This paper examines how the auditor’s evaluation of internal control impacts substantive testing in a two-location setting with correlated internal control strengths. When control strengths are independent, internal control strength pairings have no effect on the manager’s probability choice to commit fraud or on the auditor’s substantive test effort. This study shows how the manager’s opportunity to commit fraud and informational characteristics of internal control tests impact the manager’s probability choice of fraud and the auditor’s choice of substantive test effort.
Patterson, E.R. and J.R. Smith. 2016. The Strategic Effects of Auditing Standard No. 5 in a Multi-Location Setting. Auditing: A Journal of Practice and Theory 35 (1): 119-138.
Auditing Standard No. 5, An Audit of Internal Control over Financial Reporting that is Integrated with an Audit of Financial Statements, provides guidance in the required audit of internal controls. The purpose of AS 5 is to reduce the burden of SOX-required control tests by integrating them into a risk-based approach to auditing. From an internal control perspective, fraud risk is considered to increase as controls weaken because weaker controls create an opportunity for a manager to commit fraud. However, the auditor’s risk assessments and resulting audit strategy must include anticipation of the manager’s strategic behavior, which depends on conjectures about the auditor’s strategy. This paper examines how a manger’s knowledge of internal control strengths and weaknesses across different locations affects the auditor’s testing strategy and the manager’s propensity to commit fraud.
A two-stage model is created in which a manager oversees two locations and has the opportunity to commit fraud in either of the two locations alone, or at both locations simultaneously. Three situations are considered: no internal control testing, minimal internal control testing, and full internal control testing.
At the empirical level, this analysis brings the impact of global standardization on local communities of small accounting practitioners to the fore. The authors have found that accounting and auditing research has neglected both small practitioners and the impact of resilience in accounting and auditing research. At the theoretical level, this paper is the first to mobilize the notion of resilience in accounting and auditing research. It is the hope of the authors that this study will lead to a qualitative study of the formation of small practitioners’ habitus – how they are socialized in taking up the role of docile actors who tend to be obedient to their profession’s formal authorities, highly skilled in technical thinking, and not too demanding in terms of requiring justifications.
Durocher, S., Y. Gendron, and C. Picard. 2016. Waves of Global Standardization: Small Practitioners’ Resilience and Intra-Professional Fragmentation within the Accounting Profession. Auditing: A journal of Practice and Theory 35 (1): 65-88.
As the forces of globalization prompt more and more countries to open their doors to foreign investment and as businesses themselves expand across borders, both the public and private sectors are increasingly recognizing the benefits of having a commonly understood financial reporting framework supported by strong globally accepted auditing standards. These processes of globalization may seem beneficial and unproblematic from the view point of the standard setters, but that is not necessarily the case if one considers the small practitioners’ view point. Despite being the majority of all practicing accountants, small practitioners often do not have the time or ability to send representatives to work in the administration of professional bodies or on special projects that inevitably set the standards of the profession. These facts led the authors to their primary objective in writing this article. The primary objective of this study is to examine how small practitioners, in the field of accountancy, perceive and react to the global standardization agenda. This study also examines how globalization discourses are constructed and rendered practical in localities.
The authors conducted 25 semi-structured interviews with 31 participants between December 2009 and July 2011. To generate variation, practitioners having up to 39 years of experience working in firms of various sizes were interviewed.
This discussion emphasizes significant caution when interpreting the results of the study. Mainly, it is unclear if results of the study can generalize to the broader public company market in the US. Furthermore, if the results are misinterpreted (i.e., individual auditors are not systematically aggressive but, instead, high quality auditors are systematically assigned the riskiest clients) then regulation requiring audit partner identification could actually have overall negative effects on overall audit quality.
Kinney, W.R. 2015. Discussion of “Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions”. Contemporary Accounting Research 32 (4):1479-1488.
The author reviews the paper's content, analyzes its predictive validity, and discusses its multiple implications. He provides constructive suggestions for improvements. Based on predictive validity analysis, the author concludes that engagement partner assignment strategy is an important and acknowledged omitted variable that affects the study's internal validity via both the independent variable (partner's prior performance measure) and the dependent variable (borrower's cost of debt capital). The omission also affects construct validities and, if audit firms are applying a plausible assignment strategy, then interpretation of the study's main results would be reversed. Finally, the lack of a standards intervention noted by the authors and the extreme size and other differences between audits of Swedish private companies and U.S. public companies impair external validity and generalization to the U.S. intervention.
This article is a discussion.
The discussion emphasizes the following points:
Auditor aggressive/conservative reporting style may be a systematic audit partner attribute and non-randomly distributed across engagements. Particular market participants (in this case, lenders) appear to recognize and price these differences in reporting style. While the particular mechanism through which these different reporting styles occur is not possible to determine, the results suggest the importance of individual audit partners in influencing audit reporting decisions. Therefore, current regulations in both the US and EU to identify the individual partner’s identity could potentially offer valuable information to market participants.
Knechel, W. R., A. Vanstaelen, and M. Zerni. 2015. Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions. Contemporary Accounting Research 32 (4):1443-1478.
Current debate exists as to whether requiring individual auditor identification would enhance audit quality and, if so, whether investors understand and respond to these differences. This study provides empirical evidence to support the assertions that:
This study is especially relevant given both the EU’s decade old requirement to disclosure of audit engagement partner and the recent, similar PCAOB requirement that US audit partners do the same.
The authors use archival methods. They acquired panel data between 2001 – 2008 of the total clienteles of individual Big 4 audit partners of statutory audits for small, private companies in Sweden. This excludes non-Big 4 auditors and joint auditors.
In general, the frequency of Type I and II reporting errors is correlated over time for an individual partner both (1) across time for the same client and (2) between clients. As such, aggressive or conservative accounting appears to be a systematic partner attribute. Regarding investors, they appear to understand that partner reporting style is systematic across time and between clients and penalize firms audited by partners with a history of aggressive reporting via higher interest rates, lower credit ratings, and higher credit/insolvency risk. These results are, generally, economically significant.
More specific results include:
This study provides evidence on how SFAS 133 affected reporting behavior. While it is not possible to directly assess the extent to which banks might have used LLP to offset hedge ineffectiveness prior to SFAS 133, a variety of tests in this study collectively indicate that bank managers increase their reliance on discretionary LLP to counteract the “undesirable” effects of SFAS 133’s recognition requirements. The effects of SFAS 133 go beyond derivatives; SFAS 133 also altered the information content of a non-derivative financial statement component (i.e., LLP) and the pricing of that component in equity markets. The findings are particularly timely given the recent exposure draft on accounting for financial instruments.
Kilic, E., G. J. Lobo, T. Ranasinghe, and K. Sivaramakrishnan. 2013. The Impact of SFAS 133 on Income Smoothing by Banks through Loan Loss Provisions. Accounting Review 88 (1): 233-260.
This study examines the impact of SFAS 133, Accounting for Derivative Instruments and Hedging Activities, on the reporting behavior of commercial banks and the informativeness of their financial statements. SFAS 133 changed accounting for derivatives substantially by forcing recognition of (1) all hedging derivatives at their fair values, and (2) any hedge ineffectiveness in income as it occurs. As a result, the hedging derivative gains/losses recognized in income by derivative user banks almost quadrupled following the adoption of SFAS 133, with as much as 20 percent of those gains/losses arising from ineffective hedging. Clearly, hedge ineffectiveness increases income volatility because gains and losses from hedges and hedged items are not offsetting.
SFAS 133 would arguably inhibit the use of derivatives in smoothing income. This possibility raises at least two interesting research questions regarding the impact of SFAS 133 on the reporting behavior of managers, and the consequent impact on the informativeness of financial statements. In particular:
The authors obtain bank holding company financial data and derivative data from 10-K filings and FR Y-9C filings, and share price data from the CRSP data files. They restrict the pre-SFAS 133 sample period to fiscal years 1998, 1999, and 2000, and the post-SFAS 133 sample period to fiscal years 2001, 2002, and 2003. The authors use a final sample of 105 derivative-user banks. The sample of non-user banks includes 139 publicly traded banks that do not use hedging derivatives during the sample period.
The results should be considered in the context of due process for setting accounting standards and for legislating financial regulation. The study suggests that bank representatives writing negative comment letters have motives to resist accounting standards that result in reduced accounting slack and increased transparency. As one would expect, these motives and patterns of financial-reporting behavior are not mentioned in the comment letters. Instead, the negative letters submitted by responding bank representatives cite conceptual reasons for resisting proposals intended to increase financial reporting transparency. The results suggest that the processing of comment-letters should explicitly include consideration of letter-writer motivations, and weigh carefully the stated reasons for support or opposition against letter-writer incentives and potentially divergent facts.
Hodder, L. D., & Hopkins, P. E. 2014. Agency problems, accounting slack, and banks’ response to proposed reporting of loan fair values. Accounting, Organizations & Society, 39 (2): 117-133.
In May 2010, the United States (US) Financial Accounting Standards Board (FASB) issued an Exposure Draft (ED) that proposes greatly expanding fair value recognition for most financial instruments, including long-term receivables, such as bank loans. Responses received by the FASB during the ED’s comment period were overwhelmingly negative and particularly concentrated within the banking industry; specifically, the FASB received 2971 comment letters in response to the ED, with over 85% from bank representatives and banking trade organizations. Through the end of 2011, this is one of the highest comment-letter volumes in response to any single FASB-issued public-comment discussion document. Because of the large volume of negative letters received from bank representatives, the FASB withdrew the proposal in January 2011. This study seeks to understand the factors systematically associated with bank representatives’ decisions to submit comment letters.
Despite the many changes proposed in the ED, the vast majority of letters submitted by commercial-bank representatives addressed only one issue: opposition to the proposed reporting of loans at fair value. Given the large, uniform, and narrowly focused response that was concentrated in the banking industry, this suggests that responding bank representatives perceived an economic threat from the FASB’s ED and its proposal to change current accounting for loans.
The authors use logistic regression analysis to test the determinants of differential bank comment-letter writing. The primary sample consists of all private and public commercial banks with necessary financial data in the periods covered by the tests. The authors collect financial statement data from publicly available regulatory filings. The authors include quarterly data spanning 2001Q1 through 2011Q4. The sample includes 5,289 unique banks. From the FASB’s web site, the authors collect all 2,971 comment letters submitted.
The authors provide evidence suggesting that bank representatives’ objections to the ED are motivated less by stated conceptual concerns and more by self-interest. The incurred loss model for accounting for loan losses makes available accounting slack that can be used to manage capital and earnings. The finding that banks historically using accounting slack are more likely to oppose the ED suggests that the FASB’s fair value proposal is perceived to decrease available accounting slack related to loans. In the analysis of transparency-related motives, banks submitting comment letters opposing the loan-reporting provisions of the ED are:
These results are consistent with bank managers and shareholders affiliated with lobbying banks benefitting from the lower agency costs that accompany government guarantees of indebtedness and the lower levels of external monitoring that otherwise would be provided by unguaranteed debt holders and by auditors.
The results of this study are important in realizing the investor’s perception of audit quality as it relates to SAB No. 108 disclosures. Investors respond negatively to the quantification of prior period misstatement disclosures. The investor also distinguishes between misstatements that are waived by previous auditors and misstatements waived in the current year. Investors react negatively to misstatements that are disclosed in the current year. The investors also react to the importance of the client as it relates to the misstatements that are waived. Investors understand and react to the correlation between client importance, waived misstatements, and client retention. The results are important to understand that investors react to disclosures made under SAB No. 108.
Omer, T. C., M. K. Shelley, and A. M. Thompson. 2012. Investors' Response to Revelations of Prior Uncorrected Misstatements. AUDITING: A Journal of Practice & Theory 31 (4):167-192.
Staff Accounting Bulletin (SAB) No. 108 requires the disclosure of prior-period waived misstatements as well as the use of multiple methods of quantifying misstatements. The rollover method quantifies misstatement on a current year income statement effect, while the iron curtain method quantifies misstatement based on the balance sheet effect. The two methods can differ in terms of the resulting misstatement amounts. The authors of this study examine:
The authors identified 420 firms that disclosed misstatements under SAB No. 108 using EDGAR and Morningstar Document Research. Of these firms, a sample of 272 firms were chosen to complete market return tests on the data. Multivariate regression analysis was employed on firm disclosures from filings made after November 15, 2006.
The results of this study are important because they illuminate the impact of new accounting rules on standard setters and companies abiding by these rules (in this case, the specific context was the implementation process related to SOX Section 404). The study suggests that a number of steps are required in order to perfect the guidance. It is important to understand the meaning and intentions behind authoritative literature in order to follow it. The observations suggest that the process for implementing new guidance has room for change, yet has evolved over time to increase effectiveness. The findings are specific to the implementation for assessment and auditing of internal controls for public companies.
For more information on this study, please contact Zoe-Vonna Palmrose (zv.palmrose@marshall.usc.edu).
Palmrose, Z.-V. 2010. Balancing the Costs and Benefits of Auditing and Financial Reporting Regulation Post-SOX, Part I: Perspectives from the Nexus at the SEC. Accounting Horizons 24 (2):313-326.
Sarbanes-Oxley (SOX) Section 404 adds requirements for disclosures discussing management’s assessment of internal controls. Zoe-Vonna Palmrose served as the Deputy Chief Accountant for Professional Practice in the Office of the Chief Accountant. From August 2006 to July 2008, Palmrose observed the effects of SOX Section 404 on practice. The paper describes her observations related to:
The author collected data through personal experiences from August 2006 through July 2008. She observed and recorded information related to SOX Section 404 during her time as the Deputy Chief Accountant in the Professional Practice Group.
Overall, the results support concerns expressed by some observers that greater use of fair value measurements for financial instruments will trigger increased audit fees. We believe our results validate the compliance cost concerns expressed by some preparers (i.e. higher audit fees), and provide interesting and timely evidence relevant to the ongoing debate regarding the increased use of fair value measurements for financial instruments (FASB 2010; ABA2010).
For more information on this study, please contact Michael Ettredge.
Ettredge, M. L., Xu, Y., & Yi, H. S. (2014). Fair value measurements and audit fees: evidence from the banking industry. Auditing: A Journal of Practice & Theory 33(3): 33-58.
This study examines the association between audit fees and the proportions of fair-valued assets held by the sample of public U.S. bank holding companies. Motivated by claims that fair-valued assets are unusually difficult to audit (Bratten et al., 2013), we explore
Consistent with the view that audit risk and effort increase with the extent of fair-valued assets, we provide evidence that auditors charge more for higher proportions of assets held in the form of fair-valued assets. Furthermore, within fair-valued assets, the positive association between logged audit fees and the proportions of total assets that are fair-valued using Level 3 inputs is greater than its positive association with the proportions of total assets that are fair-valued using Level 1 or Level 2 inputs. We believe our results validate the compliance cost concerns expressed by some preparers (i.e. higher audit fees), and provide interesting and timely evidence relevant to the ongoing debate regarding the increased use of fair value measurements for financial instruments (FASB 2010; ABA2010).
Our data cover the years 2008-2011 with 299 unique banks for our main tests.
The paper documents that
The findings generally support FASB (2008) Exposure Draft assertions that there is often insufficient timely information about litigation available to users. Specifically, the authors find that in an unexpectedly large proportion of the cases they investigate, companies do not disclose lawsuits until a loss occurs. The authors also find a relatively high incidence of companies not providing estimated losses or ranges of losses prior to resolution. For a substantial number of cases, accruals for estimated losses are not made (or are at least not disclosed) prior to the realization of the loss. Further, the authors find a relatively high degree of disclosure of the items called for in the FASB’s (2008) Exposure Draft, suggesting that users already demand at least some of them.
For more information on this study, please contact Ray J. Pfeiffer.
Desir, R., K. Fanning, and R. Pfeiffer. 2010. Are revisions to SFAS No. 5 needed? Accounting Horizons 24 (4): 525-545.
Setting financial reporting standards, like most regulatory activities, requires decision-making under uncertainty. In a typical standard-setting issue, standard setters receive information — typically in the form of (often unsupported) assertions — that there is some deficiency in existing Generally Accepted Accounting Principles. For those alleged deficiencies that exceed a threshold, the Board and Staff of the FASB initiate a standard-setting project. In their work on projects, Board and Staff members must make difficult judgments about the nature of guidance likely to resolve the deficiency while anticipating any indirect consequences of the contemplated new guidance.
Empirical academic research has the potential to play a useful role in the standard setting process to the extent that it can be used to reduce the inherent uncertainty facing Board members. Ex ante empirical evidence is particularly desirable because it enhances the likelihood that new guidance is actually warranted and that any new guidance achieves its intended purpose.
This paper reports the findings of an example of such ex ante empirical research. The issue in question is the allegation that firms tend to provide insufficient and insufficiently timely disclosures of contingent legal obligations. This assertion was an explicit part of the rationale underlying the FASB’s Exposure Draft, “Disclosure of Loss Contingencies” (FASB 2008b). This paper has two intended contributions: (1) to report the findings of empirical research about the extent of the alleged insufficient disclosure problem; and (2) to serve as an example of how empirical academic research can be informative to the FASB Board and Staff.
The authors assembled a representative random sample of unfavorable settlements and adjudications of lawsuits in firms’ 10-Q and 10K filed during the first half of 2007. For each resolved lawsuit, the authors coded characteristics of the disclosure in the period of resolution as well as in all prior periods where disclosure existed prior to resolution. The descriptive evidence of litigation-related disclosure was from financial statement notes and required SEC disclosures in the 10K or 10-Q.