Dissertation: Auditing in the era of digital and policy uncertainties

The effects of auditor knowledge and client bargaining power on audit outcomes
Photo: Aalto University / Mikko Raskinen

In her dissertation Arpine Maghakyan observes that audit outcomes are a subject to a complex relation between auditors, clients and policy makers and these relations are rather dynamic. Here she tells more about her study:

We are living in the world where digitalization is becoming part of our lives and just being an expert in one field is not enough. When working as a consultant in accounting automation, I was working with accountants and auditors from big 4 and non-big 4 accounting firms who were true experts in accounting and auditing but what I have noticed already back then, that their familiarity with the ERP systems, understanding of IT and digitalization can make differences in outcomes of their work, sometimes just by spending more time and effort, sometimes by not taking into account some potential risks raising from the digitalization.

This observation made me think if being an expert in accounting and auditing is enough to be a good auditor. Or is there a need for expertise in digitalization, data analytics and even in statistics or in something else. However, this is not a new phenomenon, as over the course of the history accountants were in need to be an expert in more than in accounting, or to be a polymath so to say.

However, digitalization is just one of the external factors that can affect auditors, and auditors are not the only players in the auditing process. Rather as with any other market, the auditing market is also dynamically changing under internal and external circumstances that affect the auditing process from the demand (client requirements), supply (auditor characteristics), and regulations side.

The importance of auditing has been studied numerous times as high-quality auditing is an important factor for well-functioning capital markets, and auditors’ incentives play a critical role in providing high-quality audits (DeFond and Zhang, 2014).

In my dissertation I specifically study the effects of three external factors: business digitalization, regulations and economic policy uncertainty, on auditing. Particularly how digitalization and regulations penetrate through auditor competences and the policy uncertainty through client bargaining power.

Essay 1: The first essay, co-authored with Henry Jarva, Lasse Niemi, and Jukka Sihvonen, examines the relationship between audit partner expertise in client digitalization and audit fees. Changes in the digitalization of businesses create demands for auditors’ new skillsets and competences. Even if audit firms invest massively in digitalization, there is still variation between audit partners and how much partners can benefit from these investments and from inviting IT specialists in audit teams.

In his book of Range: (Why Generalists Triumph in a Specialized World) David Epstein discusses the reasons why generalists triumph in a specialized world. In this essay I discuss how audit partners who specialize in a client’s digitalization are valued by clients and charge higher audit fees. In this analogue the specialization in the digitalization for auditors is more of a sign of being a polymath and not just a generalist as they on addition to all of their knowledge and experience in accounting and auditing are also experts in their client’s digitalization. So, the additional specialization in something different from the auditing itself gives an advantage for the auditor to excel other auditors which in its place is valued by the clients. As it makes it easier to work with an auditor who will understand the digital environment of their business and make better judgments. Using data from two different countries – the US and Finland, which are two settings with different legislation and digitalization levels – and various empirical methods, we find that audit partners with expertise in client digitalization earn an audit fee premium.

Essay 2: The second essay, co-authored with Antti Fredriksson, David Hay, Jukka Karjalainen, and Lasse Niemi, explores the importance of auditors’ knowledge and skills before any specializations. More specifically, the essay focuses on the generic level of knowledge and technical competence of an auditor and how higher levels of knowledge and competence are reflected in subsequent career success and the quality of audits. This paper explores the effects of regulation in terms of professional exams aiming to guarantee that those entering the profession are sufficiently qualified. Professional exams have a long history, starting from chines imperial examinations for civil services to our days, in different professions, they are a quality mechanism and aim to give a minimum assurance for the knowledge of the people who are in profession.

Using the exam results of unique Finnish Certified Public Accountants (CPA) to proxy their general domain knowledge, findings show that, on average, auditors’ performance on the CPA exam is positively related to their career success. Specifically, auditors who passed the exam with higher exam scores are more likely to be promoted partners in Big4 firms and to reach the partner level more quickly compared to those who passed the exam with lower scores. Moreover, we find that there is a positive association between CPA examination results and auditors’ annual compensation. However, we find no association between their exam results and audit quality.

Compared to the first study where we find that auditors are valued more by their clients by their specialty knowledge, in this case we find that auditors are valued by their employers for general domain competences, however we find no evidence that these auditors provide higher audit quality.

However, regulations and policies are not always clear and predictable, as we have experienced during the last two years of our Covid ruled world. Which brings us to the topic of

Essay 3: In this essay I look into auditing from macroeconomic level, specifically continuing on the topic of policy and regulations, I study how policy uncertainty affects audit pricing and what is the level of the discretion for the clients with different importance and bargaining power.

But what is policy uncertainty? Policy uncertainty is an uncertainty caused by a global (pandemic, gulf war, terrorism attacks) or a country level (elections) event which might be followed by economic policy changes. So, events that cause policy instability. These situations can create potential tensions for firms, causing them to delay their investments, hiring, increase savings, cash holdings and financial distress of the firm. But how this high policy uncertainties are affecting the auditing process?

On the one hand during high policy uncertainty periods auditors want to increase the audit fees to encounter for higher business risk caused by the policy uncertainty, especially from the financially distressed firms. On the other hand, there is clients have increased bargaining incentives to cut their costs and auditors want to protect managers and the board. Using Baker et al.’s (2016) Economic Policy Uncertainty Index and data for US-listed firms, I observe that auditors go to compromises with larger and already high paying clients by offering lower fees, while for smaller and low paying firms they increase the audit fees. So, to keep the clients with high bargaining power, auditors reduce their fees when policy uncertainty is high. However, auditors increase audit fees for the clients in the lower tail of audit fee distribution for the same period. It seems that less important clients subsidize more important clients in times of high policy uncertainty. 

Future research can explore whether the decreased audit fees also mean decreased audit effort, or the effort is the same and costs are transferred to the next periods. As it is important to make sure that this decreased audit fees for the larger firms are not a sign of decreased audit effort in high-risk environment which can cause more serios issues such as the Enron case or (other) large audit scandals. Which can shack global economies even more.


Arpine Maghakyan's defense of dissertation will be publicly examined at the  School of Business on Friday, October 1, 2021. Welcome to follow the event online on Zoom

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