence, and 0 otherwise;

ACCEPT (⫹) ⫽ dummy variable with a value of 1 if the peer-review report identified at least one weakness

related to client acceptance and continuance, and 0 otherwise;

PERSNL (⫹) ⫽ dummy variable with a value of 1 if the peer-review report identified at least one weakness

related to personnel management, and 0 otherwise;

ENGAGE (⫹) ⫽ dummy variable with a value of 1 if the peer-review report identified at least one weakness

related to engagement performance, and 0 otherwise;

MONITOR (⫹) ⫽ dummy variable with a value of 1 if the peer-review report identified at least one weakness

related to monitoring, and 0 otherwise;

LNFEES (⫹) ⫽ natural log of total firm fees;

GROWTH (⫹) ⫽ percentage change in total audit firm staff in the year of the malpractice claim;

SEC% (⫹) ⫽ percentage of total fees from SEC clients;

JURIS (⫹) ⫽ dummy variable with a value of 1 if the firm practices in either AZ or TX, and 0 otherwise;

and

DEDUCT (⫺) ⫽ deductible included in insurance policy divided by number of firm owners.

of audit failure is positively associated with the total number of weaknesses identified in

the peer-review report (TOTFIND, p ⫽ 039)

Equation (2) examines whether the type of weakness identified in the peer-review report

is informative regarding likely audit failure We use dummy variables to indicate whether

a Correlations with absolute values greater than or equal to 16 (bolded) are significantly different from zero at the 05 level.

b See Table 2 for variable definitions.

TABLE 4 Analysis of the Relation between Peer-Review Findings and the Likelihood

of Audit Failure Using Logit

(nⴝ140)

b

Model A: CLAIM ⫽ a0⫹a TOTFIND1 ⫹ {control variables}

Model B: CLAIM ⫽ b0⫹b INDEP1 ⫹b ACCEPT2 ⫹b PERSNL3 ⫹b ENGAGE4

⫹b MONITOR5 ⫹ {control variables}

Predicted Sign a

A Estimate Wald␹2

B Estimate Wald␹2

***, **, * Indicates significance at p ⬍ 01, 05, and 10, respectively.

a All p-values are one-tailed where signs are predicted.

bDependent variable (CLAIM) equals 1 if firm had an audit related claim filed against it, and 0 otherwise See

Table 2 for additional variable definitions.

a particular type of weakness is identified in the report Results are shown in Table 4,Column B The model has a pseudo-R2 of 22.3 percent, and control variables continue to

be significant as predicted Results indicate the likelihood of audit failure is positivelyassociated with some types of weaknesses identified in peer-review reports, but not others

Firms having weaknesses related to personnel management (PERSNL) and / or engagement performance (ENGAGE) are more likely to experience audit failure (p⫽.049 and p⫽.014,

respectively), while firms having weaknesses related to independence (INDEP), client ceptance (ACCEPT), and / or monitoring (MONITOR) are not We interpret the results of

ac-these two analyses as providing support for our first hypothesis that peer-review findings

are informative as to actual audit quality—at least insofar that a malpractice claim is a

reasonable proxy for poor audit quality However, we suggest caution in interpreting our

lack of results for INDEP and ACCEPT as relatively few firms in our sample received such

comments

We next perform a series of tests for sensitivity purposes First, we estimate Equations(1) and (2) after omitting all the control variables except size Second, we estimate Equation(2) using continuous count variables rather than indicator variables for each type of weak-ness Third, although multicollinearity is not indicated, we estimate Equation (2) using one