Mergers of Auditing Firms - Literature review Example

Running Head: MERGERS OF AUDITING FIRMS Mergers of Auditing Firms [Name of the Writer] [Name of the Institution] Mergers of Auditing Firms Introduction The audit profession has undergone significant changes in the last decade. Specifically, the Big Eight was reduced to the Big Six by the merger of Deloitte, Haskins and Sells with Touche Ross to form Deloitte & Touche, and the merger of Ernst & Whinney with Arthur Young to form Ernst & Young. In addition, Peat Marwick & Mitchell merged with KMG Main Hurdman in 1987 to form KPMG Peat Marwick. These mergers, as well as additional merger discussions among the remaining Big Six accounting firms, have been attributed primarily to the cost of increased regulation, litigation, and competitive survival (Berkovitch and Narayanan, 1993, 347-362). The impact of these audit firm mergers on their output, the audit report, should be examined. To be useful in business decision making, accounting information must be reliable, relevant, and timely. The major factor determining the perception of timeliness by users of financial statements is the lag between the end of the fiscal year and the issuance of the earnings announcement. Audits of financial statements delay the release of this information to the public and other consumers of accounting information. According to Givoly and Palmon, the length of the audit is the "single most important determinant of the timeliness of the earnings announcement" (1982: 491). This timeliness is a function of the number of hours of audit time required and is also affected by such factors as the amount of interim audit work performed, the number of audit personnel assigned to the engagement, and the number of overtime hours worked. Literature Review Specifically, the purpose of this study is to provide a pre-/post-merger analysis of audit pricing. This extends prior research in important ways. First, the time period of this study is more recent than that used in prior audit pricing research; previous audit pricing studies focus on periods prior to the audit firm mergers. Also, studies to date of the impact of the audit firm mergers do not examine audit pricing. Second, while prior studies consider client/auditor traits as explanatory variables for audit pricing, this study holds these traits constant allowing the effect of audit firm mergers to be examined. Prior Research Audit pricing Several audit studies focus on audit pricing or audit efficiency proxied by audit pricing. Newton and Ashton (1989), Bamber et al. (1993), Carslaw and Kaplan (1901) and Williams and Dirsmith (1988) focus on the relationship between audit pricing and other firm characteristics such as audit technology (structure) or firm size. Audit technology here is defined as the classification of the firm's audit approach as highly structured, intermediate, or unstructured. The extant audit structure metric is a tri-level classification developed by Kinney (1986). Williams and Dirsmith (1988) report an inverse relationship between a firm's audit technology (as defined by Kinney (1986) and Gushing and Loebbecke (1986)) and audit pricing. Newton and Ashton (1989) extend audit pricing studies to Canadian Big Eight firms with the opposite results. They find structure tends to increase audit pricing. Bamber et al. (1993) recently attempted to reconcile these inconsistent results in prior research by evaluating the incentives to report on a timely basis along with audit complexity and audit technology. Their findings also suggest a positive correlation between audit technology and audit pricing. The results of this study might provide insight into why the inconsistency exists in the results of the earlier studies. Firm Mergers Organisational theory offers synergy as one motivation for corporate mergers. Synergy is defined as the ability to maximise the complementary strengths of the uniting Organisations to achieve certain objectives. According to Berkovitch and Narayanan (1993), synergy is generally measured in the post-acquisition period by an Organisation's ability to penetrate new markets, increase existing market share, and enhance revenue and market based ratios such as the price-earnings ratio. Hopkins (1991) notes that mergers are generally evaluated using one of three factors: market share, financial performance, or operational efficiency. Davis and Stout (1992) find that mergers are generally associated with a desire to survive rather than to find a common management philosophy. They, along with other Organisational theorists, find that the primary motivation for mergers is to find new markets, enhance research and development, or access new sources of technology. Evidence of this is found by Minyard and Tabor (1991) and Kaplan et al. (1990) in the increased specialisation among the Big Six firms within certain industries following the mergers. Minyard and Tabor (1991) and Kaplan et al. (1990) also suggest that audit firms have recently enjoyed significant increases in revenue from the growth in consulting and other nonaudit (or nonattestation) services. According to professional publications such as Public Accounting Report (1989), revenues from services other than the traditional audit services now exceed more than 50% of total revenue for firms such as Arthur Andersen and Ernst & Young. These services represent the outsourcing of services from the clients to the audit firms. The increase in outsourcing internal audit services alone led to a recent ruling on the AICPA's Standards of Ethics Rule (Ruling No. 97, Extended Audit Services) to provide a guideline for the outsourcing of internal audit services. Increases in market share and financial performance are attributed to the firm mergers as well as the demise of three national firms - Laventhol & Horwath, Spicer & Oppenhiem, and Pannel, Kerr, & Foster. Operational Efficiency In view of the challenges confronting the audit profession it is likely that one motivation behind the three sets of mergers is the potential to increase operating performance. Previous studies analyze the impact of the mergers on firm market share and on financial elements, such as revenue and partner earnings. However, there is a lack of information regarding the impact of the firm mergers on operational efficiency, another factor commonly used to evaluate mergers. Operational efficiency has a direct bearing on the timeliness of the audit report and earnings announcement. As operational efficiency increases, audit pricing decreases. Kinney and McDaniel (1993) find audit pricing to be related to the correction of previously reported earnings. Longer audit pricing is found when corrections of prior reported earnings are necessary. Operational efficiency is impacted by factors such as interim work performed, the number of overtime hours worked, the number of personnel assigned to the audit, as well as their experience with the company and the industry. Information about these factors is not publicly nor readily available so efficiency is inferred from the timeliness of the output or audit pricing. Measuring Audit pricing Craig (1993) examines the determinants of audit pricing metrics used previously in a sample of 318 U.S. companies. He finds firm size, industry, audit structure and calendar year-end among the variables consistently and significantly associated with audit pricing. Craig (1992) suggests that future research should examine the time-series properties of audit pricing rather than cross-sectional effect of factors on the production of audit services. In addition, O'Keefe et al. (1992) find client traits, such as risk, do not have a systematic affect on audit hours. Consequently, they also suggest a broader research focus with less emphasis on specific client or auditor traits. This study responds to the calls by both Craig (1992) and O'Keefe et al. (1992) for change in research focus. This research seeks to extend prior literature by conducting a pre-/post analysis of audit pricing to determine the impact of audit firm mergers. Hypotheses Pre-/Post-Comparison of Audit pricing of Merged Firms Dirsmith and Haskins (1991) suggest that the Organisational design for the Big Six following the mergers is improved. Thus, merged firms are expected to operate more efficiently in their selected niche following the merger. Likewise, the merged firms are expected to be more efficient than the former individual firms which merged. Audit pricing for merged firms as a class is expected to significantly decrease. This expectation is hypothesized, in the alternative form, as: [H.sub.1]: The audit pricing of merging turns will decrease following the merger. Pre-/Post-Comparison of Audit pricing of Merged Firms with that of Nonmerged Firms Organisational theorists indicate that a primary benefit of merging two large firms is achievement of Organisational synergy (Hitt et al., 1991). In the audit industry, for example, market analysis suggests that audit firms seek to become stronger industry specialists through mergers (Kaplan et al., 1990). This synergy is expected to increase audit efficiency, therefore, decreasing audit pricing. Since the competitive environment leads all audit firms to increase their operational efficiency and decrease their audit pricing over the merger period, it is important to control for changes not attributable to the mergers. Therefore, as a control, changes in audit pricing for nonmerged firms are used for comparison purposes. We expect that, over the period of study, the decrease in audit pricing for merged firms as a class will be significantly larger than the decrease for firms which did not merge. This expectation is hypothesized, in the alternative form, as follows: [H.sub.2]: Following the mergers, the decrease in audit pricing for merged firms will be greater than the decrease for nonmerging firms. Research Design Pre-/Post-analysis of Audit Firm Mergers Prior studies (i.e., Ashton et al., 1989; Carslaw and Kaplan, 1991; Newton and Ashton, 1989) focus on firm and client traits by employing the following basic regression model: Audit pricing = f (N,S,O,C,A), where, N = Audit Firm Name, S = Audit Firm Structure, O = Audit Opinion, C = Client Traits (e.g., sizes, earnings trends, or industry) A = Announcement Timing (e.g., early, average, late). This study uses a matched pair design to hold such traits constant allowing the general effect of the audit firm mergers to be examined. Parametric t-tests are used to measure the significance of changes in audit pricing over the period of study. This pre-/post-analysis will provide an indication of any synergy resulting from the mergers evidenced by decreased audit pricing. Audit pricing Metric Audit pricing serves as a proxy for timeliness (and operational efficiency) in this study. A decrease in audit pricing implies an increase in timeliness and efficiency. Audit pricing is calculated here as the number of days lapsing between the year-end date (December 31 for the companies in this study) and the fourth quarter earnings report date as reported in the COMPUSTAT data base. According to the COMPUSTAT manual, this metric is the earlier of the Wall Street Journal earnings announcement date or the actual audit report date. Validity tests of different audit pricing metrics find that audit pricing metrics provide reasonable proxies for cross-sectional differences in the percentage of audit work performed after year-end (Craig, 1992). Time Period Selection The pre-merger year selected for comparative purposes in this study is 1986, the last full year prior to the merger of Peat, Marwick & Mitchell with former ninth ranked KMG Main Hurdman in 1987. The post-merger year used is 1991. This is also the post-merger time period selected by Wootton et al. (1904) for their comparison of auditor concentration pre- and post-mergers. The Deloitte & Touche and Ernst & Young mergers were concluded prior to December $1, 1989. Using 1991 provides a two-year transition period following these audit firm mergers and a four-year transition period following the KPMG Peat Marwick merger. Sample Selection The data are drawn from the COMPUSTAT data base. The initial sample is comprised of all London Stock Exchange and British Stock Exchange firms on Standard & Poor's Industrial List. To remain in the sample, the companies must be listed in the COMPUSTAT data base for both 1986 and 1001. Companies with other than an unqualified (with or without an explanatory paragraph) audit opinion in both 1986 and 1991 are excluded from the sample. Audit report qualification is an infrequent occurrence with varying causes for most firms and exclusion of these companies from the sample eliminates the effects of a qualified opinion on the length of field audit work. Previous research (Ashton et al., 1987; Ashton et al., 1989; Craig, 1993) found a negative association between firms with a calendar year-end and length of audit pricing. Therefore, companies with noncalendar year-ends are also omitted from the sample to eliminate concerns of a nonbusy season effect on audit pricing. Companies using only Big Eight (in 1986) or Big Six (in 1991) audit firms are included in the sample. Previous research has established associations between audit pricing and proxies for company size such as total assets (Ashton et al., 1989; Newton and Ashton, 1989) or revenues (Givoly and Palmon, 1982; Ashton et al., 1987). To control for variations in such client portfolio demographics among audit firms, the client portfolio for each firm is held constant from the pre- to the post-merger period and only the change in audit pricing over the period of the study is examined. This is accomplished by eliminating those companies changing auditors during this time. A change to a merged audit firm in 1991 was not considered to be a change of auditors if the 1986 audit firm was one of the firms comprising the merger. In other words, the same companies comprise an individual audit firm's client portfolio sample in both 1986 and 1991. Therefore, the changes in audit pricing for the individual audit firms are unaffected by client portfolio differences. Elimination of companies switching auditors also controls for variations in audit pricing attributable to differences in audit technology (structure) between auditors. These sample screens result in a final sample of 204 companies which have: 1) A December 31 year-end, 2) unqualified opinions in both 1986 and 1991, and 3) the same Big Eight (Six) auditor in both years. The size of the client portfolio in 1991 for individual audit firms in this study ranges from 21 (Peat, Marwick & Mitchell) to 46 (Price Waterhouse). While the sample size is small, we believe it is representative of large U.S. audit clients who do not switch auditors, retaining the same Big Eight (Six) audit firm over the period of the study. Audit Firm Classification The merger/nonmerger classification and size of the client portfolio sample of each audit firm is summarised. Arthur Anderson, Coopers & Lybrand and Price Waterhouse are classified as nonmerged audit firms. Deloitte & Touche (formed as a result of the merger of Deloitte, Haskins & Sells with Touche Ross), Ernst & Young (formed as a result of the merger of Ernst & Whinney with Arthur Young) and KPMG Peat Marwick (formed as a result of the merger of KMG Main Hurdman with Peat, Marwick & Mitchell) are classified as merged audit firms. Limitations The post-merger period (1991) examined in this study follows the initial completion of the Big Six mergers by two years. During this period, each firm experienced significant challenges adopting new cultures, practices and Organisational and managerial philosophies into one firm-wide position (Cravens et al., 1994). Consequently, these results are preliminary and should be extended in further research to provide a more longitudinal analysis. This will allow the profession to track the stages of response to the merger activity to determine and measure the full impact and related future implications. The results suggest that audit pricing decreased, which implies an increase in timeliness and efficiency during the period of study. We have not noted or measured the impact confounding variables, such as information technology, regulatory changes and industry consolidation (e.g., bank mergers), could have on the audit process. Furthermore, we have not examined the direct impact of general changes in the delivery of audit services. This study focuses solely on the raw measure of audit pricing. While this study carefully controls for variations in a firm's client portfolio between the pre- and postmerger periods (by the use of a matched pair sample design), the only client traits controlled for are fiscal year-end and audit opinion. The lack of control for additional client portfolio trait variations between the merged and nonmerged categories of firms is an additional limitation to the study. Summary The timely release of audit reports and their accompanying information is of utmost concern to the users of the financial statements. This research analyzes the effect of the audit firm mergers on audit pricing. Previous audit pricing studies focus only on periods prior to the audit firm mergers which reduced the Big Eight to the Big Six. Studies of the post-merger period have examined the market share and financial performance characteristics in the post-merger period, but not audit pricing. This study is the first to focus on the impact of the mergers on audit pricing as a proxy for timely operational performance. A matched pair pre-/post-merger analysis is used to examine the effect of the audit firm mergers on the timely release of information as measured by audit pricing. A significant decrease in audit pricing is noted for Big Six firms taken as a whole between 1986 and 1991. However, when the firms are categorized as merged or nonmerged firms, we find a significant decrease in audit pricing only for nonmerged firms over this period; audit pricing for merged firms did not significantly decline. The results do not support the expected improvement in operational efficiency for merged firms. This challenges one of the purported benefits of audit firm mergers: increased operational efficiency through synergy. The significant improvement in the timeliness of the release of financial statement information for the Big Six firms overall can not be attributed to the mergers. Conclusion Audit management is faced with challenges of global competition, rapid changes in information delivery (e.g., Internet, Web pages), ongoing consolidations in mature industries (e.g., telecommunications), along with overnight rises to Fortune 500 status in other industries. Firms must gain an understanding of the optimal Organisational model and the relevant impact of certain strategies such as mergers. Evaluation and analysis of Organisational initiatives which are executed to achieve specific results should be measured both in cross-sectional and longitudinal formats to gain a clear understanding of its success. Because firms today seek to improve their performance through reengineering or through mergers, researchers should continue to evaluate the impact of such initiatives on the timely release of information to users of accounting information. References Ashton, R., P. Graul, and J. Newton. 1989. "Audit pricing and the Timeliness of Corporate Reporting." Contemporary Accounting Research (Spring): 657-673. Ashton, R., J. Willingham, and R. Elliott. 1987. "An Empirical Analysis of Audit pricing." Journal of Accounting Research (Autumn): 275-292. Bamber, E., L. Bamber, and M. Schoderboek. 1993. 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Williams. 1990. "The Effect of Audit Structure on the Audit Market." Journal of Accounting and Public Policy (Fall): 197-215. Kinney, W. 1986. "Audit Technology and Preferences for Auditing Standards." Journal of Accounting and Economics (March): 73-89. Kinney, W. and L. McDaniel. 1993. "Audit pricing for Firms Correcting Quarterly Earnings." Auditing: A Journal of Practice & Theory (Fall): 135-142. Minyard, D. and R. Tabor. 1991. "The Effect of Big Eight Mergers on Auditor Concentration." Accounting Horizons 5 (December): 79-90. Newton, J. and R. Ashton. 1989. "The Association Between Audit Technology and Audit pricing." Auditing: A Journal of Practice and Theory 8 (Supplement): 2037. O'Keefe, T., D. Simunic, and M. Stein. 1992. "The Production of Audit Services: Evidence from a Major Public Accounting Firm." Working Paper, University of British Columbia. Public Accounting Report. 1989. XII, 6 (March 15): 1-4. Williams, D. and M. Dirsmith. 1988. "The Effects of Audit Technology on Auditor: Auditing and the Timeliness of Client Earnings Announcements." Accounting; Organisations and Society (September): 487-508. Wootton, C., S. Tonge, and C. Wolk. 1994. "Pre and Post Big 8 Mergers: Comparison of Auditor Concentration." Accounting Horizons 8 (September): 58-74. Read More