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  • The Auditing Section
    The Pricing of National and City-Specific Reputations for...
    research summary posted May 7, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications 
    Title:
    The Pricing of National and City-Specific Reputations for Industry Expertise in the U.S. Audit Market
    Practical Implications:

    This study has practical audit client portfolio management implications for audit firms seeking to earn audit fee premiums for reputations of industry expertise. For example, auditors’ reputations for industry expertise are neither strictly national nor strictly local.  One interpretation with practical implications for such firms is that national level or city level reputations for industry expertise are not individually sufficient to maximize fee premiums.  Rather, auditors can most effectively earn fee premiums when they establish both city-level and national-level reputations for industry expertise.

    Citation:

    Francis, J. R., K. Reichelt, and D. Wang.  2005.  The Pricing of National and City-Specific Reputations for Industry Expertise in the U.S. Audit Market.  The Accounting Review 80 (1): 113-136.

    Keywords:
    Auditor industry expertise, Big 5 accounting firms, audit fees
    Purpose of the Study:

    The purpose of this study is to examine the pricing of Big 5 industry expertise in the United States based on national and city level reputations for industry expertise.  

    Industry knowledge and expertise help auditors build reputations that auditors can use to negotiate fee premiums.  Prior research suggests that industry knowledge and expertise is developed by investments in accounting professionals and their experiences in serving clients out of city-based practice offices.  However, auditors can build national reputations for industry expertise that may enable them to negotiate audit fee premiums as well.  The authors argue that the central issue in the “national” vs. “city” perspective on industry expertise is the degree to which office-specific expertise is transferrable throughout a firm. Specifically, the national perspective assumes accounting firms capture the industry expertise of its office-based professionals and distribute it throughout the entire firm.  Conversely, the city perspective assumes that auditor expertise is indelibly tied to individual professionals and cannot be distributed throughout the firm.  This study examines industry specialization audit fee premiums at the city level and national level to analyze how auditor reputations for industry expertise are viewed.  Specifically, the authors use U.S. fee disclosures to investigate audit pricing in the U.S.  audit market in order to determine: 

    • whether there is evidence that Big 5 auditor industry expertise is priced in the U.S. audit market 
    • whether the market for audit fees prices a Big 5 firm’s national (firm-wide) reputation or city-specific (local-office) reputations for industry expertise
    Design/Method/ Approach:

    The study uses data on U.S. non-financial publicly-traded companies with Big 5 auditors during the fiscal years 2000 and 2001.  The authors investigate audit fee premiums resulting from:

    • National specialization only,
    • City specialization only, and
    • Combined city and national specialization.
    Findings:
    • There is evidence of a fee premium of 19% on engagements where Big 5 auditors are both the nationally top-ranked auditor and the city-level industry leader in the city where the client is headquartered. The authors argue this indicates that national and city-specific industry leadership jointly impact auditor reputation and pricing. 
    • The magnitude of the premium for joint national-city leadership is bigger for larger clients (22 percent) than for smaller clients (7 percent).  
    • There is evidence of a fee premium of 8% on engagements where Big 5 auditors are the city-specific industry leader but not the national industry leader.  The authors argue this may indicate that auditor industry expertise is tied to individual professionals. However, the result is sensitive to test methods so the evidence is inconclusive on this point. 
    • There is no evidence of a fee premium for auditors that are national industry leaders alone without also being city-specific industry leaders.  The authors argue this indicates that national leadership alone does not result in a premium. 

    The authors argue these findings suggest that an auditor’s reputation is priced into audit fees as if both firm-wide (national) and city-specific (local) reputations are jointly relevant.

    Category:
    Client Acceptance and Continuance, Auditor Selection and Auditor Changes
    Sub-category:
    Audit fee decisions, Auditor Qualifications (e.g. size - industry expertise)
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  • Jennifer M Mueller-Phillips
    The Volatility of Other Comprehensive Income and Audit Fees
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations 
    Title:
    The Volatility of Other Comprehensive Income and Audit Fees
    Practical Implications:

    This paper asks whether auditors recognize the volatility of OCI and incorporate it into pricing of audits.  They find that audit fees do reflect changes in OCI and that these changes reflect various risk factors associated with OCI.  The findings suggest that auditors already recognize the difficulty in assessing value of fair value items which run through OCI—reinforcing regulator concerns about fair value valuation.

    Citation:

    Huang, H., S. Lin, K. Raghunandan. 2016. The Volatility of Other Comprehensive Income and Audit Fees. Accounting Horizons 30 (2): 195-210.

    Keywords:
    Other comprehensive income; audit fees; fair value audits
    Purpose of the Study:

    This study investigates whether auditors incorporate volatility in other comprehensive income (OCI) into fees.  Increased attention from standard setters, both domestically and internationally, on fair value accounting has increased auditor focus on fair value financial instruments.  Fluctuations in many of these assets are reflected in OCI, thus volatility in OCI may indeed influence the auditor’s inherent risk assessment.  Other studies have shown that investors do not seem to accurately incorporate volatility of OCI in pricing, so it is an empirical question whether auditors can incorporate it into their risk assessment.

    Design/Method/ Approach:

    The authors use a sample of S&P 500 firms from 2002 to 2006 and supplement this sample with a comparable sample from 2008 to reinforce their findings.  Data on OCI was hand collected from the SEC’s EDGAR database and combined with financial information from Compustat and auditor data from Audit Analytics.  The authors exclude financial sector firms, resulting in a final sample of 1,858 firm-year observations.

    Findings:

    The authors find:

    • A positive relationship between volatility in OCI volatility and audit fees, with or without controlling for other factors that influence audit fees.
    • Changes in OCI have predictive power for audit fees above and beyond changes in net income, suggesting items that flow through OCI are incorporated into audit pricing.
    • When breaking out OCI volatility into its components, the authors find audit fees incorporate volatility in foreign currency translation, available-for-sale investments, and minimum pension liabilities.  Audit fees increase as volatility of these items increases.
    • Audit fees have a negative relationship with volatility of cash flow hedges.  These hedges offset risk in the underlying prices; therefore, volatility in the hedges is indicative of firms successfully hedging against risk.  These firms pay lower audit fees.
    Category:
    Client Acceptance and Continuance, Engagement Management
    Sub-category:
    Audit Fee Decisions, Audit Fees & Fee Negotiations
  • 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
    Understanding Contract Audits: An Experimental Approach
    research summary posted June 6, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions 
    Title:
    Understanding Contract Audits: An Experimental Approach
    Practical Implications:

    Very little literature currently exists on contract audits and their consequences. These audits aim to decrease the information asymmetry between a buyer and seller, but the conditions in which they existences is still largely unknown. The results of this study serve as a starting point for further experimentation that will help to further understanding of the reasons why contract audits exist and the consequences of them when they are indeed used. 

    Citation:

    Bertrand, R. M., A. J. Schram, and E. H. Vaassen. 2013. Understanding Contract Audits: An Experimental Approach. Auditing 32 (1).

    Keywords:
    contract auditing; experimental economics; value of the audit; government purchasing
    Purpose of the Study:

    A contract audit is a buyer-initiated audit of prices and other conditions, which aims to decrease the information asymmetry between a buyer and a seller. These contracts are widely used, especially in monopolistic or oligopolistic markets, but current literature provides little insight into the conditions under which buyers will initiate a voluntary contract audit. The effects of contract audits are also widely unknown. This study attempts to identify the factors that explain this decision and investigate how transaction prices are affected by contract audits through a series of laboratory experiments. 

    Design/Method/ Approach:

    The authors initially used three distinct literatures (transaction cost theory, the theory of planned behavior, and social preference theory) to develop the following hypotheses:

    H1A: Contract audits increase the probability of agreement in the negotiations.

    H1B: Contract audits result in shorter negotiations.

    H2A: The more positive the buyer’s attitude toward contract auditing is the more likely he or she is to initiate a contract audit. 

    H2B: As the pressure to initiate a contract audit increases, the buyer will more often initiate a contract audit.

    H2C: If a buyer believes a contract audit is relatively easy to organize, he or she is more likely to initiate one. 

    H3: Contract audits result in lower prices compared to prices based on negotiations with no contract audit. 

    H4: Prices are higher when sellers know the outcome of a contract audit than when they do not. 

    These hypotheses were then tested in ten experimental sessions run in November 2007 at the laboratory of the Center for Research in Experimental Economics and Political Decision-making in Amsterdam. The 228 participants were students from the bachelors and masters programs at the University of Amsterdam. Each of the students participated in independent negotiation sessions to determine the validity of the previously developed hypotheses. 

    Findings:
    • The results confirm the H2A, H2B, and H2C hypotheses. 
    • A positive attitude toward audits and pressure to have audits conducted all positively contribute to the probability that an audit will be undertaken. 
    • Audits reduce transaction costs and increase gross efficiency by yielding more negotiations that are successful.
    • Prices tend to be lower than those predicted by the subgame perfect Nash equilibrium of our setup. 
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions
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  • Jennifer M Mueller-Phillips
    Voluntary Audits versus Mandatory Audits
    research summary posted March 4, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment 
    Title:
    Voluntary Audits versus Mandatory Audits
    Practical Implications:

    This analysis provides empirical support for the argument that the mandatory requirement suppresses information that is conveyed when companies are allowed to choose whether to be audited. Moreover, additional tests indicate that the opt-out companies were only passively complying with the audit requirement—evident in their attempts to reduce costs through auditor choice and fees—under the mandatory regime. In other words, it is difficult to force companies to privately contract for stringent audits if they would choose not to be audited voluntarily. However, the research on private companies cannot contribute valid insights on the relative merits of voluntary and mandatory audits for public companies.

    For more information on this study, please contact Clive Lennox.

    Citation:

    Lennox, C. S. and J. A. Pittman. 2011. Voluntary Audits versus Mandatory Audits. The Accounting Review 86 (5): 1655-1678. 

    Keywords:
    voluntary audits; mandatory audits; credit ratings
    Purpose of the Study:

    Exploiting a natural experiment in which voluntary audits replace mandatory audits for U.K. private companies, we analyze whether imposing audits suppresses valuable information about the types of companies that would voluntarily choose to be audited. Companies should be compelled to have their financial statements audited to ensure that outsiders have access to reliable accounting information. In the other direction, requiring audits suppresses the signal that is conveyed when companies exercise their discretion in choosing whether to be audited. This study provides empirical evidence on the merits of these competing arguments by analyzing economic outcomes for private companies stemming from a regime switch from mandatory to voluntary audits. The purpose of our analysis is to isolate whether this regime change permitted firms to signal new information about their types.

    Design/Method/ Approach:

    The authors compile the sample from the Financial Analysis Made Easy (FAME) database. By design, each company in the sample was required to have an audit in 2003, but not in 2004. There are two observations per company, with the first pertaining to the final year of the mandatory audit regime (2003) and the second to the initial year of the voluntary regime (2004).

    To gauge whether voluntary audits reveal new information about borrowers’ types, the authors examine the changes in credit ratings after the transition from mandatory to voluntary audits in a natural experiment. They control for the assurance benefits of auditing to isolate the role signaling plays by focusing on companies that are audited under both regimes. These companies experience no change in audit assurance, although they can now reveal for the first time their desire to be audited. The study also tests whether the companies that would choose to avoid an audit under the voluntary regime were privately contracting for a relatively low level of audit assurance during the mandatory regime.

    Findings:
    • The authors find that credit ratings rise for companies that continue being audited during the first year of the voluntary regime, and they interpret this evidence as implying that these companies enjoy ratings upgrades because their decision to remain audited conveys an incrementally positive signal about their credit risk. The level of audit assurance appears stable for these companies during the transition from mandatory to voluntary audits, as their audit fees and auditor choices do not change following the regime switch.
    • The authors also examine the impact of the regime switch on credit ratings for the companies that choose to opt out of the audit, and find that credit ratings drop when companies abandon the audit, which conveys a negative signal about their type and reduces financial reporting credibility; i.e., both signaling and the drop in assurance are responsible for their ratings falling.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Client Risk Assessment

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