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  • Jennifer M Mueller-Phillips
    Client Engagement Risks and the Auditor Search Period.
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment 
    Title:
    Client Engagement Risks and the Auditor Search Period.
    Practical Implications:

    This paper contributes to the auditing literature in three ways. First, it sheds light on whether or not perceived engagement risks affect the ASP, a previously unaddressed question. Second, it provides greater insight into the client acceptance decision. This decision has become increasingly important because of auditor litigation, insurance costs, reputational damage, and regulatory review of the auditing profession in the post-SOX era. Third, it contributes to the understanding of whether the provision of nonaudit services alters auditor decision making by documenting that the potential to provide nonaudit services does not necessarily alter the attractiveness of a prospective client or shorten the search period.
     

    Citation:

    Khalil, S. K., J. R. Cohen, and K. B. Schwartz. 2011. Client Engagement Risks and the Auditor Search Period. Accounting Horizons 25 (4): 685-702.

    Keywords:
    audit risk, auditor search period, client acceptance
    Purpose of the Study:

    The past decade has witnessed an increased interest in the auditor’s client acceptance decision and in the way audit firms evaluate potential clients. The interest arises, in part, from litigation against auditors, competitive market forces, and recent advances in information technology that have affected and redefined the attestation process. Audit firms assess the risks associated with a prospective client (also known as engagement risks or client acceptance risks), the profitability and billing rate, and the risk/return relationship before submitting a formal engagement proposal and entering into fee negotiations.

    The authors investigate whether risk lengthens the acceptance phase for audit firms and results in a longer auditor search period for their clients. The authors posit that the auditor search period (ASP) following auditor resignations is significantly longer for riskier clients because of the additional time needed to collect and analyze information and to obtain required approvals within the audit firm. They focus on auditor resignations since the ASP, which is essentially unobservable, can be more accurately approximated for auditor resignations than auditor dismissals. Firms whose auditors resign may know about the resignation decision at or just before the resignation date. As such, the audit search process formally starts at or a short time before the auditor resignation date reported on a registrant’s Form 8-K filing. In contrast, firms planning to dismiss their auditor are aware of the dismissal decision long before the dismissal date. Hence, the auditor search period may start long before the dismissal date reported on the Form 8-K filings.

    Design/Method/ Approach:

    The authors test the hypotheses using a sample of auditor resignations obtained from the Audit Analytics database. The final sample includes 216 auditor resignations in firms (1) listed on major U.S. stock exchanges (NYSE, AMEX, NASDAQ), (2) with a ticker available, and (3) reporting at least one auditor resignation over the period 20032008.

    Findings:

    Findings support the client business risk hypothesis by documenting a longer ASP for firms that are in financial distress. Results also support the audit risk hypothesis, given that the ASP is longer for firms that report internal control weaknesses issues. Findings further support the auditor business risk hypothesis by showing a shorter ASP for firms hiring an industry specialist audit firm.

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Auditor Resignation and Risk Factors.
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 02.06 Resignation Decisions, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
    Title:
    Auditor Resignation and Risk Factors.
    Practical Implications:

    This study sheds light on why auditors choose to resign from auditing particular clients. The authors find that public information about audit risk, business risk, and litigation risk as well as private information about audit risk and business risk all play a role in the auditor’s resignation decision. This is useful for audit firms and regulators to consider. 

    Citation:

    Ghosh, A. and C.Y. Tang. 2015. Auditor Resignation and Risk Factors. Accounting Horizons 29 (3): 529-549.

    Keywords:
    auditor resignations, litigation risk, audit risk, business risk
    Purpose of the Study:

    While prior research has suggested litigation risk as the main reason for auditor resignations, the competing explanations of audit risk and business risk have not been tested concurrently to discover their incremental importance. Furthermore, prior research has not been able to isolate the auditor’s private information from public information about these risks. The authors attempt to close this gap in the literature by studying whether and how much the auditor’s private information about future audit risk, business risk, and litigation risk impacts the auditor’s resignation decision.

    Design/Method/ Approach:

    The authors use data from publicly-traded companies that switched auditors during the 1999-2010 time period. First, they compare auditor resignations to auditor dismissals based on pre-switch audit risk, business risk, and litigation risk. Then they test whether auditor resignations predict post-switch audit risk (e.g. internal control problems), business risk (e.g. delisting from stock exchange), and litigation risk (e.g. class-action lawsuits).

    Findings:
    • Compared to clients from which auditors have been dismissed, clients from which auditors resigned tend to have greater litigation risk, audit risk, and business risk before the change in auditors, but greater audit risk and business risk after the change.
    • The litigation risk, business risk, and audit risk existing before an auditor chooses to resign from an engagement all impact the auditor’s resignation decision, with litigation risk having the largest impact and audit risk the smallest.
    • Clients whose auditors have resigned are more likely to experience class-action lawsuits, internal control problems, and delisting from a stock exchange.
    • Auditor resignations reveal no private information about future litigation risk.
    • Auditor resignations reveal private information about future audit risk and future business risk, especially when one of the Big 4 audit firms resigned.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment, Litigation Risk, Resignation Decisions
  • Jennifer M Mueller-Phillips
    U.S.-Listed Foreign Companies' Choice of a U.S.-Based...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 15.0 International Matters 
    Title:
    U.S.-Listed Foreign Companies' Choice of a U.S.-Based versus Home Country-Based Big N Principal Auditor and the Effect on Audit Fees and Earnings Quality.
    Practical Implications:

    This study offers insights into the value of a U.S.-based Big N audit in a U.S.-crosslisting context and suggests that the higher fees associated with a U.S.-based (vis-a` -vis home country-based) Big N principal auditor are not just price protection; i.e., U.S.-based Big N principal auditors are not simply shifting the expected cost of the additional litigation exposure to the foreign client. Rather, they are also improving the financial reporting environment by providing the U.S.-listed foreign client higher-quality audited earnings. U.S.-listed foreign companies and U.S. investors may be interested in the finding that U.S.-based (relative to home country-based) Big N principal auditors are associated with higher fees as well as higher earnings quality for these companies.

    Citation:

    Asthana, S. C., K. K. Raman, and H. Xu. 2015. U.S.-Listed Foreign Companies' Choice of a U.S.-Based versus Home Country-Based Big N Principal Auditor and the Effect on Audit Fees and Earnings Quality. Accounting Horizons 29 (3): 631-666.

    Keywords:
    audit fees, Big N auditor, outsourcing, PCAOB, quality of audited earnings, U.S.-listed foreign
    Purpose of the Study:

    In this paper, the authors examine why U.S.-listed foreign companies choose to have a U.S.-based (rather than home country-based) Big N firm as their principal auditor for SEC reporting purposes. They also investigate whether the choice of a U.S.-based Big N principal auditor impacts audit pricing and the quality of audited earnings for these U.S.-listed foreign companies. In effect, the authors examine whether these foreign companies can provide additional assurance (i.e., assurance over and above that provided by the U.S.-listing decision itself) by utilizing a U.S.-based rather than home country-based Big N principal auditor for SEC reporting purposes.

    Audit markets are country specific due to country-level regulation and licensing of auditors, as well as restrictions on the cross-border flow of labor. Further, to comply with country-specific regulations, which mandate that audit firms be controlled and owned by locally licensed professionals, the Big N are structured as an international network of independent national member partnerships. In other words, for a U.S.-listed foreign client employing a home country-based Big N auditor for SEC reporting purposes, the U.S.-based Big N firm (i.e., the U.S. affiliate) is essentially protected from the failures of the home country-based Big N firm (i.e., the home country affiliate).

    Design/Method/ Approach:

    The authors follow the sample selection procedure in Srinivasan et al. (2015). They use Audit Analytics, Compustat and CRSP to gather data for the period 20002012. This procedure leaves the authors with a sample of 5,164 client year observations for 628 unique clients from 49 countries.

    Findings:
    • The findings suggest that client size, the proportion of income earned abroad, and investor protection in the home country are all associated with the likelihood of selecting a U.S.-based (versus home country-based) Big N auditor.
    • Results suggest U.S.-based (relative to home country-based) Big N auditors charge higher audit fees for U.S.-listed foreign clients.
    • The results suggest that the higher fees reflect additional assurance in that U.S.-based (vis-a` -vis home country-based) Big N principal auditors are associated with higher earnings qualityas measured by lower income-increasing discretionary accruals, a reduced likelihood of reporting a small profit, or a small increase in earnings, as well as more timely loss reportingfor their U.S.-listed foreign clients.
    • U.S.-listed foreign clients’ reported earnings have greater explanatory power for stock returns when they are audited by a U.S.- based (versus home country-based) Big N principal auditor. 
    • The overall findings to suggest that for U.S.-listed foreign companies the quality of audited earnings is higher when the Big N principal auditor is U.S.-based rather than home country-based.
    Category:
    Client Acceptance and Continuance, International Matters
    Sub-category:
    Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    Abnormal Audit Fees and Audit Quality: The Importance of...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 11.0 Audit Quality and Quality Control, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management.
    Practical Implications:

    This paper provides new evidence on the fee-quality relationship using the propensity to use income-increasing discretionary accruals to meet or beat analysts' forecasts. The evidence in this paper suggests that abnormal audit fees are positively related to audit quality. This result is consistent with concerns raised by regulators that lower audit fees could reflect a lower level of effort provided by the auditor. This is important, given the trend of declining audit fees in recent years. By finding different results using a more focused sample of firms with the incentive and ability to manage earnings, this study highlights the importance of considering the context when performing tests of earnings management. This information is of interest to regulators, such as the SEC.

    Citation:

    Eshleman, J. D., & P. Guo. 2014. Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management. Auditing: A Journal of Practice & Theory 33 (1): 117-138.

    Keywords:
    audit fees, audit quality, discretionary accruals, meet-or-beat, earnings management
    Purpose of the Study:

    In this study, the authors attempt to shed light on the conflicting evidence by performing a study of the relationship between abnormal audit fees and audit quality using a new research design. Specifically, the authors examine whether clients paying abnormal audit fees are more or less likely to use discretionary accruals to meet or beat the consensus analyst forecast.

    A growing body of accounting literature examines the relationship between audit fees and audit quality. Researchers are interested in this relationship because, ex ante, it is not clear whether receiving higher fee revenue from a client will improve audit quality or harm it. On the one hand, it could be argued that an auditor who receives abnormally high audit fees from a client will lose their independence and allow the managers of the client firm to engage in questionable accounting practices. However, it is also possible that audit fees are a measure of audit effort, i.e., higher fees indicate that the auditor worked more hours, signaling greater effort. To the extent that audit fees are a measure of audit effort, low audit fees could harm audit quality.

    Design/Method/ Approach:

    Audit fee and auditor data are obtained from Audit Analytics, financial statement data are obtained from Compustat, and analyst forecast data are obtained from the I/B/E/S database. The authors perform tests on two samples of 4,476 firm-years and 1,670 firm-year observations spanning 2000 to 2011.

    Findings:

    The authors find that clients paying higher abnormal audit fees are significantly less likely to use discretionary accruals to meet or beat the consensus analyst forecast. If abnormal audit fees are held at their mean, a one-standard-deviation increase in abnormal audit fees decreases the client's likelihood of using discretionary accruals to meet or beat the consensus forecast by approximately 5 percent. This is consistent with higher audit fees being indicative of greater auditor effort and, ultimately, better audit quality. The authors obtain similar results whether they use the audit fee model of Choi et al. (2010), the one proposed by Blankley et al. (2012), or their own audit fee model.

    Category:
    Audit Quality & Quality Control, Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Earnings Management
  • Jennifer M Mueller-Phillips
    The Cost of Compliance to Sarbanes-Oxley: An Examination of...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions 
    Title:
    The Cost of Compliance to Sarbanes-Oxley: An Examination of the Real Estate Investment Industry.
    Practical Implications:

    The results suggest that viewing the impact of SOX as occurring only once, ignoring either the costs due to the independence requirements or the later impact of Section 404 internal control provisions, and failure to control adequately for business complexity, may have resulted in the prior studies underestimating the effect of SOX on audit and audit related fees.

    Citation:

    Shaw, W. H., and W. D. Terando. 2014. The Cost of Compliance to Sarbanes-Oxley: An Examination of the Real Estate Investment Industry. Auditing: A Journal of Practice & Theory 33 (1): 177-186.

    Keywords:
    audit pricing, Sarbanes-Oxley
    Purpose of the Study:

    The purpose of this paper is to document the extent to which Sarbanes-Oxley (SOX) impacted the costs of audits. The authors conduct a within-industry test of the effect of the SOX enactment on audit pricing in one industry, real estate investment firms (REITs). This industry was selected because of its simple business and industry structure. To retain their favorable tax structure, REITs are required to operate only domestically and in only one business segment, remain 70 percent invested in domestic real estate or real estate mortgages, and pay out 90 percent of earnings each year to investors. As a result, all REITs are classified within one four-digit SIC code. This transparent business structure eliminates the need for the inclusion of complexity variables for foreign operations and business segments. The lack of business complexity in the REIT industry would suggest that the primary determination of audit fees within the industry would be firm size. The lower inherent risk of the REIT industry is supported by the fact that level of audit fees paid by the average REIT prior to Sarbanes-Oxley was equal to that paid by an industrial firm one-seventh its size. 

    Design/Method/ Approach:

    The authors obtained a list of all publicly traded REITs from the National Association of Real Estate Investment Trusts, and from Compustat total assets, long-term debt, and cash from operations for the years 2001-2005. They compiled a final sample of 130 firms with complete data from 2001 through 2015.  Nineteen of the 112 firms were listed on the American Stock Exchange, four on NASDAQ and 89 on the New York Stock Exchange.

    Findings:
    • The authors find support for their concern that dummy variables in prior studies do not adequately capture business complexities.
    • The authors show that the REIT industry actually incurred an 88 percent increase in audit and audit-related fees during the SOX implementation period after controlling for other audit and client characteristics, as compared to 74 percent in the Ghosh and Pawlewicz (2009) study.
    • They also show that ignoring intra-industry variations in audit pricing would have led to a conclusion that the increase due to SOX for REITs was 97 percent.
    • The authors find that by assuming that the increase in audit fees due to SOX occurred only in 2002, and not also in 2004 when the internal control provisions became effective, understates the estimation of the effects of SOX on audit pricing.
    • The authors find that the enactment of Titles 200 and 300, which was meant to enhance auditor independence, resulted in a 52 percent increase in audit fees for REITs, while Section 404, which required internal control testing, led to a 145 percent increase.
    Category:
    Client Acceptance and Continuance, Standard Setting
    Sub-category:
    Audit Fee Decisions, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Impact of CEO and CFO Equity Incentives on Audit Scope...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 14.0 Corporate Matters, 14.01 Earnings Management, 14.07 Executive Compensation 
    Title:
    The Impact of CEO and CFO Equity Incentives on Audit Scope and Perceived Risks as Revealed Through Audit Fees.
    Practical Implications:

    The findings shed some light on the PCAOB proposal to require auditors to obtain an understanding of executive compensation plans. The PCAOB asserts that auditors may not adequately consider the earnings manipulation risk arising from compensation arrangement. The study finds that auditors do not charge a fee premium for delta risk. Whether that result reflects auditors’ neglect of the risks of delta or their professional diligence and an assessment that delta incentives do not pose a significant risk is unclear. The authors find that auditors charge a premium for vega incentives and that the premium is diminishing with residual auditor business risk. These results suggest that auditors are cognizant of the risk implicit in compensation arrangements and price that risk in a manner that is consistent with incentive-compatible compensation schemes.

    Citation:

    Kannan, Y. H., T. R. Skantz, and J. L. Higgs. 2014. The Impact of CEO and CFO Equity Incentives on Audit Scope and Perceived Risks as Revealed Through Audit Fees. Auditing: A Journal of Practice & Theory 33 (2): 111-139.

    Keywords:
    agency theory, audit fees, earnings manipulation, equity incentives
    Purpose of the Study:

    Consistent with agency theory, research finds that linking CEO wealth to own-firm share price reduces agency costs by aligning manager and shareholder interests. However, equity incentives may also contribute to agency costs through a higher incidence of accounting irregularities. Through an examination of the association between audit fees, and CEO and CFO equity incentives, this paper takes an audit perspective of the risks inherent in equity incentives. If the risk of accounting irregularities increases with equity incentives, the authors would expect audit fees to be positively associated with those incentives.

    In 2013, the Public Company Accounting Oversight Board (PCAOB) proposed an amendment to Auditing Standard No. 12 that would require auditors to consider executive compensation in audit planning because of potential fraud risk associated with equity incentives. The authors use the association between audit fees, and CEO and CFO equity incentives to infer whether auditors increase audit scope and perceive greater risk as equity incentives increase. Equity incentives are defined as the sensitivity of the value of executives’ equity portfolios to changes in share price (delta incentive) and to changes in return volatility (vega incentive).

    Design/Method/ Approach:

    The authors collect data from Audit Analytics, the Standard & Poor’s (S&P) ExecuComp database, S&P’s Compustat annual industrial and research files and the Center for Research in Security Prices (CRSP). The authors collect equity incentive data for both CEOs and CFOs. CEO data are available beginning in 1999; however, CFO compensation data are available only since 2006, following a change to the SEC’s disclosure regulations. Both samples end with fiscal years ending on June 30, 2012. The initial sample is 16,021 firm-years for CEOs and 8,194 firm-years for CFOs.

    Findings:

    The authors find that audit fees do not increase with CEO and CFO delta incentives and that the fee premiums for the audit risk proxies are also independent of delta incentives. These findings suggest that, from the auditor’s perspective, audit risk is not increasing with CEO and CFO delta incentives, and that the auditor’s expected losses from financial statement irregularities, as implied by the fee premiums on discretionary accruals and restatements, are unaffected by delta incentives.

    The results for vega are more complex. The authors find that audit fees increase as CEO and CFO vega incentives increase; however, the fee premium for residual auditor business risk is decreasing as vega increases. These findings lead to varying interpretations.

    The authors find a positive association between audit fees and vega, but not delta. However, when the authors interact vega with proxies for residual auditor business risk, they find that the fee premiums for risk decrease as vega increases. These results suggest that auditors do consider executive compensation in audit planning.

    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Earnings Management, Earnings Management, Executive Compensation
  • Jennifer M Mueller-Phillips
    Auditor Industry Specialization, Service Bundling, and...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 04.0 Independence and Ethics, 04.03 Non-Audit Services, 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual 
    Title:
    Auditor Industry Specialization, Service Bundling, and Partner Effects in a Mining-Dominated City.
    Practical Implications:

    The authors contribute by providing some of the first evidence of service bundling in the economics of auditing literature. In doing so, they broaden the notion that strategic pricing occurs around audit switches. This study contributes to prior mixed findings of the existence of industry specialist premiums in the small-client segment, suggesting an additional reason why these mixed findings might occur. Where opportunities to package services are attractive, auditors may strategically price and discount audits with bundling premiums in mind. Where potential for such bundling opportunities is less attractive, it is possible the auditor may instead seek to generate premiums in the audit service.

    Citation:

    Ferguson, A., G. Pündrich, and A. Raftery. 2014. Auditor Industry Specialization, Service Bundling, and Partner Effects in a Mining-Dominated City. Auditing: A Journal of Practice & Theory 33 (3): 153-180.

    Keywords:
    audit fees, industry specialization, mining industry, non-audit services, second-tier firms, service bundling
    Purpose of the Study:

    This study examines auditor industry specialization effects in Perth, a remote mining town in Australia characterized by a large number of small, homogeneous firms. In this study, the authors consider whether an auditor industry specialist may strategically price a bundle of services in the small-client segment. They argue that the small company sector is a good environment to consider the existence of service bundling. The setting is the mining development stage entity (MDSE) market in Perth, the biggest industry and city in Australia by client numbers. This market is characterized by small (high-growth) firms where auditing is arguably of less importance to the client compared to tax advisory, the other primary service provided to them. Further, the firms are relatively homogeneous, an appealing feature of industry studies. Thus, the authors have arguably an attractive setting to observe service bundling by an industry specialist.

    First, the authors examine whether industry specialist auditors earn audit fee premiums in the Perth MDSE segment. To do this, an audit pricing model is developed and includes controls likely to impact on audit fees in a mining industry context. Second, the authors redefine the dependent variable to consider the pricing implications of the bundle of services provided by industry specialists.

    Design/Method/ Approach:

    The authors utilize an OLS regression model to test for audit fee premiums with respect to brand name and industry leadership. A sample of 1,799 firms listed on the ASX as of December 31, 2009 is obtained. Of the 1,799 listed entities nationally, 668 (37.13 percent) are domiciled in Perth, making it the largest city-level market by client numbers in Australia. At the city-level, the market share of non-Big 4 firms is 70.1 percent in Perth.

    Findings:

    The authors find no evidence of auditor industry leadership audit fee premiums accruing to either Big 4 (EY) or non-Big 4 (BDO) leaders. However, when the dependent variable is redefined to include non-audit services (NAS), the industry leader, BDO, obtains a total fee premium. This finding is of added interest given that the industry leader is a second-tier firm, implying that strategic audit pricing, such as service bundling, is not confined to Big 4 auditors. Nor is it confined to merely one location, since bundling premiums are observed at the national level. The authors argue MDSEs have little in the way of financial statement complexity, so they do not value specialist audits, but rather are willing to pay more for NAS. Last, in supplementary analysis, the authors find some evidence of partner-scale effects.

    Category:
    Audit Team Composition, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Industry Expertise – Firm and Individual, Non-audit Services
  • Jennifer M Mueller-Phillips
    CEO Equity Incentives and Audit Fees.
    research summary posted September 15, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
    Title:
    CEO Equity Incentives and Audit Fees.
    Practical Implications:

    According to the authors, stock options and restricted stocks are important components in CEO compensation. This study shows that auditors do perceive greater audit risk due to CEO equity compensation adjust pricing decisions accordingly. Auditors appear more concerned about CEO’s incentives to increase a company’s risky behavior so as to the CEO’s equity based compensation as opposed to increasing stock price specifically. As a CEO’s vega (i.e. change in value of a manager’s equity portfolio due to a change in stock return volatility) increases, a manager becomes less risk averse and more willing to engage in risky behavior such as earnings management. This study offers additional insights into the cost/benefits of equity based compensation.

    Citation:

    Kim, Y., H. Li, and S. Li. 2015. CEO Equity Incentives and Audit Fees. Contemporary Accounting Review 32 (2): 608-638.

    Keywords:
    Stock Option Compensation, Audit Fees, Earnings Management
    Purpose of the Study:

    This study examines the relationship between CEO equity incentives and audit risk assessment and pricing. More specifically, it examines whether/how auditors perceive CEO equity as a risk factor and incorporate into their audit pricing decisions. The authors also seek to start reconciling prior mixed evidence regarding equity incentives and earnings management and determine whether earnings management risk is due to equity compensation’s (i.e. manager’s wealth) relationship with stock return volatility (i.e. risk) or stock price. This study refines insights into the determinants of audit risk/pricing decisions and links two literatures, executive compensation and auditor compensation.

    Design/Method/ Approach:

    Sample: S&P 1500 companies over 20002009
    Source: Audit Analytics (Audit Fees), COMPUSTAT’s ExecuComp (CEO compensation)
    ModelOLS with Log Audit Fees regressed on Log CEO Vega, Log CEO Delta, Audit Fee determinants from previous studies, and year/industry fixed effects

    Findings:

    Findings show that a CEO’s portfolio vega (i.e. change in value of a manager’s equity portfolio due to a change in stock return volatility) is the important determinant of audit risk/pricing and subsumes the effects found in the previous research of a CEO’s portfolio delta (i.e. change in value of a manager’s equity portfolio due to a change in stock price) on audit risk/pricing.

    Additional analyses/results include:  

    • Repeat main analysis for CFO equity incentives. No association found.
    • Examining “direct” effect of equity incentives on audit fees (i.e. general complexity of auditing stock-based compensation) by exploring post SFAS 123R period requirements to fair value nonexecutive employees’ stock options. No association found.
    • Alternative measures of CEO equity incentives including total options held by CEO, percent of CEO equity compensation of total CEO compensation, and broader measures of CEO equity compensation. Similar results to main results.

    Results are robust to several endogeneity tests including:

    • First time options grants and changes in audit fees model
    • Inclusion of firm fixed effects
    • Instrumental variables approach
    • Dynamic panel GMM estimation (Arellano-Bond system GMM estimator)
    • Additional controls for riskiness of firm investment and financial policies
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Earnings Management, Earnings Management
  • Jennifer M Mueller-Phillips
    The Insurance Hypothesis: An Examination of KPMG's Audit...
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
    Title:
    The Insurance Hypothesis: An Examination of KPMG's Audit Clients around the Investigation and Settlement of the Tax Shelter Case.
    Practical Implications:

    This paper makes an important contribution to the literature. Using a natural institutional setting, the authors find evidence of the insurance effect in a general sample of firms in the equity market. Understanding the role of the auditor insurance function and its association with client stock prices can help auditors to better understand the pricing of audit services and it can help lawmakers in assessing the costs and benefits of professional service litigation and of proposed future litigation reform legislation. The results aid investors in understanding one of the major economic roles of the audit function.

    Citation:

    Brown, D. L., S. Z. Shu, B. S. Soo, and G. M. Trompeter. 2013. The Insurance Hypothesis: An Examination of KPMG's Audit Clients around the Investigation and Settlement of the Tax Shelter Case. Auditing: A Journal of Practice & Theory 32 (4): 1-24.

    Keywords:
    insurance hypothesis, KPMG, tax shelter
    Purpose of the Study:

    Although prior literature has suggested that independent audits provide an implicit form of insurance against investor losses (the insurance hypothesis), it has been challenging to isolate the insurance effect. In this paper, the authors use a unique setting to examine this effect. In 2002, KPMG was investigated by the U.S. Department of Justice in relation to tax shelters sold by the firm. From then until early 2005, several news reports suggested that KPMG would be indicted and suffer potentially the same fate as Arthur Andersen. However, in August of 2005 KPMG entered into a deferred prosecution agreement with the U.S. Department of Justice (DOJ), which ended widespread speculation of an impending federal indictment against the accounting firm. Because the investigation centered around tax services offered by the firm, the authors argue that the circumstances surrounding the investigation and settlement provide a natural setting to test the insurance value provided by auditors. Specifically, the authors examine the security price reactions of KPMG’s audit clients to the news of their auditor’s investigation by, and settlement with, the DOJ.

    Design/Method/ Approach:

    The authors use Compustat, CRSP and Audit Analytics to collect data. Depending on the event window, the sample varies from 920 for the settlement period to 920 to 1,012 for the investigation period. In addition to the event study, the authors also conduct a cross-sectional analysis. They use a smaller sample of 516 firms for this part of the analysis. The authors use data from the Summer 2002 to Summer 2005.

    Findings:

    Focusing on the KPMG tax shelter investigation and settlement, the authors provide evidence consistent with an auditor insurance function being impounded in stock prices. Specifically, they find that KPMG client firms earn significantly negative abnormal returns during the periods when news reports indicated that it was subject to government prosecution over its role in marketing tax shelter products to its clients and earn positive abnormal returns following news of a settlement. They also examine whether these abnormal returns for KPMG clients are increasing for firms with a higher probability to utilize the insurance option, i.e., those subject to higher litigation risk and more financially distressed. As expected, results show that firms in financial distress and firms with high litigation risk experienced significantly higher abnormal returns.

    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fee Decisions, Litigation Risk
  • Jennifer M Mueller-Phillips
    Pricing of Risky Initial Audit Engagements.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.04 Predecessor Auditor Factors 
    Title:
    Pricing of Risky Initial Audit Engagements.
    Practical Implications:

    This research contributes to the initial engagement literature by providing evidence that successor auditors charge higher fees to their clients that previously reported disagreements and other reportable events. The authors also contribute to the literature by examining fees over a six-year period surrounding the auditor change. More importantly, they find that only Big 4 auditors appear to charge higher fees following disclosures of disagreements and other reportable events. Finally, the authors add to the existing literature on audit fees for risky clients, especially the internal control weakness literature, by providing evidence that disagreements and other reportable events are priced incremental to internal control issues.

    Citation:

    Elliott, J. A., A. Ghosh, and E. Peltier. 2013. Pricing of Risky Initial Audit Engagements. Auditing: A Journal of Practice & Theory 32 (4): 25-43.

    Keywords:
    audit fees, auditor changes, Big 4 auditors, engagement risk
    Purpose of the Study:

    In this study, the authors reexamine the association between audit fees and risky initial engagements by developing an ex ante client-risk metric that is based on auditor change 8-K filings. They group adverse disclosures embedded in auditor change filings into four categories: clients with 

    1. Internal control weaknesses,
    2. Going concern issues or those filing for bankruptcy,
    3. Disagreements with the predecessor auditor, and
    4. Other reportable events.

    Because prior studies examine internal control weaknesses and going concern opinions, the authors focus on auditor-client disagreements and other reportable events, including restatements, management integrity issues, scope limitations, illegal acts, and reaudits. A fundamental distinction between this study and prior studies on risk and fees is that the authors measure client risk based on public information available to auditors before they accept an engagement.

    The authors investigate the association between an ex ante measure of risk (using information in auditor change 8-K filings) and audit fees for initial engagements. The authors also examine whether the size of the successor/predecessor auditor affects fees. Finally, they examine inter-temporal fee changes, i.e., how fees change subsequent to a switch and how fees change prior to the switch, for both risky and other clients.

    Design/Method/ Approach:

    The auditor change and fee data are obtained from Audit Analytics. Data for the financial variables are from Compustat Annual files.  The final sample consists of 2,396 auditor switches over the years 2001 to 2011. The categorization based on auditor change 8-K filings indicates that 317 auditor switches have a disagreement or other reportable event disclosed in the filings, while the remaining 2,079 observations do not report any such issue.

    Findings:
    • The authors find that firms disclosing reportable events or auditor-client disagreements pay a fee premium of about 23 percent compared to less risky initial engagements.
    • They find that only clients switching to Big 4 auditors pay higher fees when disclosing disagreements or other reportable events in the 8-K.
    • The results indicate that Big 4 auditors charge a fee premium for risky clients, but not non-Big 4 auditors.
    • Over the three years prior to the auditor switch, audit fees for risky Big 4 clients increase by about 36 percent. Following the auditor switch, the fee premium persists for at least three years.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Predecessor Auditor Factors

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