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University of Arkansas, Fayetteville ScholarWorks@UARK Theses and Dissertations 8-2018 Implications of Audit Office Resource Allocation Shocks: Evidence from Late 10-K Filings Stuart Dearden University of Arkansas, Fayetteville Follow this and additional works at: http://scholarworks.uark.edu/etd Part of the Accounting Commons Recommended Citation Dearden, Stuart, "Implications of Audit Office Resource Allocation Shocks: Evidence from Late 10-K Filings" (2018). Theses and Dissertations. 2851. http://scholarworks.uark.edu/etd/2851 This Dissertation is brought to you for free and open access by ScholarWorks@UARK. It has been accepted for inclusion in Theses and Dissertations by an authorized administrator of ScholarWorks@UARK. For more information, please contact scholar@uark.edu, ccmiddle@uark.edu. Implications of Audit Office Resource Allocation Shocks: Evidence from Late 10-K Filings A dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Business Administration with a concentration in Accounting by Stuart Dearden Salt Lake Community College Associate of Science in General Studies, 2005 Brigham Young University Bachelor of Science in Accounting, 2009 Brigham Young University Master of Accountancy, 2009 August 2018 University of Arkansas This dissertation is approved for recommendation to the Graduate Council _____________________________ Cory Cassell, Ph.D. Dissertation Director ______________________________ Ken Bills, Ph.D. Committee Member ______________________________ Jonathan Shipman, Ph.D. Committee Member ______________________________ Gary Peters, Ph.D. Committee Member ABSTRACT Prior literature examines consequences (e.g., negative market reactions, higher subsequent audit fees, and debt covenant violations) audit clients face arising from missed regulatory due dates. These clients likely pressure the auditor to provide additional resources to perform the audit. This paper examines whether an audit office resource allocation shock stemming from late-filing clients is associated with the audit quality of the other timely-filing clients in that audit office. I find that timely-filing clients are more likely to subsequently restate their financial statements when there are late-filing clients in the same audit office. Using audit fees as a proxy for auditor effort (resource allocation), I also find evidence consistent with auditors allocating resources from timely-filing clients to late-filing clients. Subsequent tests indicate that office size mitigates the association between late-filing clients and audit quality of the timely-filing clients. Taken together, these findings support the argument that the observed relation between misstatements and late-filing clients can be linked, at least in part, to the implications of shocks to office-level resource allocation plans. Thus, my findings highlight an important factor for auditors to consider for their client acceptance and continuance decisions. These findings also have implications for standard setters considering the costs associated with regulatory due dates. TABLE OF CONTENTS Introduction ....................................................................................................................................1 Background and Development of Hypotheses .............................................................................7 Sample Selection, Methodology, and Variables of Interest .....................................................12 Sample Selection Methodology Variables of Interest Empirical Results .........................................................................................................................18 Descriptive Statistics Tests of Hypotheses Additional Analyses .....................................................................................................................23 The Mitigating Effect of Large Audit Offices Timely-Filing Clients that Share an Industry with Late-Filing Clients Resource Allocation Shocks Outside of Busy Season Resource Allocation Shocks Stemming from Missed Expected Filing Deadlines Robustness Tests ..........................................................................................................................28 Alternative Measures for Audit Quality Dropping Offices with no Late Filers Removing Influential Observations Including Late Filers that do not File Form 12b-25 Conclusion ....................................................................................................................................31 References .....................................................................................................................................35 Appendix A ...................................................................................................................................38 Tables and Figures .......................................................................................................................41 I. INTRODUCTION The Securities and Exchange Commission (SEC) requires all registrants to complete their 10-K filings within 60 to 90 days of their fiscal year-ends.1 Missing these due dates can have severe consequences for the registrant, including negative market reactions (Alford, Jones, and Zmijewski, 1994; Dee, Hillison, and Pacini, 2010; Bartov and Konchitchki, 2017; Khalil, Mansi, Mazboudi, and Zhang, 2017), higher subsequent audit fees (Wang, Raghunandan, and McEwan, 2013), and debt covenant violations (Chapman, Hyatte, and Jindra, 2015; Bartov and Konchitchki, 2017). Because the consequences of missing regulatory due dates are significant for the registrant, I posit that both the registrant and the auditor plan to file the 10-K in a timely manner. Thus, it is likely that late-filing clients negatively affect the audit office via a shock to office-level resource allocation plans.2 In this paper, I examine whether a resource allocation shock stemming from late-filing clients is associated with audit quality for the other timely-filing clients in an audit office. Because late-filing clients face significant negative consequences, they are likely to explicitly or implicitly pressure the auditor to invest additional resources to perform the audit. The investment of additional resources, in turn, could result in lower audit quality for other clients in the office that serve as the source of additional resources.3 Although prior work has investigated clientspecific implications of filing late, my study is the first to consider the potential implications late-filing clients have on other clients in the audit office. Non-accelerated, accelerated, and large accelerated filer due dates are 90, 75, and 60 days after registrants’ fiscal year-ends, respectively. 2 Throughout this paper, I use late-filing client, late filer, and non-timely filer interchangeably and use timely-filing client and timely filer interchangeably. 3 Audit firms might anticipate “fire drills” related to late-filing clients and build in enough resource slack to address unplanned circumstances. However, because resource slack is expensive, audit firms might not have enough. 1 1 Following prior research (Wang et al., 2013; Bartov and Konchitchki, 2017; Khalil et al., 2017), I use Form 12b-25 to identify late-filing clients.4 I restrict my main sample to companies with fiscal year-ends that fall during the typical busy season (i.e., mid-December through midJanuary), and that file their 10-K in a timely manner. I construct two variables that reflect officelevel resource allocation shocks associated with late filings: 1) the percentage of late-filing clients in the office; and 2) the size-weighted percentage of late-filing clients in the office. To proxy for the audit quality of timely-filing clients, I use material misstatements, as revealed by subsequent restatements (see, e.g., Choudhary, Merkley, and Schipper, 2016; Aobdia, 2017, 2018), announced in a Form 8-K. I regress material misstatements on my proxies for office-level resource allocation shocks and controls for client, audit firm, and audit office characteristics that prior literature shows to be associated with audit quality. Consistent with my prediction, I find a positive and significant association between the likelihood of a material misstatement for timely-filing clients and the percentage of late-filing clients in the office using both proxies. These results suggest that office-level resource allocation shocks from late-filing clients have implications for other clients in the office – namely, clients that file their financial statements in a timely manner. My main findings suggest that auditors do not devote sufficient resources to timely-filing clients in order to maintain a consistent level of audit quality. To supplement these findings, I perform tests to examine whether a similar shift in resources is evident in the amount of audit fees paid by timely-filing clients. I examine audit fees because they are an important input into the audit process (DeFond and Zhang, 2014) and a reasonable proxy for auditor effort (Lobo and 4 If an SEC registrant cannot file its annual report on time, the registrant must file Form 12b-25 no later than one day past their due date in order to notify regulators and investors that they will file their 10-K at a later date. Form 12b25 filings related to 10-Ks are labeled NT 10-K on Edgar. By filing its 10-K within 15 days of the due date, the registrant avoids SEC penalties. 2 Zhao, 2013). I regress audit fees on my variables of interest and find a negative and significant association between audit fees for timely-filing clients and both proxies for the percentage of late-filing clients in that office. Furthermore, I find that late-filing clients pay higher audit fees in the year they file late. These results, taken together, suggest that audit offices allocate resources from timely-filing clients to late-filing clients. I perform several additional tests to support my argument that the observed relation between material misstatements and late-filing clients can be linked to shocks to office-level resource allocation plans. I begin by examining whether my primary results are mitigated by office size. Because larger audit offices have a larger pool of resources to draw from, I expect larger audit offices to better allocate resources to late-filing clients without adversely impacting audit quality for timely-filing clients. To test this, I re-estimate my primary analyses and interact my proxies for resource allocation shocks with two proxies for office size (client count and office-level audit fees). The results of my primary tests are mitigated as audit office size increases, suggesting that larger audit offices are better able to adjust to resource allocation shocks. Next, I investigate whether my results are driven primarily by timely-filing clients that operate in the same industry as the late-filing clients. When faced with a late-filing client, I expect audit offices to first secure resources with relevant experience and knowledge (i.e., personnel from the same industry). This suggests that the effects of resource allocation shocks should be more pronounced among clients from the same industry as the late-filing clients. The results suggest that resource allocation shocks affect both same- and different-industry clients, regardless of industry. 3 In my next test, I explore whether my primary results are more pronounced when resources are more limited. The implications of resource allocation shocks should be more pronounced in the busiest quarter (i.e., the fourth quarter) and weaker in the other three. In an expanded sample, the fourth calendar quarter has the highest concentration of client fiscal yearends, with 14,625 observations, followed by the first, second, and third quarters, with 952, 1,225, and 799 observations, respectively. Thus, I expect my results to be more pronounced with increased concentration of fiscal year-ends. To test this, I re-estimate my primary analyses using samples of companies from each calendar quarter. I reconstruct my variables of interest to account for late-filing clients by calendar quarter. I then estimate separate regressions for each quarter. I find that clients with fiscal year-ends in the second and fourth calendar quarters have a positive and significant relation between the likelihood of a material misstatement and both proxies for the percentage of late-filing clients. However, I do not find statistically significant differences between any coefficients for the percentage of late filings in any quarters. These results provide weak evidence that my results are more pronounced during the busiest times of the year. I next examine whether missing expected filing dates similarly places pressure on the auditor to complete the audit. Prior research finds that missing expected filing dates results in negative abnormal returns (Chambers and Penman, 1984). If the client pressures the auditor to avoid such negative consequences, then a client that files later than expected, although still on time, might also pressure the auditor to invest additional resources in the audit. This would result in an auditor allocating resources from clients that would file when expected. I use a sample of observations consisting of clients without late filers in their office that file when expected and remeasure my variables of interest using only the percentage of clients that miss their expected 4 filing date. I find lower audit quality for clients that file on the expected date as both proxies for the percentage of clients that miss their expected filing dates increases. This is consistent with auditors allocating resources in response to client pressure stemming from negative consequences. Finally, I perform several tests to assess the robustness of my primary findings. I find similar results using alternative proxies for audit quality – discretionary accruals and combined material and immaterial misstatements. To alleviate concerns about the distributions of my variables of interest, I limit my sample to observations with late-filing clients in the audit office. The results are similar to my main findings. Next, I use Pregibon’s dbetas and leverage (Pregibon 1981) to eliminate influential observations, finding that influential observations are not driving my results. To ensure that my results are not driven by my proxy for late-filing (i.e., companies that file Form 12b-25), I re-measure my variables of interest by including the small number of clients that file later than the SEC regulatory due dates yet do not file Form 12b-25, finding similar results as my main analyses. This study provides four primary contributions. First, I contribute to the literature on regulatory due dates and late filings. Prior literature examines the regulatory and market implications that late-filing clients face (Alford et al., 1994; Dee et al., 2010; Bartov and Konchitchki, 2017), the signals that late-filing clients provide (Cao, Chen, and Higgs, 2016), the change in the late-filing rate over time (Impink, Lubberink, van Praag, and Veenman, 2012; Boland, Bronson, and Hogan, 2015; Burke and Pakaluk, 2016), and the financial reporting implications of accelerated due dates (Krishnan and Yang, 2009; Impink et al., 2012; Boland et al., 2015; Lambert, Jones, Brazel, and Showalter, 2017). My study advances prior research by 5 demonstrating that the impact of late-filing clients extends to timely-filing clients in the same audit office. Second, I contribute to the literature on the implications of audit office resource constraints and time pressure. Prior literature examines constraints related to busy season concentration (Lopez and Peters, 2011, 2012), filing deadline concentration (Czerney, Jang, and Omer, 2017), and audit office growth (Bills, Swanquist, Whited, 2016). This paper shows that office-level resource constraints arise from late-filing clients. Third, I provide evidence of an office-level signal about audit quality that is easily determinable and often revealed sooner than alternative signals (e.g., misstatements). Many misstatements are revealed several months to several years after the 10-K filing. Form 12b-25 filings are revealed during busy season. Although the implications of a revealed misstatement differ from those of Form 12b-25 (e.g., a misstatement might also imply low audit expertise, not only a resource allocation shock), Form 12b-25 is a potentially more timely indication of officelevel audit quality for investors, auditors, and regulators. Finally, my results highlight the importance of audit office resource allocation plans, resource slack, and late filings as relevant factors for auditors to consider when making client acceptance and continuance decisions. In particular, my results suggest that the average audit office has insufficient resource slack when faced with late filers, meaning that they are unable to respond to unexpected changes to resource allocation plans. This deficiency varies predictably with certain office characteristics that are influenced by client portfolio decisions. My results also underscore the importance of regulatory due dates and should inform standard setters and regulators when considering costs associated with regulatory due dates. 6