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  • Jennifer M Mueller-Phillips
    An Examination of the Credence Attributes of an Audit
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind, 11.0 Audit Quality and Quality Control 
    Title:
    An Examination of the Credence Attributes of an Audit
    Practical Implications:

    At its core, the theory proposed by the authors assumes that auditors are economic agents who provide a valuable service and can be expected to behave rationally to maximize their profits. Strategic behaviors such as under-auditing, over-auditing, or overbilling would be unobservable by an auditee in many instances. The possibility of such behaviors has important implications for the level of assurance over financial reports and can potentially affect the efficient allocation of capital resources. One of the goals of this study was to analyze how the credence aspect of audits could influence important policy decisions. Regulation may play a powerful role in mitigating the credence nature of auditing, e.g., PCAOB inspections. However, regulation can be a double-edged sword if it increases the incentive or opportunity for auditors to behave strategically. Therefore, auditors can take the theories and models presented in this study to evaluate their firms for potential profit maximizing biases that may negatively impact audit quality and efficiency. Policy makers could also use these theories and models to evaluate how new auditing policies might influence auditors’ incentives and behaviors.

    For more information on this study, please contact W. Robert Knechel.
     

    Citation:

    Causholli, M., and W. R. Knechel. 2012. An Examination of the Credence Attributes of an Audit. Accounting Horizons 26(4): 631-656.

    Keywords:
    Credence attributes; audit quality; audit efficiency.
    Purpose of the Study:

    The purpose of this study was to expand the understanding of the economics of auditing and audit markets by using the theory of credence goods as the basis for explaining auditors’ incentives. The idea of a credence good or service is that (1) the seller of the good or service is an expert who both recommends and provides a level of service to the buyer; (2) buyers of credence goods or services cannot assess how a service is a delivered and must rely on a seller’s recommendation; and (3) buyers cannot assess how well the service was performed. The authors suggest that the external audit is a credence good which provides auditors with incentives to under-audit, over-audit or overcharge their clients.

    Design/Method/ Approach:

    The authors take a purely theoretical approach to study the perspective of an audit as a credence good. The authors rely on prior research of credence goods and on the principles of Game Theory to help explain auditors’ incentives to under-audit, over-audit or overcharge clients and predict auditors’ behaviors under certain scenarios. The authors use theoretical decision trees to describe an auditor’s possible strategies for bidding for an audit, and for executing the audit. The authors also describe examples of prior auditing research that present results that support the author’s credence theory.

    Findings:

        The authors propose that if an audit is a credence good, the auditee cannot determine any of the levels of audit effort that define the auditor’s decisions. This creates information asymmetry between the auditor and auditee both before and after the audit because the auditee cannot be sure of the true level of assurance that is necessary before the audit, and the auditee cannot be sure of the true level of assurance that is gained as a consequence of the audit. The information asymmetry goes in favor of the auditor, who can act strategically to under-audit and earn greater profits because the auditee has imperfect information about the auditor’s work and the level of assurance gained by the auditor’s efforts.

     The authors also propose that there are disciplining mechanisms in the market for audit services that are in place to mitigate an auditor’s incentive to behave strategically such as an auditee’s direct knowledge, audit firm reputation and size, professional regulation, legal liability, and competition between audit firms. However, while these mechanisms may be in place, an auditor facing low penalties or risk of detection may be more likely to consider strategic actions. In environments with weak courts or regulation, auditors have more incentives to act strategically and expect to reap superior profits as a result. Similarly, changes in regulations or other structural changes in the audit market can induce changes in the incentives for auditors to behave strategically. Overall, disciplining mechanisms facilitate the operation of audit markets even though they may not completely resolve the information (credence) problem.
     

    Category:
    Audit Quality & Quality Control, Auditor Judgment, Standard Setting
    Sub-category:
    Changes in Audit Standards, Prior Dispositions/Biases/Auditor state of mind
  • Jennifer M Mueller-Phillips
    An Inductive Typology of Auditing Research
    research summary posted March 4, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards 
    Title:
    An Inductive Typology of Auditing Research
    Practical Implications:

    This study has certain limitations that could be tackled in future research: in particular, the sample is based on published articles from 25 journals, therefore neglecting other journals and “grey literature”. However, this inductive typology could be further applied to present a structured framework of auditing research, and to analyze trends and emerging issues in comparative and/or longitudinal studies, research reports, and the like. Future investigations of the way research themes emerge and evolve should certainly contribute to a better understanding of auditing research.

    For more information on this study, please contact Cedric Lesage.

    Citation:

    Lesage, C. and H. Wechtler. 2011. An Inductive Typology of Auditing Research. Contemporary Accounting Research 29 (2): 487-504. 

    Keywords:
    typology; auditing research theme
    Purpose of the Study:

    A global picture of a specific complex domain in social sciences can be provided by typologies. Despite the usefulness and subsequent applications of the typologies proposed in past research, there are four concerns. First, the SK typology is arguably less efficient for structuring auditing research knowledge 30 years later. Second, the studies cited earlier concerned either a single journal, or a single period. Third, previous typologies are concept-driven rather than data-driven classifications. Fourth, they are practice-oriented rather than research-oriented. Taking these main concerns into consideration, the authors implement the study with the purpose to propose an updated, inductive, and comprehensive typology of auditing research. 

    Design/Method/ Approach:

    The study covers 25 main journals over all their years of publication from 1926 to 2005, and uses a computer-based content analysis of the abstracts of 3,143 selected articles. The authors first investigate how the identified keywords have changed since 1926, highlighting three key periods; then they provide a comprehensive typology of 16 major themes in auditing research, with the relative importance, significant keywords and periods, and the main contributory journals presented for each scheme. After that, the authors analyze trends in the popularity of each research theme over time and examine the contribution of individual journals to each theme.

    Findings:

    Compared with previous studies, this study’s typology is the first to be data-driven and covers the whole period between 1926 and 2005, comprising 3,143 auditing research articles. As a result, this new typology of auditing research themes provides a more representative picture of actual academic production than existing typologies, which are all based on a predefined practitioner’s structure. As an illustration, the authors have applied it to analyze trends in research themes and the most contributory journals to auditing research.

    Category:
    Standard Setting
    Sub-category:
    Changes in Audit Standards
  • The Auditing Section
    An Investigation of Auditor Perceptions about Subsequent...
    research summary posted April 13, 2012 by The Auditing Section, tagged 01.0 Standard Setting, 01.07 Impact of SEC Actions, 09.0 Auditor Judgment, 09.03 Adequacy of Evidence 
    Title:
    An Investigation of Auditor Perceptions about Subsequent Events and Factors That Influence This Audit Task
    Practical Implications:

    Auditors should recognize that an implicit tradeoff exists between the availability of subsequent event evidence and timelier reporting.  However, the net effect is not well understood because prior research has only focused on quantifying the benefits of timely reporting, not the costs associated with obtaining less subsequent event evidence.  The low evidence discovery rate reported by participants suggests that the current audit methodology might suffer from inefficiencies.  Further research should establish relative frequency information to help auditors generate hypotheses and guide audit planning.

     

    Citation:

    Janvrin, D. J. and C. G. Jeffrey. 2007. An Investigation of Auditor Perceptions about Subsequent Events and Factors That Influence This Audit Task.  Accounting Horizons 21 (3):  295-312

    Keywords:
    subsequent event; evidence evaluation; auditor judgment; timely reporting; accountants’ reporting.
    Purpose of the Study:

    Generally accepted auditing standards require auditors to consider subsequent events by examining transactions that occur after the balance sheet date.  In light of the Securities and Exchange Commission’s (SEC) decision to shorten the time between the balance sheet and report dates, this study seeks to better understand how auditors search for and discover subsequent event evidence in this new reporting environment.  Prior literature on this subject is sparse.  The Canadian Institute of Chartered Accountants (CICA) and the American Institute of Certified Public Accountants (AICPA) are concerned that audit quality will suffer because auditors now have less time to discover evidence of subsequent events.  For example, earnings management behavior is difficult to detect without persuasive evidence.  Specific study goals are as follows:

    •   Verify that auditors perceive subsequent event evidence to be important.
    •  Understand the process auditors employ to search for subsequent event evidence.  Standards suggest ten search procedures (e.g., reading interim financial statements prepared since the balance sheet date), but the degree to which auditors actually follow this guidance is not evident.
    •  Determine whether auditors uncover subsequent event evidence.  Measuring the perceived effectiveness of the ten recommended search procedures provides valuable feedback to the profession.
    •  Examine factors influencing this process.  Theory suggests the intensity of auditors’ search activities is influenced by balance sheet date judgment characteristics (i.e., transaction type, amount of supporting evidence, and consistency with prior expectations), characteristics of anticipated challenge evidence (i.e., consistency with prior expectations, and materiality) and environmental characteristics (i.e., length of search period, and time pressure).
    Design/Method/ Approach:

    A field-based experiential questionnaire was issued to U.S. auditors from each of the Big-4 firms and one national firm over a one-year period prior to November 2004. Participants had an average of 9.6 years of experience. Participants were asked to rate how often they search for and discover subsequent event evidence both in general, and using the ten procedures found in auditing standards.

    Findings:
    •  The authors find that auditors generally perceive subsequent event evidence as more important than the need for timely reporting, and that they use subsequent event evidence in the audit.
    •  The authors find that most auditors perform the majority of fieldwork after the balance sheet date, leaving potentially less time to gather subsequent event evidence.
    •  The authors find that auditors generally follow the ten suggested procedures.  However, the event discovery rate using any one procedure appears to be low.
    •  The authors find that auditors are more likely to search for and find subsequent event evidence when (1) minimal historical evidence exists, and (2) their balance sheet date judgments do not meet prior expectations.
    •  The authors find that auditors are more likely to search for evidence (1) when evaluating non-routine account balances, (2) that potentially impacts the financial statements as a whole rather than one account, and (3) when they have ample time to search.
    •  The authors find that auditors are more likely to find subsequent event evidence (1) that is consistent, rather than inconsistent, with their balance sheet date judgment, and (2) when the search period is longer.
    •  The authors find that time pressure does not impact whether auditors perceive that they find significant subsequent event evidence.
    Category:
    Standard Setting, Auditor Judgment
    Sub-category:
    Impact of SEC Actions, Adequacy of Evidence
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  • Jennifer M Mueller-Phillips
    Are PCAOB-Identified Audit Deficiencies Associated with a...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 09.0 Auditor Judgment, 09.04 Going Concern Decisions 
    Title:
    Are PCAOB-Identified Audit Deficiencies Associated with a Change in Reporting Decisions of Triennially Inspected Audit Firms?
    Practical Implications:

    Our findings seem to support statements made by the PCAOB regarding the usefulness of the inspection process in changing audit firm behavior.

    The change in GC reporting decisions that we find suggests either (1) an increased conservatism following a PCAOB inspection, of the audit firm on important reporting issues, and/or (2) an increased level of competence brought to the reporting decision.

    It is important to note that we find no change in the accuracy of the GC opinions, as measured by the future bankruptcy (or not) for clients that received a GC opinion.

    For more information on this study, please contact Jayanthi Krishnan.

    Citation:

    Gramling, A.A., J. Krishnan and Y. Zhang. 2011. Are PCAOB-Identified Audit Deficiencies Associated with a Change in Reporting Decisions of Triennially Inspected Audit Firms? Auditing: A Journal of Practice and Theory 30 (3): 59-79.

    Keywords:
    PCAOB inspection reports; going-concern; audit deficiencies.
    Purpose of the Study:

    At a broad level, we are obtaining evidence on whether the PCAOB inspection process is associated with changes in auditor behavior. More specifically, we examine whether PCAOB-identified audit deficiencies are associated with a change in triennially inspected audit firms’ going concern (GC) reporting decisions for their financially distressed clients. 

    Design/Method/ Approach:

    We obtained PCAOB inspection reports, dated between 01/01/2005 and 12/31/2007, from the PCAOB website. These reports covered PCAOB inspections of audits completed by the audit firms during 2004-2007. For the audit firms included in the sample, we read the inspection reports to identify those that indicated audit deficiencies. Data on GC opinions were obtained from Audit Analytics. The final sample on which we base our results consists of 202 audit firms and 1,648 client-year observations. The sample clients are distributed across a wide spectrum of industries, with over 50 two-digit SIC industries represented.

    Findings:
    • Firms with PCAOB-identified audit deficiencies were more likely to issue GC opinions for financially distressed clients subsequent to their PCAOB inspection than prior to their inspections.
    • While there was a change in behavior, the change does not suggest an improvement in reducing Type I errors (i.e., issuing a GC opinion to clients that subsequently remain viable) or Type II errors (i.e., failure to issue a GC opinion to a client that subsequently declares bankruptcy). Additional analysis indicates no systematic change in Type I and Type II errors following the issuance of a PCAOB report.
    • We find limited evidence of a change in the likelihood of issuing a GC opinion for audit firms that had no PCAOB-identified audit deficiencies. This finding suggests that the inspection reports without identified audit deficiencies have some, but limited, impact on changing audit firm behavior.
    Category:
    Auditor Judgment, Standard Setting
    Sub-category:
    Going Concern Decisions, Going Concern Decisions, Impact of PCAOB
  • Jennifer M Mueller-Phillips
    Are Revisions to SFAS No. 5 Needed?
    research summary posted February 19, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.03 Impact of New Accounting Pronouncements 
    Title:
    Are Revisions to SFAS No. 5 Needed?
    Practical Implications:

    The findings generally support FASB (2008) Exposure Draft assertions that there is often insufficient timely information about litigation available to users. Specifically, the authors find that in an unexpectedly large proportion of the cases they investigate, companies do not disclose lawsuits until a loss occurs. The authors also find a relatively high incidence of companies not providing estimated losses or ranges of losses prior to resolution. For a substantial number of cases, accruals for estimated losses are not made (or are at least not disclosed) prior to the realization of the loss. Further, the authors find a relatively high degree of disclosure of the items called for in the FASB’s (2008) Exposure Draft, suggesting that users already demand at least some of them.

    For more information on this study, please contact Ray J. Pfeiffer.

    Citation:

    Desir, R., K. Fanning, and R. Pfeiffer. 2010. Are revisions to SFAS No. 5 needed? Accounting Horizons 24 (4): 525-545.

    Purpose of the Study:

    Setting financial reporting standards, like most regulatory activities, requires decision-making under uncertainty.  In a typical standard-setting issue, standard setters receive information — typically in the form of (often unsupported) assertions — that there is some deficiency in existing Generally Accepted Accounting Principles.  For those alleged deficiencies that exceed a threshold, the Board and Staff of the FASB initiate a standard-setting project.  In their work on projects, Board and Staff members must make difficult judgments about the nature of guidance likely to resolve the deficiency while anticipating any indirect consequences of the contemplated new guidance.

    Empirical academic research has the potential to play a useful role in the standard setting process to the extent that it can be used to reduce the inherent uncertainty facing Board members. Ex ante empirical evidence is particularly desirable because it enhances the likelihood that new guidance is actually warranted and that any new guidance achieves its intended purpose.

    This paper reports the findings of an example of such ex ante empirical research.  The issue in question is the allegation that firms tend to provide insufficient and insufficiently timely disclosures of contingent legal obligations.  This assertion was an explicit part of the rationale underlying the FASB’s Exposure Draft, “Disclosure of Loss Contingencies” (FASB 2008b).  This paper has two intended contributions:  (1) to report the findings of empirical research about the extent of the alleged insufficient disclosure problem; and (2) to serve as an example of how empirical academic research can be informative to the FASB Board and Staff.

    Design/Method/ Approach:

    The authors assembled a representative random sample of unfavorable settlements and adjudications of lawsuits in firms’ 10-Q and 10K filed during the first half of 2007. For each resolved lawsuit, the authors coded characteristics of the disclosure in the period of resolution as well as in all prior periods where disclosure existed prior to resolution. The descriptive evidence of litigation-related disclosure was from financial statement notes and required SEC disclosures in the 10K or 10-Q. 

    Findings:
    • The authors find that firms did not disclose 7.8% of the lawsuits in their sample in the quarter immediately preceding resolution, or in any period prior to resolution.
      • Twenty percent of the cases involving large losses (i.e., greater than 5% of pretax income) and 14% of the cases involving core operations fail to disclose the lawsuit in the quarter prior to resolution, suggesting this non-disclosure is not driven by lawsuits involving small dollar amounts or that are unrelated to core operations.
    • The authors find that firms provided estimates of the loss or range of possible loss (or explicitly stated that an estimate could not be made) in only 47.1% of the resolved lawsuits in their sample.
    • The authors find that companies accrue for such losses (or at least disclose that an accrual has been made) in 60.8% of cases.
      • For those cases that are larger (i.e., greater than 5% of pretax income) the accrual rate is 55%. For those cases related to core operations, the accrual rate is 59.1%, suggesting larger losses and losses related to core operations are not necessarily accrued more often.
    • The authors find a relatively high degree of disclosure of the items called for in the FASB’s (2008) Exposure Draft.
    Category:
    Standard Setting
    Sub-category:
    Impact of New Accounting Pronouncements
  • Jennifer M Mueller-Phillips
    Associations between Internal and External Corporate...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance 
    Title:
    Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements
    Practical Implications:

    Prior studies’ conflicting results regarding the association between corporate governance measures and restatements are explained (at least partially) by the time period in which the relationship is examined. The relationship is different before and after Sarbanes Oxley (2002). However, this paper cannot determine whether the change in relationship was caused by Sarbanes Oxley or whether it happened for another reason.

    For more information on this study, please contact William R. Baber.
     

    Citation:

    Baber, W. R., L. Liang, and Z. Zhu. 2012. Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements. Accounting Horizons 26 (2): 219-237.

    Keywords:
    corporate governance; governance regulation; accounting restatements
    Purpose of the Study:

    Prior studies have found conflicting results as to whether corporate governance characteristics are related to accounting restatements. Some of these prior students examine restatements prior to Sarbanes Oxley (2002), and some examine restatements afterwards. This study seeks to reconcile the findings of previous research and determine whether the relationship between corporate governance and accounting restatements has changed over time.

    Design/Method/ Approach:
    • Authors examine corporate governance data from 1997 and 2005 to compare differences in governance over time.
    • Corporate governance characteristics are divided between factors that affect internal governance (defined as characteristics that presumably govern the efficacy of board of director oversight of management) and factors that affect external governance (defined in terms of the ability of shareholders to intervene in decisions by both management and the board of directors)
    • Investigate the association between 1997 corporate governance and the probability that financial statements from 1995-1999 are restated; also investigate the association between 2005 corporate governance and the probability that financial statements from 2003-2007 are restated.
       
    Findings:
    • There is a substantial increase in internal governance during the period when changes were imposed by stock exchanges and by the U.S. Congress in the Sarbanes-Oxley Act (2002). The change in internal governance is offset by a less substantial, yet statistically significant, decrease in external governance which is consistent with the observation that shareholder oversight is recently declining.
    • In 1997, internal and external governance characteristics are substitutes for each other (firms tend to do one or the other); in 2005, however, internal and external governance is not related.
    • Corporate governance characteristics in 1997 (prior to Sarbanes Oxley) are unrelated to the probability of financial statement restatements, whereas the correlation between corporate governance characteristics and restatements is statistically significant in 2005 (after Sarbanes Oxley).
      • Thus, the cross-sectional relationship between governance characteristics and restatement changed between 1997 and 2005.
    • The relationship between corporate governance measures in 2005 and restatements in 2003-2007 is not significant if interactions between internal and external governance measures are omitted from the model.
       
  • The Auditing Section
    Assurance on XBRL for Financial Reporting
    research summary posted April 13, 2012 by The Auditing Section, tagged 01.0 Standard Setting, 01.01 Changes in Reporting Formats 
    Title:
    Assurance on XBRL for Financial Reporting
    Practical Implications:

    Auditors should recognize that agreement between the rendered and source documents alone does not provide sufficient evidence that financial statements are appropriately tagged.  If issues regarding sampling and materiality cannot be sufficiently resolved, the alternative is 100 percent testing, which may be more expensive than investors, regulators, and other users are willing to pay.  Technological advances are likely to yield applications that assist auditors in determining the appropriateness of XBRL tags based semantic relationships.  As the public availability of XBRL-tagged data reaches a critical mass, auditors may leverage it to perform analytic procedures that can be relied on to create efficiencies in other aspects of an audit engagement.  Given the granular nature of the data-centric reporting environment, different levels of assurance (e.g., data-level and continuous assurance) are receiving considerable attention by academic researchers and may eventually lead to significant shifts in the assurance model, including the use of specialized audit teams and/or third-party providers.

    Citation:

    Plumlee, R. D., and M. A. Plumlee. 2008. Assurance on XBRL for Financial Reporting.  Accounting Horizons 22 (3):  353-368. 

    Keywords:
    accountants' reporting; XBRL
    Purpose of the Study:

     This commentary raises several issues about the nature of assurance services in a data-centric reporting environment facilitated by eXtensible Business Reporting Language (XBRL), dubbed “interactive data” by the Securities and Exchange Commission (SEC).  Interactive data yields many benefits for end users.  However, the process of tagging and contextualizing financial facts creates another potential source of material misstatements.  The procedures needed to detect tagging errors are beyond the scope of a traditional financial statement audit.  As XBRL awareness increases, users will demand assurance that both the financial statement facts and the tagging of those facts are reliable.  This has important consequences for audit practitioners.

    Design/Method/ Approach:

     A sizable portion of the paper describes the history and technical features of XBRL to give readers sufficient background information to understand audit challenges posed by the tagging process.  Each audit issue is then discussed and supported by examples.

    Findings:
    •  The Public Company Accounting Oversight Board (PCAOB) and the American Institute of Certified Public Accountants (AICPA) have issued guidance for practitioners voluntarily engaged to examine XBRL-related documents that focuses on “agreeing” rendered XBRL reports with the traditional paper-centric documents (i.e., PDF, HTML or Word document).  This
      guidance caters to users who primarily rely on the printed form of financial statements and ignores how underlying tagging errors can affect computer interpretation of financial data.
    •  Current guidance suggests that auditors might use sampling techniques.  However, traditional sampling links the dollar amounts of account balances to selection probability, and it is not clear whether these techniques can be appropriately adapted to test the qualitative nature of the XBRL tagging process. 
    •  The concept of materiality has different implications for the planning of audit procedures in the XBRL environment because the risk of material mistagging is unrelated to item size (i.e., a single inappropriate or missing tag could result in the statement “taken as a whole” being materially misstated).  Furthermore, evaluation of materiality, as it relates to the financial statements taken as a whole, might no longer make sense if users selectively extract individual financial facts for peer group analysis.
    •  The XBRL assurance process is complicated by the ability of firms to create extension taxonomies (i.e. firm-specific tags that do not exist in the standard base taxonomy) because the appropriateness of such extensions is highly judgmental.
    •  The scope and form of XBRL assurance engagements has been debated.  Future considerations include whether assurance should be provided on all XBRL-related documents or just the instance document, and whether alternative engagements (i.e., reviews and agreed-upon procedures) would satisfy investors’ needs.
    Category:
    Standard Setting
    Sub-category:
    Changes in Reporting Formats, Changes in Reporting Formats
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  • Jennifer M Mueller-Phillips
    Audit Committee Director-Auditor Interlocking and...
    research summary posted March 2, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.02 Board/Financial Experts, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Audit Committee Director-Auditor Interlocking and Perceptions of Earnings Quality
    Practical Implications:

    This study is important to provide an insight into the personal relationships and familiarity between audit committee directors and external auditors in terms of auditor independence. Furthermore, our examination of AC director-auditor interlocking provides a more complete basis for understanding the effectiveness of corporate governance in guarding earnings quality. The results not only support the view that AC director-auditor interlocking positively affects investors’ perception of earnings quality, but also support the regulatory requirement that audit committees include at least one financial expert.

    For more information on this study, please contact Jeng-Fang Chen.

    Citation:

    Chen, J.-F., Y.-Y. Chou, R.-R. Duh, and Y.-C. Lin. 2014. Audit committee director-auditor interlocking and perceptions of earnings quality. Auditing: A Journal of Practice and Theory 33 (4): 41-70

    Keywords:
    Audit committee director-auditor interlocking, investor perceptions, earnings response coefficients, financial expert
    Purpose of the Study:

    In response to Enron and subsequent financial reporting scandals, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 (SOX, hereafter), which put particular emphasis on the role of audit committees in ensuring financial reporting quality. Although existing regulations stipulate the composition and qualifications of audit committee directors, audit committee director interlocking that arises when an audit committee director serves on more than one audit committee is allowed. Therefore, we analyze how investors perceive reported earnings when companies with interlocking audit committee directors are audited by the same audit firm (hereafter, AC director-auditor interlocking), using earnings response coefficients (ERCs) as a proxy for investor perceptions of earnings quality. The tendency of AC director-auditor interlocking could have positive or negative implications for the audit committee’s effectiveness in guarding earnings quality.

    • A positive influence may result insofar as closer personal relationships enhance the audit committee’s understanding and trust of auditors, thereby making interlocking audit committee directors more likely to support the auditor in accounting and auditing disputes.
    • An opposing argument is that economic incentives may compromise auditor independence. Also, interlocking audit committee directors may be less critical of auditor performance due to personal relationships with the interlocking auditor.

    Besides the relationship between AC director-auditor interlocking and ERCs, this study investigates whether the potential positive impact of AC director-auditor interlocking in improving earnings quality would be outweigh the potential negative influence in the post-SOX period, when shareholders and regulators have higher expectations and heighten liability concerns for both interlocking audit committee directors and auditors. In particular, this study examines if earnings quality is higher when interlocking audit committee directors are financial experts who are better placed to recommend streamlining of audit committee procedures on the financial reporting process.

    Design/Method/ Approach:

    We collect director information through the RiskMetrics database, which covers S&P 1500 companies, from fiscal years 1998 to 2010, while the impact of financial experts is examined by a sample from fiscal years 2003 to 2010. This study uses ERCs from returns-earnings regressions and designs three measures for the degree of a firm’s AC director-auditor interlocking to examine its impact on earnings quality. 

    Findings:
    • This study finds that a greater extent of AC director-auditor interlocking is perceived as associated with higher earnings quality.
    • This study finds that investors’ perceptions of earnings quality are more affected by the extent of AC director-auditor interlocking in the post-SOX era than before it, whatever we use the pre- and post-SOX subsamples or the interaction item of SOX for the test.
    • This study finds that investors perceive AC director-auditor interlocking especially positively when interlocked audit committee directors are financial experts. That is, the results document that the positive impact of AC director-auditor interlocking on the ERCs is more pronounced when interlocking audit committee directors are financial experts.
    Category:
    Corporate Matters, Governance, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Board/Financial Experts, Impact of SOX
  • Jennifer M Mueller-Phillips
    Audit committee stock options and financial reporting...
    research summary posted July 30, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.04 Board/Audit Committee Compensation 
    Title:
    Audit committee stock options and financial reporting quality after the Sarbanes-Oxley Act of 2002.
    Practical Implications:

    This study contributes to existing literature by re-examining the relationship between audit committee compensation and financial reporting quality. The findings indicate the continuance of a negative relationship between audit committee members’ stock-option compensation and financial reporting quality in the post-SOX era. These results are relevant to regulators, compensation committees, and auditors because they imply that shifting audit committee director compensation away from stock options has the potential to improve financial reporting quality.

    Citation:

    Campbell, J. L., J. Hansen, C. A. Simon, and J. L. Smith. 2015. Audit Committee Stock Options and Financial Reporting Quality after the Sarbanes-Oxley Act of 2002. AUDITING: A Journal of Practice & Theory 34 (2):91-120.

    Keywords:
    audit committee quality, financial reporting oversight, financial reporting quality, independence
    Purpose of the Study:

    The Sarbanes-Oxley Act (SOX) was passed by Congress in 2002 in order to improve the accuracy and reliability of corporate disclosures. The introduction of SOX resulted in a substantial increase in audit committee members’ required level of independence and responsibility. In defining independence, however, regulators did not restrict companies from providing equity incentives for audit committee members. Pre-SOX research has shown stock option incentives to be associated with lower financial reporting quality. This study aims to re-examine the association between audit committee equity-based incentives and financial reporting quality (as proxied by a company’s propensity to meet or beat its consensus analyst forecast) in the post-SOX environment.

    Design/Method/ Approach:

    After removing problematic data, the sample collected for the study consisted of audit committee members’ equity holdings and compensation data for a sample of 2,172 company-year observations from 2006 to 2008. This information was then used in conjunction with a series of probit models in order to examine whether audit committee member’ equity incentives are associated with the likelihood of meeting or beating the analyst forecast. In order to mitigate the effect of outliers, the top and bottom 1% of the selection was winsorized.

    Findings:

    Findings were consistent with stock-option incentives being associated with lower financial reporting quality. Specifically, it was found that:

    • 58.8 percent of the average audit committee members’ pay is in the form of stock options and grants.
    • The likelihood of meeting or beating analyst expectations is positively associated with audit committee members’ stock-option compensation and holdings.
    • There is no association for non-equity compensation and holdings, and meeting or beating analyst expectations.
    • A company whose audit committee holds the mean value of exercisable options (i.e., about $200,000 in exercisable options) is associated with a 10.0 percent increase in the likelihood of meeting or beating its consensus analyst forecast.
    • A high-growth opportunity company whose audit committee holds the mean value of exercisable options is associated with a 17.8 percent increase in the likelihood of meeting or beating its consensus analyst forecast.
    Category:
    Governance, Independence & Ethics
    Sub-category:
    Board/Audit Committee Compensation, Impact of SEC Rules Changes/SarBox
  • Jennifer M Mueller-Phillips
    Audit Partner Rotation and Financial Reporting Quality
    research summary posted February 15, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 11.0 Audit Quality and Quality Control, 11.01 Supervision and Review – Effectiveness 
    Title:
    Audit Partner Rotation and Financial Reporting Quality
    Practical Implications:

    This study informs the debates on costs and benefits of audit partner rotation. The results support concerns of the audit profession that audit partner rotation may impair the quality of audited financial information in the initial years of a new partner’s engagement with a client. This impairment appears to be more pronounced for larger clients and clients of non-Big 4 audit firms. Furthermore, the persistence of these quality consequences for non-Big 4 audit firms raises questions about the resource capacity of such firms to cope with imposing regulations. Given that partner rotation has both monetary and social costs, perhaps the decision to shorten partner engagement with a client from seven to five years is not in the best interests of auditors and investors. Ultimately, the costs of an audit will be passed onto investors, and as the study suggests, more frequent rotation may mean more periods of lower financial statement quality in the initial years of a partner’s engagement with a client. Additionally, the study’s city-level industry specialist and office size results suggest industry specialists and larger audit firm offices may have more capacity to absorb and manage partner rotation effects than non-specialists and smaller offices. Such findings support the audit profession’s concern over resource challenges brought on by more stringent partner rotation requirements. 

    For more information on this study, please contact Paul Tanyi.

    Citation:

    Litt, B., D. S. Sharma, T. Simpson and P. N. Tanyi. 2014. Audit Partner Rotation and Financial Reporting Quality. Auditing: A Journal of Practice and Theory 33 (3): 59-86

    Keywords:
    Audit quality, earnings management, financial reporting quality, discretionary accruals, meet or beat, partner rotation, partner change
    Purpose of the Study:

    Audit partner rotation has received considerable attention globally and in the U.S. since Section 203 of the Sarbanes-Oxley Act of 2002 accelerated the rotation period for lead and concurring engagement partners from seven to five years and expanded their cooling-off period from two to five years. Policymakers have rationalized these regulations based on enhanced partner independence and a fresh set of eyes examining the financial statements, thus increasing overall audit quality. However, the audit profession has argued that the loss of engagement partner continuity and client-specific knowledge brought on by increased rotation may actually hinder the quality of the audit. Despite such debate, there is a paucity of research on the effects of audit partner rotation in the U.S., largely due to the absence of publicly available information on audit partners. Using a novel approach to determine audit partner rotation, the authors are able to investigate the effect of rotation on financial reporting quality in the U.S. 

    Design/Method/ Approach:

    After performing procedures to obtain assurance on audit firm compliance with rotation regulations, the authors collect data from 2000 to 2010 for a sample of U.S. public clients that have changed audit firms. From this data, they are able to determine: (1) the first year of a partner’s engagement with a client (the year of audit firm change), (2) the year of audit partner rotation (five years later), and (3) the post-rotation year that a new audit partner leads the audit engagement (the sixth year post-audit firm change). The authors then examine whether financial reporting quality differs between the final two years with an outgoing partner and the first two years with a new partner post-rotation by evaluating discretionary accruals and going-concern reporting for these periods.

    Findings:
    • The authors find that financial reporting quality is lower during the first two years with a new audit partner as compared to the last two years with an outgoing partner. 
    • The authors find that partner rotation has a more adverse effect on financial reporting quality for larger clients of Big 4 auditors and across all clients of non-Big 4 auditors. 
    • The authors find the decline in financial reporting quality to be limited to the first year post-rotation for larger Big 4 clients, but persistent for up to three years post-rotation for non-Big 4 clients.
    • The authors find that non-specialist audit firms and audit firms with smaller offices at the city-level exhibit lower financial reporting quality as a result of rotation.
    • The authors find that financial reporting quality is less negatively affected during the first two years of an audit partner’s engagement with a client relative to the first two years of an audit firm’s engagement with a client.
    Category:
    Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of SOX, Supervision & Review – Effectiveness

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