Do Foreign Component Auditors Harm Financial Reporting Quality? A Subsidiary‐Level Analysis of Foreign Component Auditor Use

ABSTRACT We hypothesize and find that financial reporting quality at the foreign subsidiaries of US multinational companies (MNCs) is higher when the MNC's principal auditor engages a component auditor to audit the foreign subsidiary on its behalf. An important innovation of this study is that we focus on comparing the financial reporting quality of equivalent subsidiaries with and without component auditor work. Our approach contrasts with extant studies that examine the consequences of variation in the total amount of component auditor work at the MNC level. Our results are important for two reasons. First, we provide an alternative view on the consequences of component auditor use compared to the emerging literature in this area, which typically finds a negative association between the extent of component auditor use and financial reporting quality at the MNC level. Thus, we show that a different research design, conducted at the level at which component auditors actually perform their work, yields different inferences. Second, we demonstrate that using component auditors on US MNC group audits is an avenue through which US auditing institutions can affect financial reporting quality in foreign locations. We also reconcile our subsidiary‐level results to the MNC level by introducing a new MNC‐level component auditor “coverage” variable. Overall, we highlight that the best way to audit a foreign subsidiary is likely to be with a component auditor in the local country, which informs the debate surrounding recently proposed PCAOB guidance. RÉSUMÉ Les auditeurs des composantes situés à l’étranger nuisent‐ils à la qualité des rapports financiers? Analyse à l’échelle des filiales du recours aux auditeurs des composantes situés à l’étranger Nous postulons et établissons que la qualité des rapports financiers dans les filiales étrangères des multinationales des États‐Unis est plus élevée lorsque l'auditeur principal de la multinationale fait appel à un auditeur des composantes pour auditer la filiale étrangère en son nom. La présente étude innove de façon importante en comparant la qualité des rapports financiers de filiales équivalentes avec et sans le recours à des auditeurs des composantes. Notre approche diffère de celle des études antérieures qui examinent les conséquences des variations de la quantité totale de travail réalisé par les auditeurs des composantes à l’échelle des multinationales. Nos résultats sont importants pour deux raisons. D'abord, nous