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  • Jennifer M Mueller-Phillips
    Audit Firm Tenure, Non-Audit Services, and Internal...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 04.07 Audit Firm Rotation, 11.0 Audit Quality and Quality Control, 11.07 Attempts to Measure Audit Quality 
    Title:
    Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality.
    Practical Implications:

    The lower quality and higher effort associated with first-year audits represent additional costs that should be considered in the ongoing debate on mandatory audit firm rotation. The differential findings for private and public clients suggest that market and related regulatory forces discipline auditors of SEC clients to maintain a high level of audit quality even when tenure is long or NAS fees are high. The findings are important for regulatory policies related to audit firm tenure and auditor-provided NAS. The finding that quality declines in private-client audits as NAS fees increase or tenure becomes long should be of interest to standard setters in the private sector.

    Citation:

    Bell, T. B., Causholli, M., & Knechel, W. R. 2015. Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality. Journal Of Accounting Research 53 (3): 461-509.

    Keywords:
    audit firm tenure, audit quality, non-audit services, independence
    Purpose of the Study:

    After decades of debate and research, the auditing profession, regulators, and researchers continue to wrestle with two longstanding concerns about perceived threats to auditor independence and audit quality: (1) Social bondingbecoming personally friendly with, or increasingly trusting of, client management, and (2) Economic bondingbecoming financially dependent on multiperiod fees from audits and non-audit services (NAS) provided to the client. Regulators have argued that social bonding from long tenure erodes professional skepticism and induces auditor complacency, while economic bonding from non-audit fees prompts auditor concessions or shirking in response to management’s financial reporting demands. On the other hand, the auditing profession has argued that there is no systemic decline in audit quality as audit firm tenure or fees from NAS increase, and that restrictions on tenure or NAS disrupt auditor learning, constrain the financial and human resources available for audit production, and impede knowledge spillovers.

    The authors use data from internal assessments of audit quality in a Big 4 firm to investigate the impact of audit firm tenure and auditor-provided non-audit services (NAS) on audit quality.

    Design/Method/ Approach:

    The data used in this study consists of audit quality assessments, audit firm tenure, audit and NAS fees, total and staff-level audit labor hours, and other key client and engagement characteristics for 265 U.S. audits conducted by a Big 4 firm for both publicly listed (57%) and privately held (43%) clients. Audit firm personnel collected the data during the annual internal quality reviews performed during late spring through early fall of 2003.

    Findings:
    • Audit quality is lowest in first-year audits, improves shortly thereafter, and declines somewhat as tenure becomes very long.
    • The probability that a second-, third-, or fourth-year audit receives a high quality rating is, on average, 21 percentage points higher than the probability for a first-year audit, while audit quality for audits where tenure is greater than 13 years is not significantly different from that of a first-year audit.
    • Audit effort is significantly higher in first-year audits in spite of discounted fees.
    • In audits of SEC registrants, quality increases slowly over the entire tenure range, while audits of private clients exhibit a rapid increase in quality in early years and an equally steep decline in later years.
    • Audit partner specialization in the client’s industry is associated with higher audit quality in both the full sample and in first-year audits. For SEC clients, the authors also find that audit quality and audit effort each are positively associated with discretionary accruals (DAs), suggesting that auditors recognize the risks associated with unusual accruals and respond by conducting more effective procedures.
    • When ex-Andersen clients are removed from the sample, the authors no longer observe lower audit quality in first year audits.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Attempts to Measure Audit Quality, Audit Firm Rotation, Audit Firm Rotation, Non-audit Services
  • Jennifer M Mueller-Phillips
    Threats to Auditor Independence: The Impact of Relationship...
    research summary posted December 3, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 09.0 Auditor Judgment, 09.04 Going Concern Decisions 
    Title:
    Threats to Auditor Independence: The Impact of Relationship and Economic Bonds
    Practical Implications:

    The results of the study suggest that establishing close auditor-client relationships can reward audit firms with higher NAS revenues from clients. In particular, longer audit firm tenure and audit firm alumni directors benefit the audit firms with higher NAS provision. This indicates that a successful strategy for audit firms may be to develop long-term associations with clients at the firm level (rather than at the partner level) and to establish active alumni networks. At the same time audit firms should ensure that adequate procedures are in place to ensure that appropriate audit reports are issued, most particularly when strong auditor-client relationships are present.

    For more information on this study, please contact Elizabeth Carson.

    Citation:

    Ye, P., E. Carson, and R. Simnett. 2011. Threats to auditor independence: The impact of relationship and economic bonds. Auditing: A Journal of Practice & Theory 30 (1): 121-148.

    Keywords:
    Independence and ethics; non-audit services; going concern decisions; alumni
    Purpose of the Study:

    Auditor independence is the foundation of high quality audit services and a crucial component in the statutory corporate reporting process. The cases of high-profile corporate failure associated with auditing scandals in early 2000s have cast doubts over auditor independence and the value of auditing. Most regulatory concerns regarding auditor independence have centered on three alleged independence threats:

    • Auditor’s economic dependence on the client due to the provision of non-audit services (NAS)
    • Auditor’s familiarity with the client due to lengthy audit tenure
    • The personal relationships between the audit engagement partner and client’s directors

    Relevant regulatory reforms have taken place in both the U.S. (SOX, 2002) and Australia (CLERP 9, 2004) to mitigate such concerns. However, empirical evidence only provides limited support to the regulations, and two fundamental questions underlying the independence issue remain unanswered:

    • What factors influence a company’s decision to purchase NAS from its incumbent auditor?
    • How do the economic and social bonds between auditors and clients affect auditor independence?

    This paper addresses the questions to inform regulation by examining:

    • Whether client’s NAS purchase from the incumbent auditor is affected by four identified auditor-client relationships: (1) audit firm tenure, (2) audit partner tenure, (3) relationship tenure (ongoing personal interactions between audit engagement partner and client’s director), and (4) client’s director being an alumnus of the audit firm. 
    • Whether auditor’s propensity to issue a going-concern opinion (as the manifestation of auditor independence) is affected by the provision of NAS and the four identified auditor-client relationships.
    Design/Method/ Approach:

    The study uses 2002 Australian data on publicly-traded companies. 2002 is chosen as a period when the audit environment was still relatively unregulated. Data was hand-collected from companies’ annual reports. The impacts of various factors on auditor independence are examined using statistical analysis.

    Findings:

    The study finds:

    • Some evidence that increased audit firm tenure and the presence of directors with alumni connections to the incumbent audit firm is associated with an increased likelihood of clients’ NAS purchase from the incumbent audit firm. Such impact is stronger in companies with lower leverage and higher ownership concentration.
    • No evidence that audit partner tenure or relationship tenure (between audit partner and client director) impacts client’s NAS purchasing decisions.
    • Evidence that higher levels of NAS provision and longer audit partner tenure are associated with a lower propensity in auditor’s issuance of going-concern opinions.
    • No evidence that audit firm tenure, relationship tenure or the presence of client director’s alumnus status impacts on auditor’s propensity to issue going-concern opinions.
    • Evidence that auditors are less likely to issue a going-concern opinion when there is a high-level NAS provision to the client and the client has an incumbent audit firm alumni director.
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Going Concern Decisions, Non-audit Services
  • Jennifer M Mueller-Phillips
    Auditor fees and auditor independence ‒ Evidence from g...
    research summary posted November 12, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Auditor fees and auditor independence ‒ Evidence from going concern reporting decisions in Germany.
    Practical Implications:

    The results of this study show that in general market-based incentives, such as loss of reputation, constitute more important factors with regard to auditor independence than an economic dependence caused by higher non-audit fees. However, those safeguards may not be adequate in all situations given the relatively low litigation risk in Germany. The relatively high importance of consulting services performed in audit engagements by the Big 4 group seems to give Big 4 auditors an incentive to continue the auditor-client relationship, and is therefore to be regarded as an additional economic dependence between auditor and client. The explicit representation of liquidity risks through management appears to influence auditor reporting behavior in relation to going concern risks. This information—even if it is not presented in a separate reporting instrument, such as the Lagebericht—could also determine auditor reporting behavior outside Germany.

    For more information on this study, please contact Nicole Ratzinger-Sakel.

    Citation:

    Ratzinger-Sakel, N. V. S. 2013. Auditor fees and auditor independence ‒ Evidence from going concern reporting decisions in Germany. Auditing: A Journal of Practice and Theory 32 (4): 129-168.

    Keywords:
    Auditor independence, auditor reporting, non-audit fees, audit fees, Germany
    Purpose of the Study:

    On October 13, 2010, the European Commission published a Green Paper entitled “Audit Policy: Lessons from the Crisis”. Against the background of the recent global financial and economic crisis, this Green Paper proposes primarily reforms to improve auditor independence, and therewith audit quality, and to improve the structure of the audit market. One of the main areas of interest in this Green paper is whether the provision of consulting services by statutory auditors endanger the independence of auditors. This paper examines whether this concern can be empirically substantiated by investigating the potential for non-audit services to impair auditor independence using going concern modifications as a proxy for audit quality. While prior research has focused primarily on Anglo-Saxon environments, this study focuses on Germany because of the country’s unique reporting attributes (i.e., Lagebericht, which is a management report, and its associated Risikobericht, which is a risk report) and lower litigation risk when compared to Anglo-Saxon settings.

    Design/Method/ Approach:

    The analysis is based on a sample of financially distressed, capital market-oriented companies from the study period 2005-2009. Companies are defined as financially distressed if they meet one of the following five criteria: (1) negative equity, (2) negative operating cash flow, (3) negative working capital, (4) negative EBIT in the previous year, and (5) net loss in the previous year. These criteria are taken from a survey of German auditors, asking these to estimate the relevance of a number of indicators relating to the going concern assumption. These indicators are very similar to the criteria used in international studies for identifying financially distressed companies. In light of recent research findings on auditor reporting behavior from the United States, which, using strict control samples, report different results compared to previous U.S.-American studies, this study includes a second control sample. In alignment with the U.S.-American literature, this second control sample includes companies showing both a net loss in the previous year and a negative operating cash flow in the previous year. 

    Findings:
    • The results show no evidence of a significant negative relationship between the level of non-audit fees and the likelihood that an auditor issues a going concern opinion (GCO).
    • However, there is some evidence that the potential for non-audit services to impair auditor independence depends on the type of audit firm conducting the audit (Big 4 compared to non-Big 4). If the level of non-audit fees is relatively high, then Big 4 audit firms are less likely to issue a GCO. However, this result holds only for highly financially stressed clients.
    • The results for the examined unique German reporting environment show a positive association between liquidity risks explicitly presented in the Risikobericht and the likelihood that the auditor includes a GCO in the audit report.
    Category:
    Independence & Ethics
    Sub-category:
    Going Concern Decisions, Non-audit Services
  • Jennifer M Mueller-Phillips
    How Increased Regulatory Oversight of Nonaudit Services...
    research summary posted May 28, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services 
    Title:
    How Increased Regulatory Oversight of Nonaudit Services Affects Investors’ Perceptions of Earnings Quality
    Practical Implications:

    Although the findings of this study provide evidence of investor perceptions of NAS and of how these perceptions are conditional on regulations and audit quality, the results, and their implications for policy should be viewed with caution. These results are based on Norwegian data and a distinctive regulatory environment. The authors examined a period when a series of high-profile accounting scandals hit in Europe and the U.S., which may have also influenced investors’ earning quality perceptions. This study, however, reveals many possibilities for new research to better determine how regulations affect investor perceptions of NAS. 

    Citation:

    Eilifsen, A., and K. H. Knivsflå. 2013. How Increased Regulatory Oversight of Nonaudit Services Affects Investors’ Perceptions of Earnings Quality. Auditing 32 (1).

    Keywords:
    audit firm quality; earnings response coefficients; investor perceptions; nonaudit services; regulation
    Purpose of the Study:

    Investor confidence in financial statements and the audit process are often contingent on auditor independence. One of the most debated threats to auditor independence arises from economic bonds between auditors and clients stemming from the joint provision of audit and nonaudit services (NAS). Researchers have long sought to establish how the economic bonds between auditors and clients, arising from the provisions of NAS, affect auditor independence. In 2003, The Financial Supervisory Authority of Norway (FSA) disclosed that audit firms had violated the legal restrictions for providing NAS. In response, the FSA tightened NSA regulations. This study examines how regulatory oversight affects the relation between the provision of NAS and earnings response coefficients (ERC). 

    Design/Method/ Approach:

    The authors first developed two hypotheses for testing:

    H1: For low-quality audit firms, the association between the level of NAS and investors’ perceived earnings quality was negatively affected after the disclosure of NAS regulation violations in 2003. The effect is more negative in the disclosure year 2003 that in the new regulation period 2004-2008. 

    H2: Higher-quality audit firms moderate the negative effects associated with low-quality audit firms in H1.

    To test H1 and H2, the authors use the ERC from earnings-response regression models as a proxy for investor perceptions of earnings quality. Essentially, the ERC is the estimated effect of reported earnings or change in earnings on stock prices, stock returns, or abnormal stock returns. The sample consists of companies listed on the Oslo Stock Exchange (OSE). The final sample consists of 1,646 company-year observations for 293 individual companies for the ten-year period from 1999-2008. 

    Findings:
    • For small, non-industry specialized audit firms, the relationship between NAS and ERC is negatively affected after the 2003 disclosure of the audit firms’ violations of the legal NAS restrictions and is more negatively affected in the disclosure year 2003 than in the new regulation period 2004-2008.
    • For Big 5 firms, audit quality moderates the negative effects on investor perceptions that were associated with low-quality audit firms in 2003 and 2004-2008.
    • Industry specialization among audit firms amplifies investor concerns regarding auditor independence in 2003. 
    • Investors react negatively to the disclosure of NAS violations and new regulations ease investor concern. 
    Category:
    Independence & Ethics
    Sub-category:
    Non-audit Services
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  • Jennifer M Mueller-Phillips
    Do Former Audit Firm Partners on Audit Committees Procure...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.03 Non-Audit Services, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    Do Former Audit Firm Partners on Audit Committees Procure Greater Nonaudit Services from the Auditor?
    Practical Implications:

    This study presents new evidence that suggests the presence of AFAPs and UFAPs on the audit committee has the potential to reduce threats to auditor independence by pre-approving the purchase of less NAS form the auditor. The findings of this study are consistent with the view that AFAPs serving as independent audit committee members appear not to make economic decisions in favor of their former audit firm, and, thus, may be exercising objective and independent oversight to enhance auditor independence. This evidence is also in line with the goal of SOX to reduce actual or perceived threats to auditor independence. From a regulatory perspective, the findings suggests that concerns about audit firm alumni on client’s audit committees may not be warranted in the post-SOX environment and the three-year cooling period rule may be unnecessary. However, further research in other contexts is needed.

    For more information on this study, please contact Vic Naiker.
     

    Citation:

    Naiker, V., D. S. Sharma, and V. D. Sharma. 2013. Do Former Audit Firm Partners on Audit Committees Procure Greater Nonaudit Services from the Auditor? The Accounting Review 88 (1): 297–326.

    Keywords:
    alumni; audit committee; cooling-off period; former partner; independence; nonaudit; revolving-door
    Purpose of the Study:

    This study focuses on how the presence of a former audit firm partner (FAP) on the audit committee is related to nonaudit services (NAS) procured from the external auditor. The Sarbanes-Oxley Act of 2002 requires the audit committee to pre-approve nonaudit services procured from the auditor to prevent potential independence issues. The presence of a FAP affiliated with the current auditor on the audit committee could undermine the audit committee’s due diligence over the NAS pre-approval process. To alleviate these concerns, the SEC implemented a three-year cooling-off period for appointing audit form alumni as independent directors. This study analyzes the effects of these relationships on auditor independence.

    Design/Method/ Approach:

    A sample of 2,748 firm-year observations with available corporate governance, director, and CFO biographical data for fiscal years ending in 2004 and 2005 was selected. The sample was tested using regression models to investigate the association between affiliated former audit partners (AFAPs) and unaffiliated audit partners (UFAPs) on the audit committee and nonaudit services purchased from the auditor.

    Findings:
    • Firms with FAPs purchase significantly less NAS compared to firms without and FAP.
    • The capacity of the audit committee to reduce dependency on auditor-provided NAS in the post-SOX era may be enhanced when committee members possess partner-level experience.
    • AFAPs on the audit committee adopt a more conservative NAS pre-approval strategy by reducing NAS purchased from the auditor.
    • Audit committees including AFAPs not meeting the mandatory three-year cooling off periods are equally conservative when pre-approving NAS purchased for the auditor relative to audit committees that include AFAPs satisfying this rule and UFAPs.
       
    Category:
    Governance, Independence & Ethics, Standard Setting
    Sub-category:
    Board/Audit Committee Composition, Impact of SOX, Non-audit Services
  • Jennifer M Mueller-Phillips
    Client Importance and Earnings Management: The Moderating...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.03 Non-Audit Services, 13.0 Governance, 13.05 Board/Audit Committee Oversight 
    Title:
    Client Importance and Earnings Management: The Moderating Role of Audit Committees
    Practical Implications:

    The results of this study have implications to both New Zealand and the United States. Regulators in New Zealand should assess these results as possible indications that the profession’s self-regulated status may need to be revised in light of the existence of lower financial reporting quality for clients that have weak audit committee oversight and are economically important clients to the auditor. Additionally, these results provide evidence to contribute to the ongoing debate in the United States regarding the merits and the intended and unintended consequences of independent auditor oversight through regulatory bodies such as the PCAOB.

    For more information on this study, please contact Vineeta D. Sharma.
     

    Citation:

    Sharma, V., D.S. Divesh, and U. Ananthanarayanan. 2011. Client importance and earnings management: the moderating role of audit committees. Auditing: A Journal of Practice and Theory 30 (1): 125-156.

    Keywords:
    audit committee; auditor independence; accruals; corporate governance; fees, earnings management; non-audit
    Purpose of the Study:

    As a result of declining investor confidence in the quality of financial information due to financial scandals, many countries have implemented corporate governance reforms that specifically identify the audit committee as the primary mechanism for the oversight of auditor independence and financial statement quality. This study investigates how the association between the economic importance of a client to the auditor and earnings management is moderated by the audit committee. Client importance is a potential threat to auditor independence and thus is a potential threat to audit quality. The authors suggest that the possibility exists that auditors may view the audit wealth provided from a client as more important than maintaining independence which is determinant of the audit quality; therefore, the authors examine if there is a positive correlation between client importance and earnings management. Certain circumstances, such as management ownership, leverage, high growth, and firm size, could potentially promote an environment that is conducive to earnings management independent of the external audit. In consideration of these circumstances, the auditors studied whether the association between client importance and earnings management was effected by these firm environmental factors. The audit committee’s response and efforts to mitigate these factors were also examined, specifically in light of the best practices recommendations. 

    Design/Method/ Approach:

    The authors conducted this study by gathering empirical evidence from firms listed on the New Zealand Stock Exchange in the fiscal years 2004 and 2005. The NZSE was chosen as a proper natural laboratory because there is no ban or limit on non-audit services, no mandate on the roles and composition of the audit committee exists, the audit profession is self-regulated, it is a less litigious environment, and it is geographically and economically small.

    Findings:
    • A positive correlation was observed between client importance and the observed proxies for earnings management, which included both performance-adjusted discretionary total and current accruals. This implies that as client importance, as related to the wealth production to the external auditors, increases the possibility of the existence of earnings management in the financial statements also increases.
    • The association became more pronounced for income-increasing accruals that potentially diminish the quality of earnings and are of greater concern to regulators; however, this was moderated by the audit committee.
    • The association between client importance and earnings management is conditional on other firm characteristics such as inside ownership, growth, leverage, and firm size. These factors could create potential agency conflicts but are moderated by the audit committee.
    • Accounting expertise on the audit committee and committees composed completely of outside directors explain the moderating effects of the audit committee.
    • The association with earnings management became more pronounced when the audit committee did not meet the best practices outlined by the NZSEC. These practice suggestions from the NZSEC are merely recommendations, not requirements, as the auditing profession is self- regulated in New Zealand.
       
    Category:
    Governance, Independence & Ethics
    Sub-category:
    Board/Audit Committee Oversight, Impact of Fees on Decisions by Auditors & Management, Non-audit Services
  • Jennifer M Mueller-Phillips
    Is mandated independence necessary for audit quality?
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 11.0 Audit Quality and Quality Control 
    Title:
    Is mandated independence necessary for audit quality?
    Practical Implications:

    In the unregulated baseball card market, only offering grading services does not appear to increase market share or market value.  This may have implications in the market for assurance services.  The authors note that offering non-audit services does not appear to negatively affect auditor independence.  Additionally, it may be argued that auditors increase value by realizing economies of scope through the supply of audit as well as non-audit services to their clients.

    For more information on this study, please contact Karim Jamal.
     

    Citation:

    Jamal, K. and S. Sunder. 2011 Is mandated independence necessary for audit quality? Accounting, Organizations and Society 36 (4-5): 284-292.

    Keywords:
    None
    Purpose of the Study:

    This study seeks to address audit independence and audit quality by drawing a parallel with the unregulated market for graded baseball cards sold in online auctions.  The baseball cards used in this study had either been graded by a professional grading service company or had not been professionally graded.  The authors note that some of the grading agencies only offer grading services, while others offer grading services in addition to other non-grading products sold in the trading card market.  This field experiment examines whether providing additional services such as publishing price guides or otherwise participating in the market of cards reduces the market’s perceived quality of the grading.  The authors draw a parallel from this research to the market for assurance services, noting that some auditors provide only auditing services to their clients while others provide non-audit services as well.  This research explores the idea that providing multiple services to a market impacts perceived independence and quality of the assurance service.

    Design/Method/ Approach:

    The authors collected market data from the online auction site eBay for 1,000 rookie baseball cards and created matched pairs of both graded and ungraded cards.  Graded cards had been graded by one of six different grading agencies.  Some of the grading agencies provided other, non-grading, services to the market while some only offered grading services.

    Findings:
    • The market for graded baseball cards rewards stricter graders, regardless of whether those graders provide other, non-grading, products to the market as well.
    • The majority of the market share for graders is controlled by the grading agencies who offer numerous products to the market, not just grading services.
    • Graders who only offer grading services appear to engage in grade inflation which is discounted by the market. 
       
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Non-audit Services
  • Jennifer M Mueller-Phillips
    Internal Audit Outsourcing and the Risk of Misleading or...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.03 Non-Audit Services 
    Title:
    Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong?
    Practical Implications:

    The results of this study support the knowledge spillover argument — that financial reporting quality improves when the external auditor performs at least some internal audit work. In addition, the authors found evidence that higher quality IAFs, regardless of outsourcing arrangement, are associated with lower accounting risk. This study also provides insights on the impact of the SOX prohibition on external auditors’ provision of internal audit services to their clients, and provides evidence concerning whether private companies may benefit from a similar practice. Finally, this study provides insight on how increased interaction among different parties involved in corporate governance can positively influence financial reporting quality.

    Citation:

    Prawitt, D. F., N. Y. Sharp, and D. A. Wood. 2012. Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong? Contemporary Accounting Research 29(4): 1109-1136.

    Keywords:
    N/A
    Purpose of the Study:

    A significant change imposed by the Sarbanes-Oxley Act of 2002 (SOX) was to prohibit the outsourcing of internal audit services to firms’ external auditors. There are two competing arguments of how outsourcing the internal audit function (IAF) to the external auditor potentially impacts financial reporting quality. The knowledge spillover argument suggests that by both performing the external audit and providing non-audit services, auditors improve overall audit quality through a deeper understanding of the client. The economic bonding argument suggests that overall audit quality is compromised when the external auditor provides non-audit services, essentially because the external auditor is unwilling to stand up to aggressive or abusive accounting practices for fear of losing a lucrative client engagement Therefore, the purpose of this study was to examine whether outsourcing internal audit services to the external auditor in the pre-SOX period is associated with higher or lower accounting risk, where accounting risk is defined as the risk that clients’ financial statements contain misleading or fraudulently reported numbers. The authors specifically examined the association between accounting risk and four forms of internal audit sourcing:

    • The firm outsources at least some portion of their IAF to their Big N external auditor (pre-SOX).
    • The firm outsources its IAF to other Big N service providers.
    • The firm outsources its IAF to other non–Big N, third-party service providers
    • The firm keeps their IAF entirely in-house.
       
    Design/Method/ Approach:

        The authors used data from the Institute of Internal Auditor’s GAIN database concerning the IAFs of publicly traded companies during the years 2000 to 2002. To test accounting risk, the authors used data from Audit Integrity, LLP, which is a financial analytics organization. Audit Integrity uses publicly available accounting information as inputs to a proprietary model that measures the risk of potentially fraudulent or misleading financial reporting. The authors then developed a model to evaluate the relationship between internal audit sourcing and accounting risk.

    Findings:

    Companies that outsourced at least some portion of their IAF to their Big N external auditor (pre- SOX) had lower accounting risk than companies that (1) outsourced to other Big N service providers, (2) outsourced to other non–Big N, third-party service providers, and (3) kept their IAF entirely in-house.
    Outsourcing to the external auditor reduces accounting risk by 23 percent relative to firms that kept the IAF in-house (holding other factors constant).
    Accounting risk decreases as the percentage of work outsourced to the external auditor increases.
    Evidence that higher quality in-house IAFs are positively associated with accounting quality.
     

    Category:
    Independence & Ethics, Standard Setting
    Sub-category:
    Impact of SOX, Non-audit Services
  • Jennifer M Mueller-Phillips
    Perceived Auditor Independence and Audit Litigation: The...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Perceived Auditor Independence and Audit Litigation: The Role of Nonaudit Services Fees
    Practical Implications:

    This study provides evidence to suggest that fees from audit clients, including NAS fees, which became publicly available under the SEC’s fee disclosure mandate, are used as evidence of auditor independence impairment and are a source of audit litigation risk. While specific NAS have been banned by SOX, substantial tax and other NAS fees continue to be cited as evidence in recent litigation. Thus, these findings document important links between SEC fee disclosure mandates, NAS-induced impairment arguments, and perceptions of audit quality in audit litigation.

    For more information on this study, please contact Jaime J. Schmidt.
     

    Citation:

    Schmidt, J. J. 2012. Perceived Auditor Independence and Audit Litigation: The Role of Nonaudit Services Fees. The Accounting Review 87(3): 1033-1065.

    Keywords:
    Auditor independence; nonaudit services fees; audit litigation; auditor settlements; financial statement restatements.
    Purpose of the Study:

    In audit litigation, the plaintiff attorneys (i.e., plaintiffs’ bar) often exploit and enhance the perception that fee dependence is related to an audit failure by arguing that economic pressure to retain fees and, in particular, nonaudit services (NAS) fees led to a conflict of interest for the auditor and compromised the auditor’s independence. The purpose of this study was to investigate whether audit litigants act as if they believe jurors will perceive that substantial NAS fees contribute to an audit failure through impaired auditor independence, and thus substandard auditor performance. The author examined the initiation and resolution of audit restatement-related litigation to provide evidence on whether NAS or another source of fee dependence (e.g., client importance, audit fee dependence) impairs perceived auditor independence.

    Design/Method/ Approach:

    The author collected information concerning restatements of previously audited financial statements disclosed from January 2001 through December 2007, the auditors involved with the restatements, and the amount of fees billed during the misstated time period. The author also identified all instances of litigation disclosed as of June 2008 against the restating companies. The author then estimated a model and ran a regression to investigate whether NAS fees are associated with the initiation of audit litigation following a restatement.

    Findings:
    • Restatement-related audit litigation is more likely when NAS fees are higher.
    • This association is driven by the unspecified (i.e., ‘‘other’’) fees component of NAS rather than by tax or financial information systems design and implementation (FISDI) fees.
      • The ratio of NAS fees to total fees is positively associated with the likelihood that audit litigation results from a restatement.
    • The association between audit fees or client importance and the likelihood of litigation is statistically insignificant.
    • A restatement-related lawsuit is more than seven times as likely to reach resolution by an auditor settlement and to settle at a greater amount when the plaintiffs’ bar argues that an auditor’s reliance on client fees resulted in an auditor independence impairment.
    • The plaintiff attorneys’ arguments about NAS fees and/or client importance are associated with greater likelihood and amount of settlement.
       
    Category:
    Accountants' Reporting, Independence & Ethics
    Sub-category:
    Non-audit Services, Restatements
  • Jennifer M Mueller-Phillips
    Productivity Growth in the Public Accounting Industry: The...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 05.0 Audit Team Composition, 05.04 Staff Hiring, Turnover and Morale, 05.05 Diversity of Skill Sets e.g., Tenure and Experience, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.09 Impact of Technology on Audit Procedures 
    Title:
    Productivity Growth in the Public Accounting Industry: The Roles of Information Technology and Human Capital
    Practical Implications:

    Given the positive effects that human capital and IT accumulation had on productivity growth, the findings of this study imply that firms seeking to improve their revenues per employee could do so by investing in more IT and human capital. The potential effects of these investments on audit quality could be beneficial when determining the level of investment to make. However, firms should keep in mind the possibility of diminishing results once a certain level of IT and human capital is accumulated. This study also has implications for the debate in the United States surrounding the Sarbanes- Oxley Act which prohibits certain non-audit services by public accounting firms. The debate stem from a concern of the effects of non-audit services on independence but this study displays the benefits that could arise if non-audit services were allowed.

    For more information on this study, please contact Hsihui Chang.
     

    Citation:

    Chang, H., J. Chen, R. Duh, and S. Li. 2011. Productivity growth in the public accounting industry: the roles of information technology and human capital. Auditing: A Journal of Practice and Theory 30 (1): 21-48.

    Keywords:
    productivity growth; efficiency change; technical progress; IT capital accumulation; human capital accumulation; Big 4; non-audit services.
    Purpose of the Study:

    The audit industry has changed dramatically over the last two decades. These changes have brought on increased competition among firms which has created immense pressure for audit firms to minimize their costs while maximizing productivity. For many public accounting firms, the way to manage productivity growth and enhance service delivery came in the form of investments in information technology and human capital. Investments in information technology can increase productivity through automation of routine auditing tasks, improvements in audit team collaboration and communication, as well as through an increased level of experience with information systems which can improve auditor performance in engagements to help clients integrate their company information systems. High quality human capital, which is usually indicated through education levels and work experience and results in both technical and tacit knowledge, contributes to the productivity growth of a firm through higher quality services for clients.

    This study breaks down human capital and information technology (IT) into four drivers of productivity growth among public accounting firms; efficiency change, technical progress, IT capital accumulation, and human capital accumulation. The authors assessed both the simultaneous effects of human capital and IT as well as the individual contributions of the four distinct components of these factors on productivity growth. Some firms also chose to boost productivity through engaging in more non- audit services. Although most studies focus on the effects that non-audit services have on auditor independence, this study focuses on how non- audit services can contribute to productivity growth.
     

    Design/Method/ Approach:

    The authors analyzed data on revenues, employees, IT expenditures, and human capital for a sample of public accounting firms in Taiwan from 1993 to 2003. The data was obtained from the Annual Survey of Accounting Firms in Taiwan published by the Department of Statistic of Taiwan’s Ministry of Finance. The authors chose Taiwan as a proper setting for this study because its publications included more advantageous data than that of the United States published in Accounting Today’s annual surveys.

    Findings:
    • Public accounting firms experienced growth in productivity, specifically, labor productivity evidenced through revenue per employee. 
    • This growth, in order of least contribution to greatest contribution, resulted from efficiency improvement, technical progress, human capital accumulation, and IT capital accumulation. Thus, the primary drivers were human capital and IT accumulation.
    • There was a significant difference in productivity growth between Big 4 and non- Big 4 firms. This difference was primarily attributable to greater technical progress and IT capital accumulation among the Big 4. Additionally, there was no difference in human capital accumulation between Big 4 and non- Big 4 firms.
    • Although the advance of technology provides all accounting firms with opportunities to improve productivity, not all firms exploit these opportunities equally. The Big 4 invested more heavily in IT systems and were rewarded with higher productivity growth.
    • Firms with a greater growth in non-audit services had higher productivity than other firms because they accumulated higher IT and human capital over the sample period.
    • Early movers into non-audit services tended to have higher changes in IT capital accumulation.
    • Both early moving firms into non-audit services and firms that emphasized growth in non-audit services presented a direct relationship with productivity growth higher than that of firms which focused on traditional audit services.
       
    Category:
    Audit Team Composition, Auditing Procedures - Nature - Timing and Extent, Internal Control
    Sub-category:
    Diversity of Skill Sets (e.g. Tenure & Experience), Impact of Technology on Audit Procedures Confirmation – Process and Evaluation of Responses, Non-audit Services, Staff Hiring - Turnover & Morale

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