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  • Jennifer M Mueller-Phillips
    The Relationship between Aggressive Real Earnings Management...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    The Relationship between Aggressive Real Earnings Management and Current and Future Audit Fees
    Practical Implications:

    Prior research concerning audit fees and earnings management has focused primarily on accruals management. This article shows how the audit fee and audit risk models support auditors’ pricing behavior in a REM setting. Specifically, the results are consistent with auditors, after observing aggressive REM, increasing current audit fees to cover the cost of additional effort required to gain reasonable assurance that the financial statement are free of material misstatements and increase both current and future audit fees to cover increases in perceived business risk.     

    Citation:

    Greiner, A., M. J. Kohlbeck, and T. J. Smith. 2017. The Relationship between Aggressive Real Earnings Management and Current and Future Audit Fees. Auditing: A Journal of Practice and Theory 36 (1): 85 – 107. 

    Keywords:
    audit fees, business risk, audit risk, and aggressive real earnings management.
    Purpose of the Study:

     The authors examine whether aggressive real earnings management (REM) activities are associated with audit fees. Prior research focuses on accruals-based earnings management and suggests that auditors extract additional audit fees to cover costs associated with increased engagement risk, which includes audit risks related to the issuance of an incorrect opinion and nonaudit risk related to impaired reputation, fewer business opportunities, and the inability to collect desires and future audit fees. The distinction between accrual and real earnings management is important for auditors because the potential effects on company performance and engagement risks are different. REM alters normal firm operations, impacts current and future cash flows, imposes additional costs, and sacrifices firm value. Whether auditors charge higher fees for earnings management behavior that does not violate generally accepted accounting principles if important to study as clients continue to pursue REM to meet reporting objectives. 

    Design/Method/ Approach:

    The authors utilize a conceptual audit fee model to identify specific examples within this framework where REM is likely to increase engagement risk and thereby increase audit fees through either increased effort, a risk premium, or both. They perform further analysis to better understand the sources between aggressive REM and fees.

    Findings:
    • The authors find, overall, a positive association between aggressive REM and both current and future audit fees.
    • The authors find that changes in aggressive REM are associated with changes in fees.
    • The authors find that only current aggressive REM is positively associated with audit report delays.
    • The authors find evidence that the associations between aggressive Rem and future fees are driven by firms with higher REM incentives.
      • Further, they find that the future effect of aggressive REM is stronger among firms constrained by balance sheet bloat.
    Category:
    Corporate Matters, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Earnings Management
  • 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
    Audit Quality and Analyst Forecast Accuracy: The Impact of...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.04 Industry Experience, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Audit Quality and Analyst Forecast Accuracy: The Impact of Forecast Horizon and Other Modeling Choices
    Practical Implications:

    This paper contributes to research examining the determinants and impacts of audit quality by identifying the limitations of aspects of metrics employed in recent research that could have been utilized by practitioners and suggesting useful alternate metrics for investigating the impact of audit quality on the properties of analysts’ forecasts, including the usefulness of audited financial information and the prediction of future performance. 

    Citation:

    Wu, Y. and Wilson, M. 2016. Audit Quality and Analyst Forecast Accuracy: The Impact of Forecast Horizon and Other Modeling Choices. Auditing: A Journal of Practice and Theory 35 (2): 167-185. 

    Keywords:
    audit quality, auditor industry specialization and analyst forecast accuracy
    Purpose of the Study:

    Many studies examine the influence of auditor characteristics on the properties of analyst forecasts of client firms’ earnings. A common argument is that audit quality affects the accuracy of analyst forecasts or closely associated metrics. However, there is considerable divergence in the posited theoretical association between audit quality and forecast accuracy and in the empirical associations reported. The majority of these studies rely exclusively on measures of forecast accuracy based on analysts’ end-of-year forecasts. The authors argue that metrics drawn from these forecasts are noisy indicators of the impact of audit quality because there are convincing reasons why superior audit quality may affect the accuracy of the metrics in either direction. Financial reports of clients of higher quality auditors may be more useful for forecasting future earnings which in turn may increase forecast accuracy; however, higher quality auditors may be more effective in disallowing client attempts to manage earnings. Thus, if an auditor provides superior quality services to their client, then it is conceivable that these competing effects will offset each other, resulting in no net impact on forecast accuracy. As a result, the authors argue that the properties of analysts’ beginning-of-year forecasts provide superior measures of any of the impacts of auditor characteristics because these forecasts are less likely to induce benchmark-beating incentives for earnings manipulation and because audited financial information has a greater relative impact on analysts’ information set at the beginning-of-year than at the end-of-year. 

    Design/Method/ Approach:

    Focusing on measures of audit firm industry specialization common to papers with competing predictions and results, the authors demonstrate the noisiness and sensitivity to model specification of test based on end-of-year forecast accuracy and show that similar tests based on beginning-of-year forecast accuracy generate predicted results that are consistent over a range of modeling approaches. 

    Findings:
    • The authors find that analysts’ beginning-of-year forecasts are a potentially superior proxy for auditors’ impact on the properties of analyst forecasts because the “decision usefulness” impact of an audit is at its strongest soon after those reports are released and is likely to dominate any effect on audit quality on client benchmark-beating behavior.
    • The authors also identify the importance of other modeling choices facing researchers, such as the deflation of forecast errors and controls for the endogenous selection of industry specialist auditors. 
    Category:
    Audit Quality & Quality Control, Corporate Matters
    Sub-category:
    Earnings Management, Industry Expertise – Firm and Individual
  • Jennifer M Mueller-Phillips
    Real Earnings Management before and after Reporting SOX 404...
    research summary posted March 22, 2016 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Real Earnings Management before and after Reporting SOX 404 Material Weaknesses.
    Practical Implications:

    The authors identify a setting where there is a greater risk of value reduction for stockholders. Specifically, they find that companies which have material weaknesses in internal controls are more likely to engage in real earnings management, through inventory management and reducing discretionary expenditures. While these activities are allowed by GAAP, the findings of this paper suggest management may take actions that are detrimental to firm value.

    Citation:

    Jarvinen, T. and E. Myllymaki. 2016. Read Earnings Management before and after Reporting SOX 404 Material Weaknesses. Accounting Horizons 30 (1): 119-141.

    Keywords:
    internal control, material weakness, real earnings management
    Purpose of the Study:

    This study investigates whether SOX Section 404 material weaknesses manifest in real earnings management behavior. The authors compare companies with effective internal controls to companies with existing material weaknesses, specifically looking at manipulation of real activities (particularly inventory overproduction). Such activity would suggest that companies strive to mitigate the expected negative reaction to disclosed material weaknesses by engagement in real earnings management.

    Design/Method/ Approach:

    The authors use company-year observations from public U.S. companies from 2004 to 2012. These company-years are split into three categories: 1) first year of internal control material weakness 2) years in which material weaknesses were disclosed as remediated 3) years in which material weaknesses were disclosed as nonremediated, and 4) company-years with effective internal controls. The authors observe differences in the extent of inventory management after controlling for various other predictors of real earnings management.

    Findings:

    The authors find:

    • Manipulation of real operational activities is associated with both the first-time existence of a material weakness and the subsequent disclosure of the material weakness.
    • Inventory overproduction is employed as an earnings management method before and after material weakness disclosure, and especially when the company has previously had poor financial performance.
    • Companies appear to cut discretionary expenditures when they have material weaknesses and when they have previously had poor financial performance.
    • Reduction in discretionary expenses is also used in the year when companies disclose and remediate material weaknesses.
    Category:
    Corporate Matters, Internal Control
    Sub-category:
    Earnings Management, Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    The Spillover of SOX on Earnings Quality in Non-U.S....
    research summary posted March 22, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    The Spillover of SOX on Earnings Quality in Non-U.S. Jurisdictions.
    Practical Implications:

    The costs and benefits of SOX have been researched by numerous authors, however the benefits outside of the United States have generally been limited to those of firms that are listed on U.S. exchanges. The authors observe improvements in earnings quality for subsidiaries of U.S. firms which file financial reports in Belgium, suggesting that there is a spillover effect of SOX compliance outside of domestic firms. The authors caveat that they cannot determine if the results are driven by improved internal controls or improved audit quality of the parent company, but they show improvement in foreign-filing earnings in spite of these financial reports being generated outside of the U.S. reporting process.

    Citation:

    Dutillieux, W., J.R. Francis, M. Willekens. 2016. The Spillover of SOX on Earnings Quality in Non-U.S. Jurisdictions. Accounting Horizons 30 (1): 23-39.

    Keywords:
    Earnings quality, U.S. foreign subsidiaries, Sarbanes-Oxley
    Purpose of the Study:

    The authors use Belgian subsidiaries of Belgian companies and U.S. companies around the implementation of SOX to determine if SOX compliance effects performance outside of the United States. While other research has looked at the effect of SOX on foreign firms trading on U.S. exchanges, this study looks into the quality of financial reporting of foreign subsidiaries in their own country, which would be a second-order effect of SOX compliance.

    Design/Method/ Approach:

    The analyses in this paper utilize a sample of Belgian subsidiaries owned by U.S.-based and Belgian-based firms from 1999 to 2005, excluding 2002 (the year of implementation) for a clean separation of pre- and post-SOX windows. The sample of over 2,000 subsidiaries is used to observe the change of earnings quality measures from pre-SOX to post-SOX, and how that changes differs between U.S.-owned subsidiaries and Belgian-owned subsidiaries.

    Findings:

    The authors look at earnings quality for subsidiaries which file financial reports outside of the U.S. which are still obligated to comply with SOX regulations. They find that SOX has a spillover effect on these firms specifically in that they report higher quality earnings relative to a control group of subsidiaries from the same country which do not have to comply with SOX. The U.S.-owned subsidiaries report smaller abnormal accruals and recognize losses more timely, whereas the Belgian-owned subsidiaries had no improvement or even a decline in some instances.

    Category:
    Corporate Matters, Standard Setting
    Sub-category:
    Earnings Management, Impact of SOX
  • Jennifer M Mueller-Phillips
    Regulation and the interdependent roles of managers,...
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 14.0 Corporate Matters, 14.01 Earnings Management, 14.11 Audit Committee Effectiveness 
    Title:
    Regulation and the interdependent roles of managers, auditors, and directors in earnings management and accounting choice.
    Practical Implications:

    This review paper provides an overview of how financial reporting, auditing, and corporate governance regulations influence the earnings management and accounting choice decisions of key stakeholders. The paper provides a summary of key insights (summarized above) of interest to practitioners, researchers, and regulators. Further, the paper highlights the key benefits of experimental and survey work in terms of identifying causal mechanisms and investigating the impact of potential regulatory actions not yet in existence.

    Citation:

    Libby, R., K. Rennekamp, and N. Seybert. 2015. Regulation and the interdependent roles of managers, auditors, and directors in earnings management and accounting choice. Accounting, Organizations and Society 47: 25-42.

    Keywords:
    Earnings management, earnings quality, accounting choice, financial reporting, auditing, corporate governance, experimental design, surveys, regulation
    Purpose of the Study:

    This paper reviews recent experimental and survey studies of key stakeholders decisions that influence earnings management and accounting choice, and how financial reporting affects these decisions. The authors summarize the contribution of the studies, directions for future research, and key methodological recommendations for researchers doing experimental and survey work. The authors define earnings management and accounting choice broadly to include: 1) choices of accounting methods; 2) implementation decisions related to estimates, classifications, levels of detail, and display format used in mandatory disclosures; 3) the frequency, timing, and content of voluntary disclosures; and 4) investment, financing, and operating choices based on their accounting consequences. The focus of this review is on the determinants (rather than consequences) of accounting choice. In examining the effects of regulation on managers’, auditors’, and directors’ (or audit committee members’) judgments and decisions with respect to earnings management, the study focuses on three types of regulation: 1) financial reporting regulations, 2) auditing regulations, and 3) other corporate governance regulations.

    Design/Method/ Approach:

    The paper focuses on studies published in Accounting, Organizations, and Society, Contemporary Accounting ResearchJournal of Accounting Research, and The Accounting Review from 2008 through 2014. Relevant working papers from SSRN and select older papers that provide motivation for more recent work are also discussed.

    Findings:
    • Financial reporting regulation:
      • Effects of rules- versus principles-based standards on reporting choices:
        • Overall, evidence indicates the ability of a principles-based standard to constrain aggressive reporting is likely limited.
        • Joint goals of reducing the complexity of standards while also constraining aggressive reporting will only be met where a less-stringent set of rules is replaced with a more-stringent general principle.
      • Effects of information quantity or information location on reporting choices:
        • Overall, research suggests when more detailed information about estimates or economic events must be reported, managers will engage in a lower level of misreporting and auditors will scrutinize the numbers to a greater extent.
        • Effect is dampened when information appears in a footnote disclosure rather than on the face of the financial statements.
      • Effects of reporting frequency and accruals timing on investment choices:
        • Overall, research demonstrates how reporting differences such as reporting frequency, expense deferral, and impairment reversibility can alter project choices, investment location, and investment magnitude.
        • These decisions have direct immediate and/or future real economic consequences and represent a tradeoff between short-term reporting issues and long-term firm value.
    • Auditing regulation:
      • Overall, research suggests the effects of regulations are complicated.
      • Both increased auditor independence and increased auditor accountability can fail to produce desired outcomes and even lead to unanticipated consequences.
      • Open question as to which types of regulation might successfully shift auditors’ incentives away from pleasing client management and towards pleasing other non-client stakeholders.
    • Corporate governance regulation:
      • Overall, research suggests audit committee involvement has improved in recent years and more knowledgeable and independent directors have been more likely to support correction of discovered errors and constrain earnings management.
      • In some cases, however, directors are not as effective at helping auditors to reign in within-GAAP earnings management.
    Category:
    Corporate Matters, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Earnings Management
  • Jennifer M Mueller-Phillips
    Materiality Judgments and the Resolution of Detected...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees.
    Practical Implications:

    The results of this study shed light on the complex interplay between analyst following, the pressure that managers face to manage earnings, the pressure that auditors face to protect their reputations in the post-SOX environment, and the important role that audit committees can play in settings in which managers may act strategically to achieve desired financial reporting outcomes.

    Citation:

    Keune, M. B., and K. M. Johnstone. 2012. Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees. Accounting Review 87 (5): 1641-1677.

    Keywords:
    audit committees, audit fees, error correction, materiality, stock analysts
    Purpose of the Study:

    Auditors detect and inform client managers and audit committees of misstatements, and these agents must reach agreement about whether managers will correct the misstatements prior to issuing the financial statements. Managers may waive correcting misstatements if auditors and audit committees conclude that the misstatements do not render the financial statements materially incorrect. Yet, the Securities and Exchange Commission (SEC) and others have asked the rhetorical question: If a misstatement is immaterial, then why not correct it? Given the absence of bright-line criteria for assessing materiality, judgments about resolving misstatements may be strategic to achieve desired financial reporting outcomes. Analysis of the role of managers, auditors, and audit committees in misstatement materiality judgments is therefore important because it can aid understanding of observed audit and financial reporting outcomes that can affect users.

    In this study the authors make use of regulation concerning the resolution of detected misstatements contained in Staff Accounting Bulletin No. 108 (SAB 108). The implementation of SAB 108 provides disclosure data on detected misstatements that were previously judged immaterial and were not corrected in the financial statements until the release of the new guidance. The authors use the SAB 108 disclosures to measure both the qualitative and the quantitative materiality of misstatements during the periods in which they remained uncorrected.

    Design/Method/ Approach:

    The data-collection period covers 10-Qs filed from November 15, 2006 to February 28, 2007 and 10-Ks filed from November 15, 2006 to February 15, 2008, and the analyses examine waived misstatements that existed in the financial statements during the period January 1, 2003 to September 30, 2006. To identify these misstatements, the authors read SAB 108 disclosures to find companies that corrected misstatements under SAB 108. 

    Findings:
    • The authors find that managers are generally more likely to waive qualitatively material misstatements as analyst following increases, but this effect is primarily present when audit fees are relatively low.
    • They find auditors are less likely to allow managers to waive quantitatively material misstatements as audit fees increase.
    • The authors also find a negative interaction between audit fees and analyst pressure on the likelihood that auditors will allow managers to waive qualitatively material misstatements.
    • Specifically, auditors’ incentives to protect their reputations weaken the effect of managerial incentives associated with the pressure created by analyst following; auditors are less likely to allow managers to waive qualitatively material misstatements as audit fees increase.
    • The authors find that audit committees with greater financial expertise are less likely to allow managers to waive qualitatively or quantitatively material misstatements than are audit committees with less expertise.
    Category:
    Corporate Matters, Governance, Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Board/Audit Committee Oversight, Earnings Management, Earnings Management, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Abnormal Audit Fees and Audit Quality: The Importance of...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 11.0 Audit Quality and Quality Control, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management.
    Practical Implications:

    This paper provides new evidence on the fee-quality relationship using the propensity to use income-increasing discretionary accruals to meet or beat analysts' forecasts. The evidence in this paper suggests that abnormal audit fees are positively related to audit quality. This result is consistent with concerns raised by regulators that lower audit fees could reflect a lower level of effort provided by the auditor. This is important, given the trend of declining audit fees in recent years. By finding different results using a more focused sample of firms with the incentive and ability to manage earnings, this study highlights the importance of considering the context when performing tests of earnings management. This information is of interest to regulators, such as the SEC.

    Citation:

    Eshleman, J. D., & P. Guo. 2014. Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management. Auditing: A Journal of Practice & Theory 33 (1): 117-138.

    Keywords:
    audit fees, audit quality, discretionary accruals, meet-or-beat, earnings management
    Purpose of the Study:

    In this study, the authors attempt to shed light on the conflicting evidence by performing a study of the relationship between abnormal audit fees and audit quality using a new research design. Specifically, the authors examine whether clients paying abnormal audit fees are more or less likely to use discretionary accruals to meet or beat the consensus analyst forecast.

    A growing body of accounting literature examines the relationship between audit fees and audit quality. Researchers are interested in this relationship because, ex ante, it is not clear whether receiving higher fee revenue from a client will improve audit quality or harm it. On the one hand, it could be argued that an auditor who receives abnormally high audit fees from a client will lose their independence and allow the managers of the client firm to engage in questionable accounting practices. However, it is also possible that audit fees are a measure of audit effort, i.e., higher fees indicate that the auditor worked more hours, signaling greater effort. To the extent that audit fees are a measure of audit effort, low audit fees could harm audit quality.

    Design/Method/ Approach:

    Audit fee and auditor data are obtained from Audit Analytics, financial statement data are obtained from Compustat, and analyst forecast data are obtained from the I/B/E/S database. The authors perform tests on two samples of 4,476 firm-years and 1,670 firm-year observations spanning 2000 to 2011.

    Findings:

    The authors find that clients paying higher abnormal audit fees are significantly less likely to use discretionary accruals to meet or beat the consensus analyst forecast. If abnormal audit fees are held at their mean, a one-standard-deviation increase in abnormal audit fees decreases the client's likelihood of using discretionary accruals to meet or beat the consensus forecast by approximately 5 percent. This is consistent with higher audit fees being indicative of greater auditor effort and, ultimately, better audit quality. The authors obtain similar results whether they use the audit fee model of Choi et al. (2010), the one proposed by Blankley et al. (2012), or their own audit fee model.

    Category:
    Audit Quality & Quality Control, Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Earnings Management
  • 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 influence of director stock ownership and board...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.04 Board/Audit Committee Compensation, 14.0 Corporate Matters, 14.01 Earnings Management, 14.11 Audit Committee Effectiveness 
    Title:
    The influence of director stock ownership and board discussion transparency on financial reporting quality.
    Practical Implications:

    Understanding why stock ownership can bias directors’ objectivity, and examining how board discussion transparency can yield differential effects for stock-owning and non-stock-owning directors makes it possible to anticipate the effects of increased board transparency on earnings management and directors’ decisions. The notion of increased board discussion transparency is valid in the current environment in which shareholders are pushing for “constituency board seats” because information leaks surrounding board discussions likely will result when constituent directors report back to their shareholder groups. Hence, if controversial boardroom discussions are eventually divulged to the public, the findings suggest that directors’ judgments and decisions will be influenced by knowledge of increased board transparency.

    Citation:

    Rose, J. M., C. R. Mazza, C. S. Norman, and A. M. Rose. 2013. The influence of director stock ownership and board discussion transparency on financial reporting quality. Accounting, Organizations & Society 38 (5): 397-405.

    Keywords:
    stock ownership, board of directors, transparency in organizations, earnings management, corporate governance quality
    Purpose of the Study:

    Stock ownership requirements for directors have become commonplace, and institutional investors can pressure corporate boards to rely wholly or partly on stock based forms of pay for board service. Consistent with the underlying principles of agency theory, the usual justification for stock ownership requirements is for directors to have “skin in the game,” thus aligning their personal interests with those of company shareholders. Recent archival studies strongly favor board stock ownership requirements and indicate that firms with ownership requirements exhibit better performance the year after implementing the requirements. Existing literature often equates director stock ownership with improved financial performance and improved corporate governance. On the other hand, improved firm performance associated with stock ownership could arise from a narrow focus on short-term earnings. Support for this potential alternative explanation is provided by extant archival studies indicating that managers often become myopic when paid with stock options and stock grants. In addition, recent experimental findings suggest that director stock ownership can harm objectivity and lead to biased financial reporting.

    The current study examines whether stock ownership will induce directors to go along with management’s aggressive revenue recognition in light of pressure from the Chief Audit Executive (CAE) to take a more conservative approach. In particular, the authors examine whether the effects of board stock ownership are dependent upon board discussion transparency.

    Design/Method/ Approach:

    The current study involves a 2 X 2 between-participant randomized experiment. The experiment was computerized and administered via the Internet. The authors contacted current and former CEOs and board chairs to request the participation of board members. 72 directors completed all of the response items and correctly answered manipulation check items. Of the 72 directors who are included in the final sample, there were 58 (81%) male and 14 (19%) female directors. This data was collected prior to July 2013.

    Findings:

    The authors find that stock ownership can affect directors’ independence and objectivity as well. They conclude that independence requirements resulting from SOX and adopted by the NYSE and NASDAQ focusing on board member affiliation are threatened by directors’ ownership of stock in the companies for which they serve. The authors suggest that the temptation of stock-owning directors to engage in myopic behavior that could boost the company’s stock price can be mitigated by increasing the transparency of board discussions. In examining the effects of transparency of board discussions on the likelihood of directors agreeing with management’s aggressive reporting attempts, the authors find competing effects, depending on whether directors own or do not own stock. Specifically, directors who own stock were less likely to agree with management’s aggressive reporting when board discussions were more transparent, compared to less transparent. Yet, there were no benefits of increased transparency for directors who did own stock, and directors who did not own stock were more likely to support earnings management attempts than were stock owning directors when transparency was high.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Audit Committee Oversight, Earnings Management

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