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  • The Auditing Section
    A Reexamination of Behavior in Experimental Audit Markets:...
    research summary posted May 4, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.04 Moral Development and Individual Ethics Decisions 
    Title:
    A Reexamination of Behavior in Experimental Audit Markets: The Effects of Moral Reasoning and Economic Incentives on Auditor Reporting and Fees
    Practical Implications:

    These findings suggest that auditors with lower moral reasoning scores (i.e., who tend to cooperate with close allies, but tend to be less cooperative with other parties) might in some cases better adhere to the profession’s duties.  Auditors with higher moral reasoning scores (i.e., who tend to view norms and rules as flexible and interpret them depending on a situation) are more likely to depart from auditing conventions and cooperate with others to their mutual benefit.  There have been similar findings, i.e. contrary to what we might expect in relation to moral reasoning, in other research settings.

    Citation:

    Schatzberg, J. W., G. R. Sevcik, B. P. Shapiro, L. Thorne, and R. S. O. Wallace. 2005. A reexamination of behavior in experimental audit markets: The effects of moral reasoning and economic incentives on auditor reporting and fees. Contemporary Accounting Research 22 (1): 229-264.

    Keywords:
    Audit fee, auditor reporting, cooperation, moral reasoning
    Purpose of the Study:

    In this study, the authors examine how “moral reasoning” (as measured by a commonly-used test) affects auditor reporting under different economic incentives, in an experimental setting.  In the audit of the financial statements process, cooperation between auditors and managers is important so that sufficient evidential matter can be obtained. The authors examine whether auditors are more or less likely to cooperate with management, based on the level of moral reasoning, and penalties for mis-reporting. 

    Design/Method/ Approach:

    The authors assign participants to either a “higher” or “lower” moral reasoning group based on each participant’s “higher” or “lower” score on a commonly-used moral reasoning test.  A lower score on the moral reasoning test indicates that the participant is focused on what is good for him or her whereas a higher score indicates the individual considers what is best for society.  Although not specifically stated in the study, the data appears to have been collected prior to 2005.  The participants used in this study were recruited from MBA classes.  Participants had to consider whether they would truthfully report a “low” outcome, or report “high” even though the outcome was low (i.e. cooperate with management), which would harm investors but economically benefit the participants.  The authors varied the level of penalty for misreporting to observe how this changes behavior. 

    Findings:
    • Moral reasoning and the economic penalty both significantly affected reporting behavior.  The smaller the economic penalty for misreporting the more frequently the participants tended to misreport.
    • As the economic penalty increased, truthful reporting increased.
    • When auditors engaged in “cooperative reporting behavior” (saying outcome was high when it was really low), managers tended to respond with cooperative contracting behavior (rewarding auditor participants).  Such cooperative contracting behavior was more frequent in higher moral reasoning groups, which is contrary to what we might expect (we would expect higher moral reasoning groups to report truthfully more often as opposed to less often). 
    Category:
    Independence & Ethics
    Sub-category:
    Impact of Fees on Decisions by Auditors & Managmeent, Moral Development and Individual Ethics Decisions
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  • James L Fuehrmeyer
    An Empirical Analysis of Auditor Independence in the Banking...
    research summary posted March 19, 2013 by James L Fuehrmeyer, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.03 Non-Audit Services 
    Title:
    An Empirical Analysis of Auditor Independence in the Banking Industry
    Practical Implications:

    The results suggest that fees paid to auditors, even for non-audit services, can potentially threaten auditor independence, particularly among banks that are not subject to the same level of regulatory scrutiny as large banks.

    Citation:

    Kanagaretnam, K., G. V. Krishnan, and G. J. Lobo. 2010. An Empirical Analysis of Auditor Independence in the Banking Industry. The Accounting Review 85 (6): 2011-2046.

    Keywords:
    auditor independence; earnings management; auditor fees; bank loan
    Purpose of the Study:

    Auditor independence is vital to maintaining public confidence in capital markets and to the integrity of corporate financial statements. The objective of this study is to examine auditor independence in the banking industry.

    • The study provides evidence on the relation between fees paid to auditors of banks and the extent of earnings management via loan loss provisions (LLPs).
    • The study is timely and relevant given the recent banking crisis and that governments around the world are contemplating new banking regulations.
    • The research informs policymakers on the relationship that existed between fees paid to auditors and the extent of earnings management in banks prior to the current banking crisis.
    • Authors examine difference between large and small firms that face different levels of regulation. Small firms are not subject to regulation under the Federal Deposit Insurance Corporation Improvement Act (FICIA) of 1991.
    Design/Method/ Approach:

    The authors collected 1,740 bank-year observations over the years 2000–2006. The authors determine abnormal LLPs and examine the association between abnormal LLPs and unexplained total fees and unexplained non-audit fees. They then examine whether the association is different depending on whether the bank is small (total assets of less than $500 million or less than $1 billion, effective 2005, or non-accelerated filers under Section 404 of Sarbanes-Oxley Act, effective 2004) or large.

    Findings:
    • For large banks, there is no relationship between abnormal LLPs and unexplained total fees or unexplained non-audit fees.
    • For small banks, higher unexplained total fees and unexplained non-audit fees are positively associated with income-increasing earnings management through LLPs. Higher unexplained total fees and unexplained non-audit fees are negatively associated with income-decreasing earnings management through LLPs. These two results provide evidence that banks that pay higher audit fees engage in more earnings management.
  • Jennifer M Mueller-Phillips
    An Examination of How Entry-Level Staff Auditors Respond to...
    research summary posted July 15, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.04 Moral Development and Individual Ethics Decisions, 04.09 Individual & Team Conduct - e.g., premature signoff, underreporting hours 
    Title:
    An Examination of How Entry-Level Staff Auditors Respond to Tone at the Top vis-a`-vis Tone at the Bottom.
    Practical Implications:

    These findings add to the understanding of how accountants respond to ethical tones at all levels within their organization and provide important evidence that the tone at the bottom is a key determinant, more so than tone at the top, of the ethical decision making of staff auditors. This study provides important insights into how ethical tone at multiple levels of an organization impacts entry-level employees’ ethical decision making. By recognizing the important role that immediate supervisors play in influencing their subordinates, organizations can more effectively promote an ethical culture at all levels of the organization and not simply at the top.

    Citation:

    Pickerd, J. S., Summers, S. L., & Wood, D. A. 2015. An Examination of How Entry-Level Staff Auditors Respond to Tone at the Top vis-a`-vis Tone at the BottomBehavioral Research in Accounting 27 (1): 79-98.

    Keywords:
    accountability, auditing, control environment, tone at the top, underreporting
    Purpose of the Study:

    The purpose of this study is to examine how entry-level staff auditors make decisions in the presence of sometimes conflicting ethical tones set by their supervising senior (tone at the bottom) and partner (tone at the top).

    The authors employ self-concept maintenance theory, which argues that unethical behavior becomes acceptable to the degree the action can be rationalized, is used to motivate this study. The low ethical tone of supervisors at the top and/or bottom may cause entry level staff auditors to construe unethical situations as devoid of ethical implications, such that entry level staff auditors may act more unethically if either (or both) of their supervisors exhibit a low ethical tone. Further, in-group bias theory, which suggests that individuals will be more influenced by close in-group members who are similar to them than by out-group members who are dissimilar to them, is used to predict that entry-level staff auditors will follow the tone set by their senior more than the tone set by a partner. This study also examines how individuals perceive their own ethical decisions under such conditions.

    Design/Method/ Approach:

    A 2x2 between-subjects experiment is administered to 114 graduate accounting students from a private university. 70 percent of participants had performed an internship and 72 percent had signed with an employer. Participants are told they went over budget on the number of hours they spent auditing cash and must decide how many to report. Ethical tone is manipulated using the tone from both the engagement senior and engagement partner. The evidence was gathered prior to September 2014.

    Findings:
    • The findings indicate that tone at the top and tone at the bottom interact, such that if either the partner and/or the senior exhibit low tone, then participants are more likely to misreport the number of hours they worked on the engagement.  
    • Participants are more influenced by the tone set by their supervising senior than that of their engagement partner. This suggests to the authors that tone at the bottom is a critical determinant of the ethical decision making of entry-level staff auditors.  
    • Tone significantly affects whether participants interpret the decision to underreport as an ethical dilemma. 
    • When both a partner and a senior exhibit high tone, participants are significantly more likely to interpret their decision on whether to underreport hours as an ethical dilemma than in the other conditions. This result suggests that poor tone causes individuals to cease considering the ethical implications of their decisions, thus allowing them to maintain a high self-concept when they violate organizational standards.
    Category:
    Independence & Ethics
    Sub-category:
    Impact of Fees on Decisions by Auditors & Management, Individual & team conduct (e.g. premature signoff - underreporting hours), Moral Development and Individual Ethics Decisions
  • Jennifer M Mueller-Phillips
    An Experimental Investigation of the Influence of Audit Fee...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 03.0 Auditor Selection and Auditor Changes, 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management 
    Title:
    An Experimental Investigation of the Influence of Audit Fee Structure and Auditor Selection Rights on Auditor Independence and Client Investment Decisions
    Practical Implications:

     Lowballing has been cited as a threat to auditor independence and manager performance in regulatory reports and academic research. This study suggests that auditors may face independence issues at the beginning of a client relationship under the lowballing fee structure because of the uncertainty of retaining a client. The study also suggests, however, that these independence issues seem to dissipate over time. Therefore, auditors should be aware of these potential opportunities to lose objectivity when they acquire new audit clients and continue to rely on professional skepticism to evaluate management assertions.

    For more information on this study, please contact Darius J. Fatemi.
     

    Citation:

    Fatemi, D. J. 2012. An Experimental Investigation of the Influence of Audit Fee Structure and Auditor Selection Rights on Auditor Independence and Client Investment Decisions. Auditing: A Journal of Practice and Theory 31(3): 75-94.

    Keywords:
    Audit fees; auditor independence; experimental economics; manager investment; auditor selection.
    Purpose of the Study:

    The purpose of this paper is to investigate the effect of audit fee structure on auditors, their clients, and investors. The author wanted to specifically investigate how a lowballing audit fee structure as opposed to a flat rate fee structure impacts:

    • manager investment decisions
    • the degree of investigation of management decisions by auditors
    • the price that investors pay for shares of the company

    The author also investigated whether a cause-effect relationship exists between the use of a lowballing audit fee structure (in which auditors provide initial services at reduced prices but at higher prices in later periods) and auditor independence when retention is of concern to the auditor.

    Design/Method/ Approach:

    The author utilized an experimental market using undergraduate accounting majors that were randomly assigned to the roles of managers, investors, and auditors.  The auditors followed either a lowballing fee structure or a flat rate fee structure. Auditor selection was performed by either the managers or the investors. The managers bid on firm assets and provided a disclosure of the value of the assets to the investors. Auditors decided the extent to which they investigated managers’ claims and either concurred with manager’s disclosures or they provided information that the auditors believed to be more accurate.

    Findings:

    Compared to the flat-rate fee structure, managers under a lowballing fee structure scheme were:

    • more willing to make a high cost/return investment
    • more concerned with the credibility of their reports
       

    Auditor behavior is summarized as a response to past manager choices: when managers were especially willing to invest and be honest, auditors performed fewer tests of manager disclosures. Additionally, under manager selection and when lowballing existed, auditors attributed a higher accuracy to investigations indicating high manager investment than tests that suggest low investment, while accuracy assessments of favorable and unfavorable test results did not differ under investor selection. Finally, auditor retention under manager selection was negatively impacted by both unreliable auditing and disagreements with managers, but retention was only affected by unreliable auditing under investor selection.

    Category:
    Auditor Selection and Auditor Changes, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Auditor Choice and Audit Fees in Family Firms:Evidence from...
    research summary posted July 20, 2017 by Jennifer M Mueller-Phillips, tagged 04.02 Impact of Fees on Decisions by Auditors & Management 
    Title:
    Auditor Choice and Audit Fees in Family Firms:Evidence from the S&P 1500
    Practical Implications:

    This study provides policy-makers and practitioners with critical insight into differences in auditor selection criteria between family and non-family firms and differences in the severity of their agency conflicts between shareholders and managers and also between family owners and minority shareholders.

    Our empirical evidence also sheds light on how family firms view and value the external audit and whether they are selecting auditors on price or quality, or some combination of these factors. In addition, given the current downward trend in audit revenues as a percentage of total revenues, our findings could lead accounting firms to re-examine how they market audit services to family firms.

    Citation:

    Ho, J.L., and F.Kang. 2013.Auditor Choice and Audit Fees in Family Firms: Evidence from the S&P 1500.Auditing: A Journal of Practice and Theory32(4): 71-93

    Keywords:
    Auditor choice; audit fees; family firms; agency problems
    Purpose of the Study:

    The authors study auditor choice and audit fees in family firms, which have a special ownership structure and different types of agency problems. Family firms are both prevalent and important in the U.S. About one-third of the S&P 500 are family-controlled companies in which the founding families on average own 11 percent of the cash flow rights and 18 percent of the voting rights.

    The unique class of family shareholders may influence firms’ auditor choice in two competing ways. On one hand, compared to non-family firms, family owners can more directly and closely monitor managers and therefore have less severe agency conflicts with managers. This may result in a lower demand for high-quality auditors. On the other hand, due to the agency problems between family owners and minority shareholders, family firms may have incentives to hire high-quality auditors as a signal of credible financial reporting in exchange for better contracting terms (e.g., lower cost of capital). Similarly, the different types of agency problems in family firms may also affect the level of audit fees. Family owners’ active monitoring reduces the inherent risk of material misstatements in financial reporting and results in a lower demand for audit effort, and therefore audit fees. However, the severe agency problems between family owners and minority shareholders suggest that family firms may incur higher audit fees due to higher audit risk and greater audit effort. Therefore, the effect of family firm characteristics on auditor choice and audit fees warrants empirical investigation.

    Design/Method/ Approach:

    The empirical analysis is performed on firms listed on the S&P 1500 index from 2000 through 2008. We define family firms as those in which founders or their family members (by either blood or marriage) are key executives, directors, or block holders and update the classification every year. We hand collected the ownership of the founding family and test our hypotheses on family firms’ auditor choice and audit fees using regressions.

    Findings:
    • The authors find that, on average, family firms are less likely to appoint top-tier accounting firms and incur lower audit fees than non-family firms.
    • The authors observe that the tendency not to hire top-tier accounting firms and to pay lower audit fees is more significant for firms in which family owners are the largest shareholders.
    • The authors find that, compared to family firms without dual-class shares, family firms with dual-class shares tend to mitigate their more severe agency problems between family owners and minority shareholders by hiring top-tier accounting firms to signal their earnings quality and they incur higher audit fees.
    • The authors also find that active family control (i.e., family members as CEOs or on the board) is associated with a lower tendency to hire top-tier accounting firms and lower audit fees.
    Category:
    Independence & Ethics
    Sub-category:
    Impact of Fees on Decisions by Auditors & Management
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  • Jennifer M Mueller-Phillips
    Auditor Fees and Auditor Independence: Evidence from Going...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 09.0 Auditor Judgment, 09.04 Going Concern Decisions 
    Title:
    Auditor Fees and Auditor Independence: Evidence from Going Concern Reporting Decisions
    Practical Implications:

    The finding of this study suggest that concerns over the relation between auditor fees and the possible impairment of auditor independence, as reflected in going concern modification decisions, are supported in the more recent years for highly distressed clients. The relationship between auditor fees and impairment of auditor independence with respect to auditor decision-making has long been a concern of many regulators in the accounting industry. This research may inform both audit firms and standard setters with respect to specific types of engagements and the judgments or behaviors most likely to be affected.

    For more information on this study, please contact Allen D. Blay.
     

    Citation:

    Blay, A. D., and M. A. Geiger. 2013. Auditor Fees and Auditor Independence: Evidence from Going Concern Reporting Decisions. Contemporary Accounting Research 30 (2).

    Keywords:
    auditor fees; auditor independence; going concern; regression analysis
    Purpose of the Study:

    The possible adverse effect of auditors providing services to clients who pay them directly has historically been a concern of the public accounting profession. Without independence there is no need for external auditors attesting to the purported accuracy and completeness of company financial statements. The association between fees received by audit firms directly from clients and the possible impairment of auditor independence, particularly with respect to going concern decisions, continues to be of considerable interest to regulators and others. This study assesses the potential impairment of auditor independence in the context of going concern reporting.

    Design/Method/ Approach:

    The authors derive their findings examining the association between both current and future audit service and nonaudit service fees received by U.S. auditors and the type of opinion rendered to a financially distressed client. To achieve their sample, the authors used the Audit Analytics database and first identified firms that received a going concern modified (GCM) audit opinion in the years 2004-2006. They also identified firms that had both negative income and cash flows from operations in the same year but did not receive a GCM opinion. Finally, the authors tested their hypotheses by using a research model to determine the probability of issuing a GCM audit opinion to a financially distressed client. 

    Findings:

    A negative correlation exists between future fees paid to auditors and auditor going concern opinion decisions.
    Higher levels of current nonaudit service fees paid to auditors reduces the frequency of going concern opinion modifications in the more recent 2004-2006 time period when using a more stringent control sample of financially distressed firms.
    Findings related to going concern decisions and nonaudit service fees in the United States are sensitive to both the time period examined and the selection of appropriate control samples of distressed non-GCM firms.
    A negative association exists between current nonaudit service fees and total subsequent fees paid to auditors.
     

    Category:
    Auditor Judgment, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Going Concern Decisions, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Client Importance and Earnings Management: The Moderating...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.03 Non-Audit Services, 13.0 Governance, 13.05 Board/Audit Committee Oversight 
    Title:
    Client Importance and Earnings Management: The Moderating Role of Audit Committees
    Practical Implications:

    The results of this study have implications to both New Zealand and the United States. Regulators in New Zealand should assess these results as possible indications that the profession’s self-regulated status may need to be revised in light of the existence of lower financial reporting quality for clients that have weak audit committee oversight and are economically important clients to the auditor. Additionally, these results provide evidence to contribute to the ongoing debate in the United States regarding the merits and the intended and unintended consequences of independent auditor oversight through regulatory bodies such as the PCAOB.

    For more information on this study, please contact Vineeta D. Sharma.
     

    Citation:

    Sharma, V., D.S. Divesh, and U. Ananthanarayanan. 2011. Client importance and earnings management: the moderating role of audit committees. Auditing: A Journal of Practice and Theory 30 (1): 125-156.

    Keywords:
    audit committee; auditor independence; accruals; corporate governance; fees, earnings management; non-audit
    Purpose of the Study:

    As a result of declining investor confidence in the quality of financial information due to financial scandals, many countries have implemented corporate governance reforms that specifically identify the audit committee as the primary mechanism for the oversight of auditor independence and financial statement quality. This study investigates how the association between the economic importance of a client to the auditor and earnings management is moderated by the audit committee. Client importance is a potential threat to auditor independence and thus is a potential threat to audit quality. The authors suggest that the possibility exists that auditors may view the audit wealth provided from a client as more important than maintaining independence which is determinant of the audit quality; therefore, the authors examine if there is a positive correlation between client importance and earnings management. Certain circumstances, such as management ownership, leverage, high growth, and firm size, could potentially promote an environment that is conducive to earnings management independent of the external audit. In consideration of these circumstances, the auditors studied whether the association between client importance and earnings management was effected by these firm environmental factors. The audit committee’s response and efforts to mitigate these factors were also examined, specifically in light of the best practices recommendations. 

    Design/Method/ Approach:

    The authors conducted this study by gathering empirical evidence from firms listed on the New Zealand Stock Exchange in the fiscal years 2004 and 2005. The NZSE was chosen as a proper natural laboratory because there is no ban or limit on non-audit services, no mandate on the roles and composition of the audit committee exists, the audit profession is self-regulated, it is a less litigious environment, and it is geographically and economically small.

    Findings:
    • A positive correlation was observed between client importance and the observed proxies for earnings management, which included both performance-adjusted discretionary total and current accruals. This implies that as client importance, as related to the wealth production to the external auditors, increases the possibility of the existence of earnings management in the financial statements also increases.
    • The association became more pronounced for income-increasing accruals that potentially diminish the quality of earnings and are of greater concern to regulators; however, this was moderated by the audit committee.
    • The association between client importance and earnings management is conditional on other firm characteristics such as inside ownership, growth, leverage, and firm size. These factors could create potential agency conflicts but are moderated by the audit committee.
    • Accounting expertise on the audit committee and committees composed completely of outside directors explain the moderating effects of the audit committee.
    • The association with earnings management became more pronounced when the audit committee did not meet the best practices outlined by the NZSEC. These practice suggestions from the NZSEC are merely recommendations, not requirements, as the auditing profession is self- regulated in New Zealand.
       
    Category:
    Governance, Independence & Ethics
    Sub-category:
    Board/Audit Committee Oversight, Impact of Fees on Decisions by Auditors & Management, Non-audit Services
  • The Auditing Section
    Client Importance, Institutional Improvements, and Audit...
    research summary posted May 7, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions, 15.0 International Matters, 15.01 Audit Partner Identification by Name 
    Title:
    Client Importance, Institutional Improvements, and Audit Quality in China: An Office and Individual Auditor Level Analysis
    Practical Implications:

    This study uses engagement-level audit partner data, to analyze whether audit quality is driven by client importance at the office- or partner-level.  Overall, the results contribute to evidence showing that investor protection rules and laws at the country-level are associated with engagement-level audit quality.  This indicates the importance of strong investor protection regulations.  These results may be of interest to shareholders and securities market regulators, especially in developing economies, transitional economies, or economies where such regulations are weak.  Additionally, these results may be of interests to auditors in countries with such economies.  Finally, to the extent that audit firms serve clients with investors that receive varying levels of protection (i.e. public vs. private or a “well-known seasoned issuer”), these results may indicate opportunities for such firms to enhance audit requirements for certain non-public engagements. 

    The results of this study also suggest that audit accountability at the individual level makes auditors more sensitive to the costs of audit failure.  This result may have implications for auditor accountability from a regulatory standpoint, as well as an audit firm policy standpoint.

    Citation:

    Chen, S., S. Y. J. Sun, and D. Wu. 2010. Client Importance, Institutional Improvements, and Audit Quality in China: An Office and Individual Auditor Level Analysis. The Accounting Review 85 (1): 127-158.

    Keywords:
    international matters, audit quality, quality control, client importance, litigation, audit-reporting decision
    Purpose of the Study:

    This study addresses the broad question of whether the economic importance of a client impairs audit quality.  The authors use Chinese data to: 

    • Investigate whether institutional improvements in a country's investor protection environment affect engagement-level audit quality.
    • Examine the relationship between client economic importance to the individual auditor (individual engagement partners) and audit quality in China.
    Design/Method/ Approach:

    The authors use a sample of 8,917 client firm-year observations from 1995 to 2004 where 1995 to 2000 is the low investor protection period and 2001 to 2004 is the high investor protection environment following changes by the Chinese Supreme Court to heighten investor protection rules. Audit quality is measured using the probability of the auditor issuing a modified audit opinion.  Client importance is measured using the ratio of individual client assets to the total client assets audited at both the office level and partner level.

    Findings:
    • Client importance at the partner level impaired audit quality during a period when investor protection was weak (1995-2000).
    • Auditors appear to have become more conservative after improvements were made to investor protection rules and laws.  This is evidenced by a positive correlation between audit quality and client importance at the partner level from 2001-2004.
    • Client importance at the office level is not significantly associated with audit quality in either period (1995-2004).
    • Audits that received a sanction by the Chinese government as an audit failure were more likely to be for clients of high importance to the auditor in the pre 2001 period and were more likely to be for clients of low importance to the auditor in the post 2001 period.
    Category:
    Independence & Ethics, Accountants' Reporting, International Matters
    Sub-category:
    Impact of Fees on Decisions by Auditors & Managmeent, Going Concern Decisions, Going Concern Decisions, Audit Partner Identification by Name
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  • The Auditing Section
    Client Retention and Engagement-Level Pricing
    research summary posted April 13, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.06 Resignation Decisions, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 04.02 Impact of Fees on Decisions by Auditors & Management 
    Title:
    Client Retention and Engagement-Level Pricing
    Practical Implications:

    The results of this study are useful for regulators to consider the motives for auditor changes and to understand audit client portfolio management. The findings underscore the importance of engagement pricing as a determinant of audit firm’s client retention decisions.  Specifically, the evidence suggests that engagement pricing pressure occurs on more than an isolated basis and the audit firm’s inability to recover unexpectedly high labor usage is associated with the severing of the auditor-client relationship.

    Citation:

    Hackenbrack, K. E. and C. E. Hogan. 2005. Client Retention and Engagement-Level Pricing.  Auditing: A Journal of Practice and Theory 24 (1): 7-20. 

    Keywords:
    Engagement realization rates, client retention, engagement-level pricing, engagement management, client acceptance and continuance.
    Purpose of the Study:

    Prior research suggests that auditors do not accept new audit clients that are expected to yield audit fees insufficient to cover expected costs. This implies that auditors may not expect to frequently have engagements which generate insufficient rates of return in their portfolios. This study focuses on this matter by examining the relationship between engagement-level pricing and auditor retention decisions. The objectives of the study are to examine: 

    • whether audit firms find themselves in the position of earning an insufficient audit fee on more than an isolated occurrence 
    • how important engagement-level pricing is, relative to other factors, in audit firms’ client retention decisions 
    • Another important factor affecting client retention examined in the study is client delays which unexpectedly cause auditors to use more engagement hours than budgeted.  

    The engagement-level pricing measure used in the study is the difference between “realized” realization rates (the ratio of the audit fee billed to the standard audit fee) and “expected” realization rates for each segment of the firm’s client portfolio. This measure is also referred to as an unexpected component of realization rates.

    Design/Method/ Approach:

    The authors employ a sample of fiscal 1991 public and private audit engagements of a Big 6 audit firm. The data used are from proprietary sources, including a survey, audit working papers, and a 1996 client list of the audit firm, as well as public sources. The authors use these data to examine the relationship between the unexpected component of realization rates and the audit firm’s client retention over the five-year window (fiscal 1991 - 1996).

    Findings:
    • The authors document that the likelihood of client retention over a five-year window decreases as the difference between realized realization rate and the expected realization rate decreases. 
    • The authors find that the probability of retaining a client decreases with a combination of the impact of client-induced delays on engagement hours and the auditor’s inability to recover unexpectedly high labor usage. The probability of client retention, however, does not depend on the realization rates alone or client-induced delays alone.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit fee decisions, Resignation Decisions, Impact of Fees on Decisions by Auditors & Managmeent, Audit Fees & Fee Negotiations
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  • Jennifer M Mueller-Phillips
    Did SOX Influence the Association between Fee Dependence and...
    research summary posted February 20, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 09.0 Auditor Judgment, 09.04 Going Concern Decisions 
    Title:
    Did SOX Influence the Association between Fee Dependence and Auditors’ Propensity to Issue Going-Concern Opinions?
    Practical Implications:

    This research note presents evidence that the question of whether new standards or regulations have achieved the objective of altering the behavior of their intended target cannot be adequately assessed shortly after they have come into effect, as the implementation often requires a steep learning curve and is frequently accompanied by intense public debates and media scrutiny. From the policy standpoint, it suggests that the concern expressed by the U.S, Treasury Department officials about auditors’ applying an overly strict approach in their audits to counter elevated liability after SOX may not be warranted.

    For more information on this study, please contact Wenjun Zhang.

    Citation:

    Kao, J. L., Y. Li., and W. Zhang. 2014. Did SOX influence the association between fee dependence and auditors’ propensity to issue going-concern opinions? Auditing: A Journal of Practice and Theory 33 (2): 165-185

    Keywords:
    Fee dependence, going-concern opinion, auditor independence, SOX
    Purpose of the Study:

    Li (2009) shows that the association between fee dependence (FEEDEP) and auditors’ likelihood to issue qualified going-concern audit opinions (GCO) changes from insignificant in 2001 to positive in 2003. Since then, several studies have quoted Li’s (2009) findings as evidence that SOX has led auditors to behave more conservatively with respect to going-concern reporting.

    This research note extends Li’s (2009) post-SOX sample period from 2003 to 2011 and demonstrates that her findings for 2003 do not hold over a much longer post-SOX period, implying that SOX has had little effect on auditors’ behavior with respect to going-concern reporting for their large financially distressed clients. These results call into question whether the positive FEEDEP-GCO association identified by Li (2009) indeed represents new audit practice in the post-SOX era.

    This research note is motivated by Feldmann and Read (2010), who showed that the incidence of qualified going-concern opinions issued to subsequently bankrupt companies reverted back to the pre-Enron level by 2006-2007 after a brief increase in 2002-2003, suggesting that the year right after the passage of SOX was not typical. Thus, by focusing on 2003, researchers merely capture a transitory reaction by the audit profession to intense public scrutiny following SOX.

     

    Reference: Li, C. 2009. Does client importance affect auditor independence at the office level? Empirical evidence from going-concern opinions. Contemporary Accounting Research 26 (1): 201-230.

    Design/Method/ Approach:

    The authors run ten annual regressions (2001; 2003-2011) of auditors’ propensity to issue qualified going-concern opinions to financially distressed audit clients (GCO) on a fee dependence measure (FEEDEP). Comparing the association between GCO and FEEDEP before versus after the passage of SOX, the authors draw inferences about whether the more conservative going-concern reporting documented by Li (2009) indeed represents a long-term equilibrium behavior in the post-SOX audit market. 

    Findings:
    • The authors find no association between auditors’ propensity to issue qualified going-concern opinions to financially distressed audit clients and the fee dependence measure over an extended post-SOX period (i.e., 2003-2011), implying that SOX has had no observable lasting effect on auditor conservatism with respect to going-concern reporting.
    • The authors find that while auditors were equally cautious in issuing qualified going-concern opinions to clients that eventually failed, both before and after SOX, they have made more Type I misclassifications in 2003 by issuing qualified going-concern opinions to clients that remained solvent within two years of financial statement dates. 
    Category:
    Auditor Judgment, Independence & Ethics, Standard Setting
    Sub-category:
    Going Concern Decisions, Impact of Fees on Decisions by Auditors & Management, Impact of SOX

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