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  • Jennifer M Mueller-Phillips
    The Effect of Lame Duck Auditors on Management Discretion:...
    research summary posted August 30, 2016 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    The Effect of Lame Duck Auditors on Management Discretion: An Empirical Analysis
    Practical Implications:

    These results should be of specific interest to regulators who have proposed rules to increase the accountability of auditors by more clearly aligning their reputations with assurance quality, as well as to regulators who have expressed concerns that pressures associated with future audit fee dependence could influence the extent to which auditors behave independently. This study is not meant to be used to influence discussion surrounding mandatory audit firm rotation, as the study focused on voluntary, not mandatory, terminations of the audit-client relationship.

    Citation:

    Cassell, C., L. Myers, T. Seidel, and J. Zhou. 2016. The Effect of Lame Duck Auditors on Management Discretion: An Empirical Analysis. Auditing: A Journal of Practice and Theory 35 (3): 51-73.

    Keywords:
    auditor independence, earnings management, discretionary accruals, management discretion, and mandatory audit rotation
    Purpose of the Study:

    This study focuses on the unique situation in which the auditor-client bond is severed for future reporting periods but continues for the current reporting period. The authors label the auditors in this situation “lame duck auditors,” borrowing the expression from the political realm. In the context of politics, lame duck politicians frequently act with greater freedom because they are not concerned about how their actions will affect their chances of re-election. This could mean a politician would vote for measures that are better for his constituents no matter the consequences, or he could more easily succumb to pressures from outside influences like lobbyists. Just like in the political setting, the term “lame duck”” should not necessarily convey a negative connotation; the term simply refers to a situation that could alter an auditor’s responsibilities and incentive structures, which could lead to a change in behavior. The authors believe that financial reporting quality is higher in lame duck situations and completed this study to test that hypothesis. 

    Design/Method/ Approach:

    The authors use data from 2000-2010 and focus their investigation on the effect of lame duck auditors on the quality of the quarterly financial statements. Interim quarterly reporting is the primary focus because it allows the authors to focus on the effect of reputation concerns rather than litigation risk.

    Findings:
    • The authors find that auditor independence and/or reputation concerns are strengthened in lame duck situations because financial reporting quality is higher when a lame duck auditor performs the quality review.
    • The authors find that lame duck auditors are more likely among older companies, accelerated filers, companies with a material weakness in internal control, and companies announcing a restatement during the current or prior year.
    • The authors find that lame duck auditors are less likely among larger companies, companies audited by a Big N auditor, and companies with higher leverage and higher revenue volatility.
    • The authors’ findings verify that the main results of the study are not attributable to systematic differences between lame duck and non-lame duck auditor observations. 
    • The authors’ findings suggest that creating more uncertainty regarding the present value of expected future cash flows or increasing potential reputational concerns has the potential to improve assurance quality.
    Category:
    Corporate Matters, Independence & Ethics
    Sub-category:
    Audit Firm Rotation, Earnings Management
  • Jennifer M Mueller-Phillips
    The Effects of Auditor Rotation, Professional Skepticism,...
    research summary posted September 15, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind 
    Title:
    The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality.
    Practical Implications:

    The results of this study are important for both audit firms and regulators when considering the potential impact of mandatory audit firm rotation. Standard setters appear to increasingly advocate for auditors to utilize a mental frame in which they evaluate management assertions in terms of their level of dishonesty relative to verification their honesty. If this preference is ultimately paired with mandatory audit firm rotation, it could actually have a deleterious effect on audit quality. Conversely, this study finds that audit firm rotation can increase audit quality when auditors frame their mental representations of management’s assertions in terms of verification of their honest representations.

    Citation:

    Bowlin, K. O., J. L. Hobson, and M. D. Piercey. 2015. The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality. The Accounting Review 90 (4): 1363-1393.

    Keywords:
    auditor rotation, professional skepticism, audit quality, game theory
    Purpose of the Study:

    Regulators argue that audit firm rotation can improve audit quality by reducing the potential for longstanding auditor-client relationships to impair auditor independence. Standard setters have also recently noted that auditors often focus on verifying the honesty of management representations, and have encouraged auditors instead to evaluate them in terms of their potential dishonesty. This study examines whether the effects of auditor rotation on audit quality is dependent upon the mental frame used to evaluate either the honesty or dishonesty of management representations about the financial statements.

    Mental frame refers to whether an auditor frames their assessments of management representations in terms of either their potential honesty or their potential dishonesty. Psychology research finds that individuals do not make subjective probability assessments, like the probably that management’s assertions are honest (dishonest), based on normative laws of probability, but rather on the amount of subjective psychological support that comes to mind. When decision makers feel relatively unfamiliar with, and therefore, less competent to evaluate, subjective probabilities these individuals often find it difficult to produce psychological support for the probably of their current assessment frame, making them less likely to choose the action associated with that mental frame.  

    Design/Method/ Approach:

    The authors’ model the auditor-client relationship as a strategic game in which the auditor chooses a level of effort based on their perceived level of honesty within management’s financial statements whereas managers choose a level of honesty in reporting based on their perceived level of effort outlayed by the auditor. The researchers utilized an experimental economics experiment. The participants were undergraduate students who were tasked to repeatedly play a game for money designed to model this strategic interaction between auditors and clients. In the audit firm rotation condition the auditor was paired with a different manager each round. The evidence was gathered prior to October 2012.

    Findings:
    • When auditors assess the honesty of management representations, auditor rotation increases audit effort and decreases the frequency of low-effort audits paired with aggressive financial reporting, decreasing the likelihood of audit failure.
    • When auditors assess the dishonesty of management representations, auditor rotation decreases audit effort and increases low-effort audits paired with aggressive reporting.
    • Increasing the level of interpersonal interaction between auditors and managers via informal communication decreases audit effort, but does not interact with the auditor’s mental frame (honest versus dishonest).
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Audit Firm Rotation, Prior Dispositions/Biases/Auditor state of mind
  • Jennifer M Mueller-Phillips
    The Effects of Client Identity Strength and Professional...
    research summary posted February 17, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind 
    Title:
    The Effects of Client Identity Strength and Professional Identity Salience on Auditor Judgments
    Practical Implications:

    The results of this study provide an improved understanding of the joint effects of identity strength and salience on auditor judgments. Even in a setting with no prior auditor-client history, auditors who more strongly identify with the clients (i.e., share common values) agree more with the client. This is informative to debates about auditor rotation and independence, as it highlights short-tenure independence threats that rotation is unlikely to mitigate. Fortunately, the results also suggest heightening professional identity salience is a cost-effective alternative to auditor rotation to maintain auditor independence, even when auditor tenure is short.

    For more information on this study, please contact Tim Bauer.

    Citation:

    Bauer, T. D. 2015. The effects of client identity strength and professional identity salience on auditor judgments. The Accounting Review 90 (1): 95-114.

    Keywords:
    auditor independence; professional skepticism; professional identity; client identity; identity salience; identity strength.
    Purpose of the Study:

    Considerable accounting research, as well as recent proposed and mandated audit regulation has focused on auditor independence threats arising over long auditor tenure. Psychology research, however, suggests independence threats also likely arise when auditor tenure is short because auditors can quickly develop a strong client identity (i.e., overlap of norms and values), due to extensive auditor-client interaction. Rotation can even accelerate strong identity formation because it can increase bidding for clients and research has shown auditors try to strengthen social bonds with clients during the client acquisition process. This raises questions about the effectiveness of mandatory audit partner or firm rotation to address independence concerns.

    Relying on Social Identity Theory (SIT), this paper examines mechanisms for promoting auditor independence that can be implemented regardless of auditor tenure or rotation. Specifically, SIT suggests arousing an auditor’s identity as a professional (i.e., by increasing its salience) can promote auditor independence in mind, and mitigate threats to auditor judgment quality that stem from a stronger client identity. 

    Design/Method/ Approach:

    Two experiments are used to test hypotheses, in a setting with no prior auditor-client history.

    • Experiment One: going concern setting; conducted in 2010; participants are seniors, managers, and senior managers from several Big 4 accounting firms in Canada.
    • Experiment Two: inventory writedown setting; conducted in 2013; participants are seniors from a Big 4 firm in the U.S.
    Findings:
    • As predicted, auditors who identify more strongly with their clients, by sharing their values, agree more with the client’s preferred accounting treatment, unless the salience or arousal of their professional identity is heightened.
    • Further, as predicted, heightening professional identity salience increases professional skepticism. 
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Audit Firm Rotation, Prior Dispositions/Biases/Auditor state of mind

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