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  • Jennifer M Mueller-Phillips
    The Earnings Quality Information Content of Dividend...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions 
    Title:
    The Earnings Quality Information Content of Dividend Policies and Audit Pricing
    Practical Implications:

    Taken together, the results of this study suggest that dividends provide information to auditors and mitigate concerns over their clients’ earnings quality. It appears dividends provide incremental information to auditors beyond other audit risk indicators, such as low earnings persistence or high accruals. These findings also suggest that firms’ dividend-paying status provides an easily observable cue to auditors and others that can be used when assessing a firms’ earnings quality. 

    Citation:

    Lawson, B. P. and D. Wang. 2016. The Earnings Quality Information Content of Dividend Policies and Audit Pricing. Contemporary Accounting Research 33 (4): 1685 – 1719. 

    Purpose of the Study:

    This study further explores the earnings quality information content of firms’ dividend policies by examining whether auditors incorporate this information into the assessment of their clients’ earnings quality as reflected in their audit pricing decisions. The authors choose to delve into the question of whether dividends’ association with higher earnings quality influences auditors’ risk assessment of their clients. In addition, they examine the incremental earnings quality information that dividends can provide auditors by testing two separate earnings risk settings. 

    Design/Method/ Approach:

    The authors test two separate earnings risk settings by using audit fees and financial statement data from 2004 to 2012. 

    Findings:
    • The authors find that dividend-paying firms pay lower audit fees than nondividend-paying firms after controlling for various determinants of audit pricing decisions.
    • The authors find that audit fees are significantly lower (higher) for dividend-initiating (-omitting) firms compared to benchmark audit fees.
    • The authors find that the negative association between audit fees and earnings persistence is more pronounced for dividend firms, suggesting that as earnings persistence increases, dividends provide auditors with assurance regarding the lower audit risk embedded in more persistent earnings. 
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    The Effects of Clients’ Controversial Activities on Audit P...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 06.06 Earnings Management 
    Title:
    The Effects of Clients’ Controversial Activities on Audit Pricing
    Practical Implications:

    We focus on the business risk associated with controversial corporate activities. By examining a wider range of controversial corporate activities, we are able to conduct a broader investigation into the association between auditor business risk and audit fees.  Our study finds that adverse social performance arising from controversial activities affects firms’ audit fees. Specifically, our results indicate that auditors charge fee premiums ranging from 5.4% to 13.2% for clients that are involved with controversial activities related to consumers, employees, the community, and the environment.  We also find that corporate controversial activities are associated with higher risks of financial misstatement and adverse financial performance.  These results provide triangulation on our inference that auditors’ raise their assessment of clients’ business risks when their clients are involved in controversial activities, and charge such clients higher audit fees.  

     

    For more information on this study, please contact Kevin Koh.

    Citation:

    Koh, K. and Y. H. Tong. 2013. The Effects of Clients’ Controversial Activities on Audit Pricing. Auditing: A Journal of Practice and Theory 32 (2): 67-96.

    Keywords:
    audit fees; audit pricing; corporate social responsibility (CSR); controversial corporate activities; business risk; financial misstatement
    Purpose of the Study:

    We examine the effects of clients’ involvement in controversial corporate activities on audit pricing. Clients’ involvement in controversial activities raises concerns about management integrity and ethics. Moreover, clients involved in such activities are perceived to have higher risk of adverse financial performance. As a result, there is greater potential for financial misstatement, which increases the auditor’s perceived business risk. We hypothesize that, given the higher perceived business risk, auditors charge higher fees to clients engaged in controversial activities. We also hypothesize that lower corporate social performance is associated with adverse financial performance as these clients can face public criticism, consumer boycotts, reputation loss, fines or other regulatory actions over their controversial activities. Adverse financial performance heightens managerial incentives to manage earnings, increasing the risk of financial misstatement.

    Design/Method/ Approach:

    Our sample spans the period 2000 to 2010, as audit fee data are publicly available only as of 2000.  We obtain audit fee data from the Audit Analytics database and identify audit clients involved in controversial activities related to consumers, employees, the community, and the environment using a unique dataset from Kinder, Lydenberg, and Domini (KLD).   The KLD dataset is the most commonly used database for assessing corporate social performance. KLD rates each firm’s social actions along seven broad dimensions: consumer, employee, diversity, community, human rights, environment, and corporate governance. We use a regression model to examine the relation between controversial activities and audit fees. In order to examine the validity of our assumptions and to triangulate our results, we investigate the association between controversial activities and the risks of financial misstatement and adverse financial performance with regression models.   

    Findings:

    We find evidence consistent with audit firms charging higher audit fees to firms involved in controversial activities. Specifically, our results indicate that auditors charge fee premiums ranging from 5.4% to 13.2% for clients that are involved with controversial activities related to consumers, employees, the community, and the environment.  In comparison, in our sample, the Big 4 and industry-specialist audit fee premiums amount to 29.7% and 10.8%, respectively.  The fee premiums related to the various controversial activities thus appear to be economically significant. 

    We also find that clients involved in controversial activities report higher level of abnormal accruals and are more likely to be issued a going concern opinion compared to clients not involved in such activities. These results strengthen our inference that auditors raise their assessment of auditor business risk for clients engaged in controversial activities and charge higher audit fees.   

    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fee Decisions, Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment, Earnings Management, Earnings Management, Management Integrity
  • 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
    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
  • 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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