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.
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.
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.
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.
Diversions can have important practical implications beyond the setting of deliberate earnings management. Managers may divert auditors from higher risk areas to accounts that they believe are not at risk of misstatement. The findings suggest that auditors would be susceptible to these diversions as well. However, to the extent that errors can occur anywhere, managers might mistakenly direct auditors’ attention to an area with errors, which could backfire on managers. Even more broadly, managers may inadvertently direct auditors’ attention from an account that materially misstates earnings to another account that does not. No matter the cause of the diversion, the results demonstrate that such diversions significantly influence an auditor’s detection of a material misstatement of earnings elsewhere in the financial statements.
Luippold, B. L., Kida, T., Piercey, M. D., & Smith, J. F. 2015. Managing audits to manage earnings: The impact of diversions on an auditor’s detection of earnings management. Accounting, Organizations & Society (41):39-54.
The evidence indicates that tone manipulation succeeds in misleading investors, and that this effect is incremental to the effect of accruals management. An abnormally positive tone incites an overly optimistic immediate stock price response to the earnings announcement and a subsequent return reversal. The evidence indicates that abnormal positive tone contains negative information about future firm fundamentals, that firms tend to engage in tone management particularly when incentives to manipulate investor perceptions are high, and that investors are misinformed by tone management.
Huang, X., Teoh, S. H., & Zhang, Y. 2014. Tone Management. Accounting Review 89 (3): 1083-1113.
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.
While prior research has investigated audit effects in for profit industries, this study investigates audit effects at nonprofit organizations. Nonprofits in general and PHAs in particular are largely served by smaller auditors frequently classified in prior research as lower quality. Further, nonprofits in general represent low litigation risks for the auditors and the threat of litigation and associated economic loss is generally considered one motive for an audit firm to perform a high quality audit. The evidence suggests that audits matter in the nonprofit industry. So even in a setting where research would suggest there would be low audit quality, when the auditor is smaller and the risk of litigation is low, auditors make significant adjustments to pre-audited data and help to constrain management bias toward meeting pre-established financial thresholds.
For more information on this study, please contact Barbara Grein.
Grein, B. M., and S. L. Tate. 2011. Monitoring by Auditors: The Case of Public Housing Authorities. The Accounting Review 86 (4):1289-1319.
Our study evaluates a provision of Dodd-Frank which provided permanent exemption from Section 404b compliance to non-accelerated filers. Our results show that these small firms did not improve their reporting quality to the same extent as large firms implying that the Dodd-Frank exemption will probably serve to keep the reporting quality of the exempted firms at lower than achievable levels.
We also note that as part of the Dodd-Frank legislation, the SEC was given a mandate to investigate raising the Section 404b exemption requirements from $75 million to $250 million in market capitalization (Dodd Frank 2010). While the SEC eventually decided to leave the exemption criterion at $75 million, this matter is still considered to be an open topic (SEC 2011). Our study informs this ongoing debate.
For more information on this study, please contact
Anthony D. Holder, PhD, CPA
Assistant Professor, Department of Accounting - MS 103
University of Toledo
Toledo, OH 43606-3390
Email: Anthony.Holder@utoledo.edu
Web: http://homepages.utoledo.edu/aholder4/
Phone: 1.419.530.2560
Fax: 1.419.530.2873
Holder, A., K. Karim, and A. Robin. 2013. Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance? Accounting Horizons 27 (1): 1-22.
The results of this study are important for auditors, investors, clients’ audit committees, and regulators. Disclosure about auditor resignations may reveal useful information about clients’ financial reporting practices. Since auditor resignations potentially signal risk arising from clients’ opportunistic financial reporting behavior, investors can make more informed decisions when they understand the linkage between RAM and auditor resignations. The findings of this study also have an important implication for clients’ audit committees, because these committees can help to avoid potential negative consequences associated with RAM and auditor resignations by overseeing management reporting practices. Further, the results of this study are important for regulators because they are concerned about auditor changes that are triggered by management opportunism.
For more information on this study, please contact Yongtae Kim.
Kim, Y., and M. Park. 2014. Real Activities manipulation and auditors’ client-retention decisions. The Accounting Review 89 (1): 367-401.