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  • Jennifer M Mueller-Phillips
    External Auditor Evaluations of Outsourced Internal...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    External Auditor Evaluations of Outsourced Internal Auditors.
    Practical Implications:

    These results have implications for both audit research and practice as well as policy makers and firms deciding on whether to outsource the internal audit function. From a research perspective, this study is the first to examine how external auditors view various internal audit outsourcing arrangements. Further, the results indicate a potential cost of internal audit outsourcing that has not been previously considered. That is, if outsourced internal auditors provide other services, the cost of the external audit could increase, which potentially interferes with some of the expected cost savings of AS No. 5.

    Citation:

    Brandon, D. M. 2010. External Auditor Evaluations of Outsourced Internal Auditors. Auditing: A Journal of Practice & Theory 29 (2): 159-173. 

    Keywords:
    auditor independence, external auditing, nonaudit services, outsourced internal auditing
    Purpose of the Study:

    In the last several decades many companies began outsourcing the internal audit function (IAF) to public accounting firms. The prevalence of outsourcing is likely to continue given current exchange requirements to establish and maintain an IAF. Further, lack of an IAF could be considered a significant internal control deficiency or even a material weakness. The primary concern over external auditors providing nonaudit services appears to be the potential negative effects of the fees from those services on the external auditor’s objectivity. This concern was so pervasive that part of the Sarbanes-Oxley Act prohibits external auditors from performing certain nonaudit services for external audit clients. The Panel on Audit Effectiveness acknowledges the role of internal audit in maintaining good corporate governance and encourages the cooperation between internal and external auditors. Public accountants can utilize the client-specific expertise possessed by strong internal audit departments to increase external audit efficiency (resulting in cost savings that could be passed on to the auditee) and also provide a higher level of assurance. These benefits are of particular interest given concerns over the cost of complying with Section 404 of the Sarbanes-Oxley Act (SOX).

    This study investigates some implications of an outsourced internal auditor providing nonaudit services.

    Design/Method/ Approach:

    The 89 participants for the study were experienced practicing auditors. Fifty-six participants were obtained via contact partners at the respective firm. The contact partners were asked to distribute the instruments to auditors who typically evaluate internal auditors. The remaining participants were obtained through an in-house training session. 89 auditors participating, approximately 64 percent were CPAs and had an average of 4.7 years of audit experience. The evidence was gathered prior to September 2007.

    Findings:

    Results indicate that certain external auditor judgments and decisions are negatively affected when an outsourced internal auditor also provides consulting services, while other judgments (long touted by proponents of auditor-provided nonaudit services as benefits) are not. Specifically, inconsistent with proponents of auditor-provided nonaudit services, competence perceptions do not appear to be improved by the provision of consulting services. Consistent with arguments of opponents of auditor-provided nonaudit services, external auditor perceptions of internal auditor objectivity appears to be impacted negatively by the provision of consulting services. Further, consistent with previous research, these results appear to be tempered by the staffing of the team providing the consulting services.

    Other results indicate reduced planned reliance on outsourced internal auditors also providing other services. External auditors appear reluctant to rely on outsourced internal auditors providing additional services, regardless of staffing decisions. Results also indicate differences in audit fee adjustments. Specifically, participants would recommend greater audit fee increases when consulting services are provided, again regardless of the outsourcing arrangement.

    Category:
    Governance, Independence & Ethics
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Non-audit Services
  • Jennifer M Mueller-Phillips
    Future Nonaudit Service Fees and Audit Quality.
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services 
    Title:
    Future Nonaudit Service Fees and Audit Quality.
    Practical Implications:

    The results indicate that prior to the Sarbanes-Oxley Act, rewards to the auditor in the form of future additional nonaudit service fees from current-year high fee-growth-opportunity clients adversely affects audit quality. This effect is particularly strong among companies with powerful incentives to manage earnings. The findings indicate that regulators should consider the multi-period nature of the client-auditor relationship when contemplating policies that restrict nonaudit services, as well as the overall environment in which audit partners operate. This might include partner compensation arrangements that put pressure on audit partners to focus on increasing revenue at the expense of audit quality.

    Citation:

    Causholli, M., D. J. Chambers, and J. L. Payne. 2014. Future Nonaudit Service Fees and Audit Quality. Contemporary Accounting Research 31 (3): 681-712.

    Keywords:
    auditor independence, revenue, auditor-client relationships, financial management, auditing, non-audit services
    Purpose of the Study:

    Prior to the Sarbanes-Oxley Act of 2002, audit partners experienced economic pressure to grow revenue from the sale of nonaudit services to their audit clients. To an auditor who is highly rewarded for revenue generation and growth, nonaudit services may represent a particularly strengthened economic bond with the client. Prior research shows that, in general, nonaudit service fees received in the current period do not impair audit quality. The authors examine a different setting. Future nonaudit fees present an important source of career advancement and a source of particularly strengthened economic bond with the client. They propose that auditor independence can become impaired, and audit quality compromised, when clients that currently purchase relatively low amounts of nonaudit services, increase their purchases of nonaudit services from the auditor in the subsequent period. They test the prediction in the context of earnings management as a proxy for audit quality, measured by (a) performance-adjusted discretionary accruals and (b) classification shifting of core expenses.

    Design/Method/ Approach:

    The authors obtain the data on the Big-N clients’ audit and nonaudit fees from Audit Analytics, the data on client characteristics from COMPUSTAT, and the data on stock returns from CRSP for fiscal years 2000-2001. The Accruals Model has a sample of 4,078. The Classification-shifting Model has a sample of 3,361.

    Findings:
    • The results show that earnings management is higher for high fee-growth-opportunity clients who increase their future nonaudit services (NAS) purchases from the auditor.
    • Both forms of earnings management are higher for companies with relatively low NAS in the current year that simultaneously increase future NAS purchases from the auditor.
    • The negative effect of future NAS is even more pronounced in companies that have greater incentives to manage earnings such as those that meet or just beat earnings forecasts or those that issue equity and less likely to occur in companies with strong corporate governance.
    • When using the absolute value of discretionary accruals to proxy for earnings management, the authors find that future increases in NAS fees are positively associated with the absolute discretionary accruals for high fee-growth-opportunity clients. This association continues to hold when the authors separate total discretionary accruals into income-increasing and income-decreasing accruals.
    • When using the association between unexpected core earnings and income-decreasing special items as the proxy for classification shifting, the authors find that the association becomes more positive, indicating greater classification shifting for high fee growth opportunity clients who increase future NAS purchases.
    Category:
    Independence & Ethics
    Sub-category:
    Non-audit Services
  • Jennifer M Mueller-Phillips
    How Increased Regulatory Oversight of Nonaudit Services...
    research summary posted May 28, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services 
    Title:
    How Increased Regulatory Oversight of Nonaudit Services Affects Investors’ Perceptions of Earnings Quality
    Practical Implications:

    Although the findings of this study provide evidence of investor perceptions of NAS and of how these perceptions are conditional on regulations and audit quality, the results, and their implications for policy should be viewed with caution. These results are based on Norwegian data and a distinctive regulatory environment. The authors examined a period when a series of high-profile accounting scandals hit in Europe and the U.S., which may have also influenced investors’ earning quality perceptions. This study, however, reveals many possibilities for new research to better determine how regulations affect investor perceptions of NAS. 

    Citation:

    Eilifsen, A., and K. H. Knivsflå. 2013. How Increased Regulatory Oversight of Nonaudit Services Affects Investors’ Perceptions of Earnings Quality. Auditing 32 (1).

    Keywords:
    audit firm quality; earnings response coefficients; investor perceptions; nonaudit services; regulation
    Purpose of the Study:

    Investor confidence in financial statements and the audit process are often contingent on auditor independence. One of the most debated threats to auditor independence arises from economic bonds between auditors and clients stemming from the joint provision of audit and nonaudit services (NAS). Researchers have long sought to establish how the economic bonds between auditors and clients, arising from the provisions of NAS, affect auditor independence. In 2003, The Financial Supervisory Authority of Norway (FSA) disclosed that audit firms had violated the legal restrictions for providing NAS. In response, the FSA tightened NSA regulations. This study examines how regulatory oversight affects the relation between the provision of NAS and earnings response coefficients (ERC). 

    Design/Method/ Approach:

    The authors first developed two hypotheses for testing:

    H1: For low-quality audit firms, the association between the level of NAS and investors’ perceived earnings quality was negatively affected after the disclosure of NAS regulation violations in 2003. The effect is more negative in the disclosure year 2003 that in the new regulation period 2004-2008. 

    H2: Higher-quality audit firms moderate the negative effects associated with low-quality audit firms in H1.

    To test H1 and H2, the authors use the ERC from earnings-response regression models as a proxy for investor perceptions of earnings quality. Essentially, the ERC is the estimated effect of reported earnings or change in earnings on stock prices, stock returns, or abnormal stock returns. The sample consists of companies listed on the Oslo Stock Exchange (OSE). The final sample consists of 1,646 company-year observations for 293 individual companies for the ten-year period from 1999-2008. 

    Findings:
    • For small, non-industry specialized audit firms, the relationship between NAS and ERC is negatively affected after the 2003 disclosure of the audit firms’ violations of the legal NAS restrictions and is more negatively affected in the disclosure year 2003 than in the new regulation period 2004-2008.
    • For Big 5 firms, audit quality moderates the negative effects on investor perceptions that were associated with low-quality audit firms in 2003 and 2004-2008.
    • Industry specialization among audit firms amplifies investor concerns regarding auditor independence in 2003. 
    • Investors react negatively to the disclosure of NAS violations and new regulations ease investor concern. 
    Category:
    Independence & Ethics
    Sub-category:
    Non-audit Services
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  • Jennifer M Mueller-Phillips
    Internal Audit Outsourcing and the Risk of Misleading or...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.03 Non-Audit Services 
    Title:
    Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong?
    Practical Implications:

    The results of this study support the knowledge spillover argument — that financial reporting quality improves when the external auditor performs at least some internal audit work. In addition, the authors found evidence that higher quality IAFs, regardless of outsourcing arrangement, are associated with lower accounting risk. This study also provides insights on the impact of the SOX prohibition on external auditors’ provision of internal audit services to their clients, and provides evidence concerning whether private companies may benefit from a similar practice. Finally, this study provides insight on how increased interaction among different parties involved in corporate governance can positively influence financial reporting quality.

    Citation:

    Prawitt, D. F., N. Y. Sharp, and D. A. Wood. 2012. Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong? Contemporary Accounting Research 29(4): 1109-1136.

    Keywords:
    N/A
    Purpose of the Study:

    A significant change imposed by the Sarbanes-Oxley Act of 2002 (SOX) was to prohibit the outsourcing of internal audit services to firms’ external auditors. There are two competing arguments of how outsourcing the internal audit function (IAF) to the external auditor potentially impacts financial reporting quality. The knowledge spillover argument suggests that by both performing the external audit and providing non-audit services, auditors improve overall audit quality through a deeper understanding of the client. The economic bonding argument suggests that overall audit quality is compromised when the external auditor provides non-audit services, essentially because the external auditor is unwilling to stand up to aggressive or abusive accounting practices for fear of losing a lucrative client engagement Therefore, the purpose of this study was to examine whether outsourcing internal audit services to the external auditor in the pre-SOX period is associated with higher or lower accounting risk, where accounting risk is defined as the risk that clients’ financial statements contain misleading or fraudulently reported numbers. The authors specifically examined the association between accounting risk and four forms of internal audit sourcing:

    • The firm outsources at least some portion of their IAF to their Big N external auditor (pre-SOX).
    • The firm outsources its IAF to other Big N service providers.
    • The firm outsources its IAF to other non–Big N, third-party service providers
    • The firm keeps their IAF entirely in-house.
       
    Design/Method/ Approach:

        The authors used data from the Institute of Internal Auditor’s GAIN database concerning the IAFs of publicly traded companies during the years 2000 to 2002. To test accounting risk, the authors used data from Audit Integrity, LLP, which is a financial analytics organization. Audit Integrity uses publicly available accounting information as inputs to a proprietary model that measures the risk of potentially fraudulent or misleading financial reporting. The authors then developed a model to evaluate the relationship between internal audit sourcing and accounting risk.

    Findings:

    Companies that outsourced at least some portion of their IAF to their Big N external auditor (pre- SOX) had lower accounting risk than companies that (1) outsourced to other Big N service providers, (2) outsourced to other non–Big N, third-party service providers, and (3) kept their IAF entirely in-house.
    Outsourcing to the external auditor reduces accounting risk by 23 percent relative to firms that kept the IAF in-house (holding other factors constant).
    Accounting risk decreases as the percentage of work outsourced to the external auditor increases.
    Evidence that higher quality in-house IAFs are positively associated with accounting quality.
     

    Category:
    Independence & Ethics, Standard Setting
    Sub-category:
    Impact of SOX, Non-audit Services
  • Jennifer M Mueller-Phillips
    Internal Control Quality: The Role of Auditor-Provided Tax...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 13.0 Governance, 13.05 Board/Audit Committee Oversight 
    Title:
    Internal Control Quality: The Role of Auditor-Provided Tax Services.
    Practical Implications:

    The results of this study are important to audit regulators as they make decisions regarding policies, and to corporate governance officials as they make decisions regarding the audit firms they engage to provide tax nonaudit services. The evidence indicates that tax nonaudit services accelerate audit firm awareness of material transactions as these services are associated with a lower likelihood of a material weakness in internal controls. In addition, further evidence supports that this finding is not simply due to impaired auditor independence. Overall, this suggests that tax nonaudit services provided by the audit firm improve internal control quality. As regulators and companies evaluate the consequences of tax nonaudit services, the findings in this paper may impact their conclusions.

    Citation:

    De Simone, L., M.S. Ege, and B. Stomberg. 2015. Internal Control Quality: The Role of Auditor-Provided Tax Services. The Accounting Review. 90(4): 1469-1496.

    Keywords:
    auditor fees, nonaudit services, auditor independence, internal controls, tax, financial reporting quality
    Purpose of the Study:

    Audit regulators and companies’ corporate governance officials are charged with understanding and creating policies for auditor provided nonaudit services. To make informed decisions, it is important for these groups to know the benefits and costs of auditor provided nonaudit services. Previous research has reported a positive association between tax nonaudit services and financial reporting quality and audit quality. This paper investigates the relationship between tax nonaudit services and a specific component of financial reporting quality: internal control quality. Specifically, the authors:

    • Examine the relationship between tax nonaudit services and the probability of a material weakness in internal controls (i.e. internal control quality).
    • Examine whether tax nonaudit services are beneficial to companies experiencing a shock to their internal control environment.
    • Examine how the relationship between tax nonaudit services and internal control quality is affected by audit firm tenure.

    The authors also explain the process through which they propose tax nonaudit services affects non-tax financial reporting quality.

    Design/Method/ Approach:

    The authors collected auditor internal control opinions and data necessary to calculate control variables on publicly-traded companies that are subject to SOX Section 404(b). The information collected on these companies was for years 2004-2012.

    Findings:
    • The authors find that companies that purchase tax nonaudit services are significantly less likely to disclose a material weakness. A one standard-deviation increase in tax nonaudit services is associated with approximately a 13% decrease in the rate of material weaknesses relative to the base rate. Further analysis indicates that impaired auditor independence does not account for this result.
    • The authors find that when companies experience a significant shock to their internal control environment, tax nonaudit services incrementally benefit internal control quality relative to other companies.
    • The authors find that the benefits of tax nonaudit services on internal control quality are greater in the early years of audit firm tenure.
    Category:
    Governance, Independence & Ethics, Internal Control
    Sub-category:
    Board/Audit Committee Oversight, Non-audit Services, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Is mandated independence necessary for audit quality?
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 11.0 Audit Quality and Quality Control 
    Title:
    Is mandated independence necessary for audit quality?
    Practical Implications:

    In the unregulated baseball card market, only offering grading services does not appear to increase market share or market value.  This may have implications in the market for assurance services.  The authors note that offering non-audit services does not appear to negatively affect auditor independence.  Additionally, it may be argued that auditors increase value by realizing economies of scope through the supply of audit as well as non-audit services to their clients.

    For more information on this study, please contact Karim Jamal.
     

    Citation:

    Jamal, K. and S. Sunder. 2011 Is mandated independence necessary for audit quality? Accounting, Organizations and Society 36 (4-5): 284-292.

    Keywords:
    None
    Purpose of the Study:

    This study seeks to address audit independence and audit quality by drawing a parallel with the unregulated market for graded baseball cards sold in online auctions.  The baseball cards used in this study had either been graded by a professional grading service company or had not been professionally graded.  The authors note that some of the grading agencies only offer grading services, while others offer grading services in addition to other non-grading products sold in the trading card market.  This field experiment examines whether providing additional services such as publishing price guides or otherwise participating in the market of cards reduces the market’s perceived quality of the grading.  The authors draw a parallel from this research to the market for assurance services, noting that some auditors provide only auditing services to their clients while others provide non-audit services as well.  This research explores the idea that providing multiple services to a market impacts perceived independence and quality of the assurance service.

    Design/Method/ Approach:

    The authors collected market data from the online auction site eBay for 1,000 rookie baseball cards and created matched pairs of both graded and ungraded cards.  Graded cards had been graded by one of six different grading agencies.  Some of the grading agencies provided other, non-grading, services to the market while some only offered grading services.

    Findings:
    • The market for graded baseball cards rewards stricter graders, regardless of whether those graders provide other, non-grading, products to the market as well.
    • The majority of the market share for graders is controlled by the grading agencies who offer numerous products to the market, not just grading services.
    • Graders who only offer grading services appear to engage in grade inflation which is discounted by the market. 
       
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Non-audit Services
  • Jennifer M Mueller-Phillips
    Nonaudit Services and Independence in Appearance: Decision...
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
    Title:
    Nonaudit Services and Independence in Appearance: Decision Context Matters.
    Practical Implications:

    An implication of the findings from experiment one is that restricting the auditor’s provision of NAS may lead to fewer lawsuits and, importantly, a reduction in the deadweight costs associated with litigation. But such restrictions mean that companies forgo the potential benefits (e.g., knowledge spillovers) of acquiring NAS from the auditor. Based on the findings from experiment two, participants perceive that the potential benefits of NAS outweigh the potential costs, notably when performing a conventional assessment of asset value. The net benefits are lost when the auditor is prohibited from providing NAS. The authors encourage future study to examine the net effect of restricting the auditor’s provision of NAS on social welfare.

    Citation:

    Church, B. K., and P. Zhang. 2011. Nonaudit Services and Independence in Appearance: Decision Context Matters. Behavioral Research in Accounting 23 (2): 51-67.

    Keywords:
    auditor independence, auditor litigation, decision context, nonaudit services
    Purpose of the Study:

    Following the Enron and WorldCom scandals, the Sarbanes-Oxley Act of 2002 (SOX) prohibited the auditor’s provision of many nonaudit services (NAS). The passage of SOX suggests that regulators and legislators believe that certain NAS impair auditor independence and, in turn, lower financial reporting quality. Archival data, however, provide scant evidence of a relation between NAS and audit quality (independence in fact). Notwithstanding, auditors must still maintain independence in appearance for their reports to be credible.

    The fundamental question is whether users’ perceptions of NAS differ across decision contexts; that is, whether NAS are viewed as detrimental in one context and beneficial in another. By examining the effect of decision context on users’ assessments, the authors seek to identify an important factor that may account for some of the mixed findings documented elsewhere. The authors suggest that decision context influences users’ motives, such that the auditor’s provision of NAS is interpreted opportunistically—in a manner that best suits users’ self-interest. If that is the case, then users’ assessments of independence are malleable, which can be problematic for regulators; the challenge of prescribing rules to ensure independence in appearance becomes quite daunting. Because auditor independence is a cornerstone of auditing, regulators may opt to err on the side of caution and mandate strict rules. Yet, such rules may not be socially optimal.

    Design/Method/ Approach:

    The authors design two experiments to investigate. For experiment one, the authors recruited 27 students from a large university to participate in the experiment. The authors recruited 37 students from a large university to participate in experiment two. All the students were in at least their third year, and all but one were pursuing a program of study in business or economics. The evidence was gathered prior to November 2011.

    Findings:
    • The results of the experiments indicate that users’ perceptions of NAS differ across decision contexts.
    • In the first experiment, participants initially perceive that NAS are associated with auditor faultin the face of a bad outcome (loss in value), NAS are perceived negatively.
    • In the second experiment, participants initially provide a higher assessment of asset value when the auditor supplies NASthat is, the net effect of NAS on asset value is beneficial.
    • In both experiments participants eventually decipher the experimental relationsthat NAS are not associated with auditor fault or asset value.
    • The findings indicate that decision context dramatically alters users’ perceptions of NAS and auditor independence.
    • Undoubtedly accounting scandals, which create significant losses for owners and creditors, can lead users to question auditor independence.
    • The findings suggest that users react in this manner for strategic reasons.
    • In responding to public outcry, regulators may overreact, for political purposes, and enact laws/rules that are excessive, potentially sacrificing social welfare.
    Category:
    Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk, Non-audit Services
  • Jennifer M Mueller-Phillips
    Perceived Auditor Independence and Audit Litigation: The...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Perceived Auditor Independence and Audit Litigation: The Role of Nonaudit Services Fees
    Practical Implications:

    This study provides evidence to suggest that fees from audit clients, including NAS fees, which became publicly available under the SEC’s fee disclosure mandate, are used as evidence of auditor independence impairment and are a source of audit litigation risk. While specific NAS have been banned by SOX, substantial tax and other NAS fees continue to be cited as evidence in recent litigation. Thus, these findings document important links between SEC fee disclosure mandates, NAS-induced impairment arguments, and perceptions of audit quality in audit litigation.

    For more information on this study, please contact Jaime J. Schmidt.
     

    Citation:

    Schmidt, J. J. 2012. Perceived Auditor Independence and Audit Litigation: The Role of Nonaudit Services Fees. The Accounting Review 87(3): 1033-1065.

    Keywords:
    Auditor independence; nonaudit services fees; audit litigation; auditor settlements; financial statement restatements.
    Purpose of the Study:

    In audit litigation, the plaintiff attorneys (i.e., plaintiffs’ bar) often exploit and enhance the perception that fee dependence is related to an audit failure by arguing that economic pressure to retain fees and, in particular, nonaudit services (NAS) fees led to a conflict of interest for the auditor and compromised the auditor’s independence. The purpose of this study was to investigate whether audit litigants act as if they believe jurors will perceive that substantial NAS fees contribute to an audit failure through impaired auditor independence, and thus substandard auditor performance. The author examined the initiation and resolution of audit restatement-related litigation to provide evidence on whether NAS or another source of fee dependence (e.g., client importance, audit fee dependence) impairs perceived auditor independence.

    Design/Method/ Approach:

    The author collected information concerning restatements of previously audited financial statements disclosed from January 2001 through December 2007, the auditors involved with the restatements, and the amount of fees billed during the misstated time period. The author also identified all instances of litigation disclosed as of June 2008 against the restating companies. The author then estimated a model and ran a regression to investigate whether NAS fees are associated with the initiation of audit litigation following a restatement.

    Findings:
    • Restatement-related audit litigation is more likely when NAS fees are higher.
    • This association is driven by the unspecified (i.e., ‘‘other’’) fees component of NAS rather than by tax or financial information systems design and implementation (FISDI) fees.
      • The ratio of NAS fees to total fees is positively associated with the likelihood that audit litigation results from a restatement.
    • The association between audit fees or client importance and the likelihood of litigation is statistically insignificant.
    • A restatement-related lawsuit is more than seven times as likely to reach resolution by an auditor settlement and to settle at a greater amount when the plaintiffs’ bar argues that an auditor’s reliance on client fees resulted in an auditor independence impairment.
    • The plaintiff attorneys’ arguments about NAS fees and/or client importance are associated with greater likelihood and amount of settlement.
       
    Category:
    Accountants' Reporting, Independence & Ethics
    Sub-category:
    Non-audit Services, Restatements
  • Jennifer M Mueller-Phillips
    Productivity Growth in the Public Accounting Industry: The...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 05.0 Audit Team Composition, 05.04 Staff Hiring, Turnover and Morale, 05.05 Diversity of Skill Sets e.g., Tenure and Experience, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.09 Impact of Technology on Audit Procedures 
    Title:
    Productivity Growth in the Public Accounting Industry: The Roles of Information Technology and Human Capital
    Practical Implications:

    Given the positive effects that human capital and IT accumulation had on productivity growth, the findings of this study imply that firms seeking to improve their revenues per employee could do so by investing in more IT and human capital. The potential effects of these investments on audit quality could be beneficial when determining the level of investment to make. However, firms should keep in mind the possibility of diminishing results once a certain level of IT and human capital is accumulated. This study also has implications for the debate in the United States surrounding the Sarbanes- Oxley Act which prohibits certain non-audit services by public accounting firms. The debate stem from a concern of the effects of non-audit services on independence but this study displays the benefits that could arise if non-audit services were allowed.

    For more information on this study, please contact Hsihui Chang.
     

    Citation:

    Chang, H., J. Chen, R. Duh, and S. Li. 2011. Productivity growth in the public accounting industry: the roles of information technology and human capital. Auditing: A Journal of Practice and Theory 30 (1): 21-48.

    Keywords:
    productivity growth; efficiency change; technical progress; IT capital accumulation; human capital accumulation; Big 4; non-audit services.
    Purpose of the Study:

    The audit industry has changed dramatically over the last two decades. These changes have brought on increased competition among firms which has created immense pressure for audit firms to minimize their costs while maximizing productivity. For many public accounting firms, the way to manage productivity growth and enhance service delivery came in the form of investments in information technology and human capital. Investments in information technology can increase productivity through automation of routine auditing tasks, improvements in audit team collaboration and communication, as well as through an increased level of experience with information systems which can improve auditor performance in engagements to help clients integrate their company information systems. High quality human capital, which is usually indicated through education levels and work experience and results in both technical and tacit knowledge, contributes to the productivity growth of a firm through higher quality services for clients.

    This study breaks down human capital and information technology (IT) into four drivers of productivity growth among public accounting firms; efficiency change, technical progress, IT capital accumulation, and human capital accumulation. The authors assessed both the simultaneous effects of human capital and IT as well as the individual contributions of the four distinct components of these factors on productivity growth. Some firms also chose to boost productivity through engaging in more non- audit services. Although most studies focus on the effects that non-audit services have on auditor independence, this study focuses on how non- audit services can contribute to productivity growth.
     

    Design/Method/ Approach:

    The authors analyzed data on revenues, employees, IT expenditures, and human capital for a sample of public accounting firms in Taiwan from 1993 to 2003. The data was obtained from the Annual Survey of Accounting Firms in Taiwan published by the Department of Statistic of Taiwan’s Ministry of Finance. The authors chose Taiwan as a proper setting for this study because its publications included more advantageous data than that of the United States published in Accounting Today’s annual surveys.

    Findings:
    • Public accounting firms experienced growth in productivity, specifically, labor productivity evidenced through revenue per employee. 
    • This growth, in order of least contribution to greatest contribution, resulted from efficiency improvement, technical progress, human capital accumulation, and IT capital accumulation. Thus, the primary drivers were human capital and IT accumulation.
    • There was a significant difference in productivity growth between Big 4 and non- Big 4 firms. This difference was primarily attributable to greater technical progress and IT capital accumulation among the Big 4. Additionally, there was no difference in human capital accumulation between Big 4 and non- Big 4 firms.
    • Although the advance of technology provides all accounting firms with opportunities to improve productivity, not all firms exploit these opportunities equally. The Big 4 invested more heavily in IT systems and were rewarded with higher productivity growth.
    • Firms with a greater growth in non-audit services had higher productivity than other firms because they accumulated higher IT and human capital over the sample period.
    • Early movers into non-audit services tended to have higher changes in IT capital accumulation.
    • Both early moving firms into non-audit services and firms that emphasized growth in non-audit services presented a direct relationship with productivity growth higher than that of firms which focused on traditional audit services.
       
    Category:
    Audit Team Composition, Auditing Procedures - Nature - Timing and Extent, Internal Control
    Sub-category:
    Diversity of Skill Sets (e.g. Tenure & Experience), Impact of Technology on Audit Procedures Confirmation – Process and Evaluation of Responses, Non-audit Services, Staff Hiring - Turnover & Morale
  • Jennifer M Mueller-Phillips
    The Association between Actuarial Services and Audit...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 05.0 Audit Team Composition, 05.01 Use of Specialists e.g., financial instruments, actuaries, valuation 
    Title:
    The Association between Actuarial Services and Audit Quality.
    Practical Implications:

    Involving two service providers, rather than one, conveys potential benefits similar to those argued for joint audits. Auditor independence is enhanced because each firm provides a reciprocal check on the diligence of the other, and the allocation of fees between providers reduces economic bonding between the client and any one firm. Regulators might consider requiring disclosure of the recipient of NAS payments for both the audit firm and other consultants to allow a more complete examination of the influence of NAS on audit quality in other settings.

    Citation:

    Gaver, J. J., and J.S. Paterson. 2014. The Association between Actuarial Services and Audit Quality. Auditing: A Journal of Practice & Theory 33 (1): 139-159.

    Keywords:
    actuaries, auditor independence, insurance industry, knowledge spillover, non-audit services, reserve management
    Purpose of the Study:

    A challenge facing the accounting profession is the creation and maintenance of auditor independence from clients, both in fact and in appearance. The authors examine the association between non-audit services and audit quality among firms in the property-casualty insurance industry. Limiting the sample to insurance firms conveys benefits that provide a more powerful test of the audit quality-NAS relation than has been possible in prior studies. This setting allows the authors to focus on a specific non-audit service that is purchased by almost all firms in the industry. The insurance setting is unique because the non-audit service that the authors examine is purchased by all firms in the sample, and they can identify both the audit and non-audit service provider. This allows the authors to directly address the NAS separation issue while holding NAS quality constant.

    Since 1990, the National Association of Insurance Commissioners (NAIC) has required a "Statement of Actuarial Opinion" regarding the adequacy of the company's loss reserve to be submitted with the insurer's Annual Statement. Although auditing standards and SOX both prohibit the audit firm from determining insurance company policy reserves (the audit client must use its own actuaries or third-party actuaries to provide management with primary actuarial capabilities), it is acceptable for actuaries from the audit firm to review and certify reserves established by the client and to sign the Statement of Actuarial Opinion. The loss reserve is the largest liability on insurer balance sheets, and establishing comfort on reserve levels is a crucial aspect of an insurance company audit.

    Design/Method/ Approach:

    The sample consists of 3,261 insurer-year observations where both audit and actuarial services are provided by a Big N firm. The sample was derived from a property-casualty database of the NAIC during the years 1993 through 2006. In 2,977 cases, the services are obtained from the same Big N firm; in the remaining 284 cases, one Big N firm conducts the audit and a different Big N firm certifies the reserves.

    Findings:

    The authors find that when actuarial work is obtained only from Big N firms (NAS quality is constant), audit quality is higher when separate Big N firms provide audit and actuarial services. The implication is that separating audit and NAS functions between two quality providers is beneficial, compared to allowing one quality firm to provide both services.

    The results indicate that joint provision of services is related to significantly more over-reserving by healthy insurers, compared to the case where audit and actuarial services are obtained from two independent firms. Although over-reserving by financially secure insurance clients does not present the same risk of audit failure as does under-reserving by weak insurers, both findings suggest that reserves are more likely to be biased in the client's favor when multiple services are consolidated in one provider. Specifically, jointly provided audit and actuarial services are associated with a greater tendency for weak insurers to under-reserve and strong insurers to over-reserve.

    Category:
    Audit Team Composition, Independence & Ethics
    Sub-category:
    Non-audit Services, Use of Specialists (e.g. financial instruments – actuaries - valuation)

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