Given that auditor concentration is an important topic that has seen relatively little empirical research, this study contributes to the literature by providing more complete evidence on the relation between auditor concentration and audit quality. Concentration reduced the opportunity for Big 4 clients to switch auditors particularly given the new auditor independence requirements following the 2002 Sarbanes-Oxley Act. Reduced choice is seen as increasing auditor entrenchment and complacency, and potentially contributing to a more lenient and less skeptical audit for clients.
Boone, J. P., I. K. Khurana, and K.K. Raman. 2012. Audit Market Concentration and Auditor Tolerance for Earnings Management* Audit Market Concentration and Auditor Tolerance for Earnings Management. Contemporary Accounting Research 29 (4): 1171-1203.
The results of this study suggest that auditors spend a greater effort on analyzing income-increasing items compared to income-decreasing items. They also suggest that auditors compensate for greater risk associated with income-increasing items by requiring greater verification of such items. Because of the limitations placed on the results of this study due to the specific context of the experiment, future research should try and examine such differences in auditors’ decision-making processes.
For more information on this study, please contact Naman K. Desai.
Desai, N. K., and G. J. Gerard. 2013. Auditors’ Consideration of Material Income-Increasing versus Material Income-Decreasing Items during the Audit Process. Auditing 32 (2).
The evidence on the firm-to-firm spread of financial reporting behavior via board networks contributes to a little-studied area in accounting that should be important. The authors contribute to the corporate governance literature by offering evidence that contagion effects vary with board positions. They show that board supervision of management is important for ensuring high-quality financial reporting and that board linkages affect the success of this supervision. Regulators concerned about improving financial reporting quality should consider the board connectivity of companies.
Chiu, P. C., S. H. Teoh, and F. Tian. 2013. Board Interlocks and Earnings Management Contagion. Accounting Review 88 (3): 915-944.
According to the authors, stock options and restricted stocks are important components in CEO compensation. This study shows that auditors do perceive greater audit risk due to CEO equity compensation adjust pricing decisions accordingly. Auditors appear more concerned about CEO’s incentives to increase a company’s risky behavior so as to the CEO’s equity based compensation as opposed to increasing stock price specifically. As a CEO’s vega (i.e. change in value of a manager’s equity portfolio due to a change in stock return volatility) increases, a manager becomes less risk averse and more willing to engage in risky behavior such as earnings management. This study offers additional insights into the cost/benefits of equity based compensation.
Kim, Y., H. Li, and S. Li. 2015. CEO Equity Incentives and Audit Fees. Contemporary Accounting Review 32 (2): 608-638.
Earnings management has received significant attention in the business press and from regulators and investors. Auditors are expected to constrain earnings management and, more generally, to enhance the quality of financial reporting. The passage of the 2002 SOX Act has substantially increased the legal liability for auditors and, therefore, has influenced their mindset toward conservative reporting. The results of this study show how auditors respond to earnings management risk via audit pricing and client retention decisions in a sequential way. The type of strategies that auditors employ varies with the level of earnings management risk. If the trade-off between return and risk is acceptable, auditors are willing to retain clients that engage in upward earnings management by charging higher audit fees. However, if the risk exceeds an acceptable level, auditors will choose to resign. The study provides evidence that a pecking order of auditors’ strategies exists in response to various risk levels in the post-SOX period.
For more information on this study, please contact Gopal Krishnan.
Krishnan, G., L. Sun, Q. Wang, and R. Yang. 2013. Client Risk Management: A Pecking Order Analysis of Auditor Response to Upward Earnings Management Risk. Auditing: A Journal of Practice and Theory 32 (2): 147-170.
The results of this study provide important evidence to the earnings management literature. Recent studies provide several plausible alternative explanations for the discontinuities in earnings distributions near earnings benchmarks. Though the findings of this study cannot readily be extrapolated to a broader sample of firms, the authors found evidence that firms commit less egregious earnings management in order to meet earnings benchmarks. This study is therefore important in considering whether earnings management plays a role in the discontinuities in various earnings distributions documented by prior studies.
For more information on this study, please contact Dain C. Donelson.
Donelson, D. C., J. M. McInnis, and R. D. Mergenthaler. 2013. Discontinuities and Earnings Management: Evidence from Restatements Related to Securities Litigation. Contemporary Accounting Research 30 (1).
The results of this study greatly contribute to the literature on the relation of earnings quality to dividends. Companies that report fraudulent financial statements have caused significant problems for financial markets and economies, and additional research in this are remains vital. The evidence found in this paper is consistent with the notion that dividend-paying firms are less likely to engage in fraud because they know they cannot maintain their same dividend policies if earnings are fraudulent. Fraud firms cannot keep pace with non-fraud firms in terms of dividend policy and fraud firms’ dividends are less related to earnings that are non-fraud firms.
For more information on this study, please contact Judson Caskey.
Caskey, J., and M. Hanlon. 2013. Dividend Policy at Firms Accused of Accounting Fraud. Contemporary Accounting Research 30 (2).
The study provides useful insight into current regulatory debates on the auditor’s economic dependence on the client and increases understanding to the reasons why previous research provides mixed evidence on the association between various fee metrics and the extent of earnings management. If the association between abnormal fees and the magnitude of discretionary accruals is conditioned on the sign of abnormal fees, examining the association without reference to the sign of abnormal fees most likely leads to observations of insignificant associations, as also reported in most previous studies. This study’s findings suggest that future research on similar issues should take into account the asymmetric nonlinearity in the fee-quality relation.
Choi, J. H., J. B. Kim, and Y. Zang. 2010. Do Abnormally High Audit Fees Impair Audit Quality? Auditing: A Journal of Practice & Theory 29 (2): 115-140.
Chen, Q., K. Kelly, and S. Salterio. 2012. Do changes in audit actions and attitudes consistent with increased auditor scepticism deter aggressive earnings management? An experimental investigation. Accounting, Organizations and Society 37 (2): 95-115.
This paper provides fresh empirical evidence on long-term financial reporting strategies that managers use to impact perceptions of credit risk. It is among the first to examine reporting strategies in a setting where companies with stronger incentives to manage earnings to affect debt ratings can be identified. The authors find evidence that earnings smoothing activities appear to be affectively employed by managers to improve firm credit ratings.
For more information on this study, please contact Boochun Jung.
Jung, B., N. Soderstrom, and Y. S. Yang. 2013. Earnings Smoothing Activities of Firms to Manage Credit Ratings. Contemporary Accounting Research 30 (2).