Prior research concerning audit fees and earnings management has focused primarily on accruals management. This article shows how the audit fee and audit risk models support auditors’ pricing behavior in a REM setting. Specifically, the results are consistent with auditors, after observing aggressive REM, increasing current audit fees to cover the cost of additional effort required to gain reasonable assurance that the financial statement are free of material misstatements and increase both current and future audit fees to cover increases in perceived business risk.
Greiner, A., M. J. Kohlbeck, and T. J. Smith. 2017. The Relationship between Aggressive Real Earnings Management and Current and Future Audit Fees. Auditing: A Journal of Practice and Theory 36 (1): 85 – 107.
The authors examine whether aggressive real earnings management (REM) activities are associated with audit fees. Prior research focuses on accruals-based earnings management and suggests that auditors extract additional audit fees to cover costs associated with increased engagement risk, which includes audit risks related to the issuance of an incorrect opinion and nonaudit risk related to impaired reputation, fewer business opportunities, and the inability to collect desires and future audit fees. The distinction between accrual and real earnings management is important for auditors because the potential effects on company performance and engagement risks are different. REM alters normal firm operations, impacts current and future cash flows, imposes additional costs, and sacrifices firm value. Whether auditors charge higher fees for earnings management behavior that does not violate generally accepted accounting principles if important to study as clients continue to pursue REM to meet reporting objectives.
The authors utilize a conceptual audit fee model to identify specific examples within this framework where REM is likely to increase engagement risk and thereby increase audit fees through either increased effort, a risk premium, or both. They perform further analysis to better understand the sources between aggressive REM and fees.
The authors examine an important aspect of audit-client history and provide evidence on how the timing of auditor concessions in one period affects financial officers’ negotiation judgments in the subsequent period. They also show the importance of incorporating this variable into auditor-client negotiation studies.
Cheng, M. M., H. T. Tan, K. T. Trotman, and A. Tse. 2017. The Impact of the Timing of a Prior Year’s Auditor Concessions on Financial Officers’ Judgments. Auditing: A Journal of Practice and Theory 36 (1): 43 – 62.
Auditors and clients frequently engage in negotiations to resolve disagreements over financial reporting decisions. These negotiations ultimately lead to concessions being made either by the auditor, the client, or both. Existing research delves into the effect of strategies employed during negotiations in the current period, but this study differs by examining multi-period effects of negotiation strategies. Specifically, the authors consider the impact of negotiation history by investigating three concession timing strategies (concession-start, concession-end, and gradual concession) used by auditors in the previous negotiation period and their effect on financial officers’ negotiation judgments for the current year audit.
The authors conduct an experiment where financial officers made negotiation judgments after receiving information about an auditor’s negotiation behavior in the prior year.
Understanding that auditors allocate greater resources to fraud brainstorming when engagement risk is significant fosters brainstorming of a superior caliber corresponds to stronger regulatory compliance. Auditors report that engagement teams are holding fraud brainstorming sessions earlier in the audit, document more detailed risk assessments, plan more specific procedures, and retain more documentation. These characteristics contribute to adequately addressing increased PCAOB regulatory scrutiny. Additionally, brainstorming sessions are highly regarded when they occur in a face-to-face fashion and are attended by multiple levels of firm personnel—whether that is “core” or “non-core” professionals. Fraud brainstorming sessions are executed less mechanically (as determined by PCAOB inspectors) by using fewer checklists and increase the amount of time auditors prepare for brainstorming sessions.
Dennis, S. A., and K. M. Johnstone. 2016. A Field Survey of Contemporary Brainstorming Practices. Accounting Horizons 30 (4): 449–472.
The purpose of this study is to further understand current fraud brainstorming practices minding regulatory climate and its impression of brainstorming practices. The authors seek to understand the auditing profession’s existing framework to effectively brainstorm by evaluating audit team characteristics; attendance and communication; structure, timing, effort; and brainstorming quality. Fraud brainstorming environment is considered with respect to client characteristics; particularly, inherent, fraud, and engagement risks, and if the client is publicly traded or privately held. The authors refer to the characteristics as “partitions”. The partitions allow the study to better examine how each characteristic effects the deployment of resources in response to risk levels and trading status.
The study poses further exploration into the implementation of Statement of Auditing Standards No. 99 and its effect on fraud brainstorming practices. Particularly addressing the Public Company Accounting Oversight Board’s report suggesting auditing professionals were “mechanically” addressing fraud-related auditing standards. SAS 99 sought to blend experienced audit professionals—those with greater client experience—with less-seasoned auditors to brainstorm how a fraud could occur specific to the client. As part of the brainstorming framework, the study seeks to understand if senior-level auditors (partners and managers) and seniors and staff members, along with “non-core” professionals, cultivate meaningful brainstorming sessions.
The authors collected field data from audits conducted between March 2013 and January 2014, per a survey of 77 audit engagements. Information pertaining to the client, audit team, and brainstorming sessions were called upon in the survey. The majority (93 percent) of observations were obtained by two Big 4 firms—7 percent from one non-Big 4 global firm. Each engagement’s partner received instructions for the distribution of the survey to lead managers and lead seniors on the respective engagement while the partner withheld that the survey was for research purposes. A total of 75 managers and 73 seniors participated.
Relationships between an auditor and the client have the capacity to impair auditor independence, which may have a negative impact on financial reporting quality. As such, research that examines issues that have the potential to impair audit quality should be important to the auditing profession. Furthermore, audit committees play a critical role in ensuring auditor independence and audit quality; therefore, it is important to consider the potential impact of the auditor’s economic dependence created by interlocking on audit quality.
Hossain, S., G. S. Monroe, M. Wilson, and C. Jubb. 2016. The Effect of Networked Clients’ Economic Importance on Audit Quality. Auditing: A Journal of Practice and Theory 35 (4): 79 – 103.
The authors examine the association between audit quality and the economic importance of client networks that are created by audit committee member-audit partner interlocks, which occur when an audit committee member of a company is also an audit committee member of other companies that are audited by a common audit firm and engagement audit partner. When an audit partner audits several companies that have audit committee members in common, there is potential for a self-interest threat to auditor independence. The interlocked audit partner may perceive that disputes with the management of a particular client within the network may threaten future fee income from the other companies in the network; thus, these economic ties have the have the potential to erode auditor independence and, as a consequence, reduce audit quality.
The authors test the association between each audit-quality proxy and each client network fee dependence measure using regressions based on unrestricted samples and samples of clients matched on their inherent propensity to be associated with an audit committee-audit partner interlock.
This paper extends previous work by examining how clients’ use of contending tactics affect auditors’ decisions during a negotiation, which separates itself from the research of the past by investigating the clients’ current negotiation tactics, not the tactics of the past. This paper also introduces the level-of-aspiration theory into consideration for auditor negotiation literature.
Bergner, J. M., S. A. Peffer and R. J. Ramsay. 2016. Concession, Contention, and Accountability in Auditor-Client Negotiations. Behavioral Research in Accounting 28 (1): 15-25
This study focuses on investigating how tactics employed by a client during negotiations impact experienced auditors’ propensity to waive material adjustments and whether the salience of a concurring partner review (CPR) can affect these negotiations. The audit profession as a whole remains fixated upon auditor independence and financial statement quality, so it is important to examine potential tactics by a client since negotiations directly affect the resulting financial statements. The authors of this study hope to expound upon existing literature by examining how a client who is concessionary or contentious during the negotiation may affect its outcome. In addition, they study whether a CPR reduces auditors’ propensities to waive material adjustments.
The authors conduct an online experiment in which auditors make decisions about the audit of a hypothetical client. They manipulate two independent variables: client tactics and CPR salience.
The findings of this study suggest that the training and functional expertise of the CEO can affect the auditor’s perception of engagement risk, observed through a reduction in audit fees. They add to the growing literature of CEO characteristics which highlight how top managers influence firm outcomes.
Kalelkar, R., S. Khan. 2016. CEO Financial Background and Audit Pricing. Accounting Horizons 30 (3): 325-339.
Theory suggests that the audit pricing decision is a function of a client’s audit risk and business risk. Recent literature has suggested that CEO characteristics can affect how auditor’s perceive the firm’s audit risk and the resulting audit pricing decision. This paper addresses how the financial expertise of Chief Executive Officer influences audit fees. The authors hypothesize that a CEO’s financial expertise can affect the level of audit fees through two channels:
• Reducing the firm’s business risk through greater performance and profitability and
• Reducing the firm’s audit risk by improving the quality of the firm’s financial reporting.
Specifically, they suggest that a CEO’s financial expertise will lower both the firm’s audit risk and business risk resulting in lower audit effort and a corresponding reduction in audit fees.
The authors use a sample of firms with changes in CEO financial expertise between 2004 and 2013. Specifically, they look at firms that switched from a CEO with financial expertise to a CEO with no financial expertise and vice versa, resulting in a sample of 77 firms and 81 changes in financial expertise.
Alternatively, to address the unobservable characteristics of the firm which may influence both accounting outcomes and CEO selection, the authors utilize an instrumental variables two-stage model. They use the local density of financial firms as an instrument for the financial expertise of the focal firm. The location of the firm can influence the financial expertise of the board of directors. When the board holds greater financial expertise this can limit the demand for a CEO with similar functional expertise within the firm.
The results of this study are important to consider when examining the effects of the audit committee on managers’ judgments. This study identifies the changes to the reporting environment stemming from the implementation of SOX, particularly with respect to communications between auditors and the audit committee and the authority and responsibility of the audit committee. This study adds insight to prior archival research that suggests that audit committees considered to be effective are associated with greater financial reporting quality. Further, these findings suggest that managers act as if auditors and audit committees that jointly resist management pressures to engage in aggressive reporting play important roles in ensuring high financial reporting quality.
Brown-Liburd, H., A. Wright and V. Zamora. 2016. Managers’ Strategic Reporting Judgments in Audit Negotiations. Auditing, A Journal of Practice and Theory 35 (2): 47-64.
Prior research has largely characterized audit issue negotiations as a dyadic relationship between auditors and managers. However, the Sarbanes Oxley Act (SOX) substantially enhanced the audit committee’s oversight responsibilities for the financial reporting and auditing process. Thus, negotiations post-SOX may be viewed as a triadic relationship involving managers, auditors, and the audit committee. Differing judgments between auditors during negotiations and managers during financial reporting exist because they have different perspectives and incentives. Whereas managers’ incentives relate to maximizing financial reporting outcomes while maintaining the firm’s reporting reputation, auditors’ incentives relate to fostering a functioning working relationship with the client while appropriately attesting to the financial statements. These differences in perspectives and incentives yield contrasting expectations of negotiation judgments for auditors and managers. This study seeks to examine the joint effects of past auditor-client negotiations and audit committee strength on management’s strategic reporting judgments.
The authors recruited participants from an executive training session attended by CFOs/controllers and held at a large public university in the southeastern U.S. During a controlled experiment, participants completed the hard copy experimental case. Participants engaged in planning for an upcoming audit negotiation involving a subjective estimate for an inventory write down due to obsolescence. The authors asked participants to identify their initial offer and their perception of the negotiated ultimate final outcome. Audit committee strength was manipulated as either weak or strong. The nature of past auditor-client negotiations over “grey” misstatements was manipulated as either contentious or cooperative.
The results are consistent with a strong combined effect of the roles of both the auditor and the audit committee in managers’ pre-negotiation judgments.
The authors’ results indicate that the complexity associated with auditing more subjectively valued assets may affect audit fees in a manner that is not fully captured by the traditional log transformation. Based on their findings, the authors also suggest that future audit fee studies assess alternative mathematical transformations of client size variables.
Cullinan, C. P., H. Du, and X. Cheng. 2016. Size Variables in Audit Fee Models: An Examination of the Effects of Alternative Mathematical Transformations. Auditing: A Journal of Practice and Theory. 35 (3): 169-181.
Company size, typically measured as total assets, is an important factor in audit fee models. The size measure is usually transformed by taking the natural logarithm of total assets. The log of assets and the log of audit fees are used when studying audit fees to control for the non-linear relationship between asset size and audit fees. For example, as the population size (the number of individual assets held) increases, the sample size necessary to audit the population is only minimally affected, creating a non-linear relationship. This method was born from necessity after the realization that there was no true way to determine the form of the function; however, when this method became widely used, fair value accounting was not commonly used. Now that fair value accounting has become the “norm” and there are different methods of measuring fair value, mathematical transformations should be revisited. ASC 820 requires the disclosure of whether fair values were determined based on directly observable inputs (Level 1), indirectly observable inputs (Level 2), or unobservable inputs (Level 3). The authors combine the two insights regarding fair valued assets and mathematical transformations to examine whether the log transformation of different types of fair valued assets provides the best fit in an audit fee model, or whether other mathematical transformations may better reflect the non-linear nature of the relationship between different types of fair valued assets and audit fees.
The authors examine these issues in audit fee models among closed-end mutual funds and among a broad-based sample of publicly traded companies.
This paper asks whether auditors recognize the volatility of OCI and incorporate it into pricing of audits. They find that audit fees do reflect changes in OCI and that these changes reflect various risk factors associated with OCI. The findings suggest that auditors already recognize the difficulty in assessing value of fair value items which run through OCI—reinforcing regulator concerns about fair value valuation.
Huang, H., S. Lin, K. Raghunandan. 2016. The Volatility of Other Comprehensive Income and Audit Fees. Accounting Horizons 30 (2): 195-210.
This study investigates whether auditors incorporate volatility in other comprehensive income (OCI) into fees. Increased attention from standard setters, both domestically and internationally, on fair value accounting has increased auditor focus on fair value financial instruments. Fluctuations in many of these assets are reflected in OCI, thus volatility in OCI may indeed influence the auditor’s inherent risk assessment. Other studies have shown that investors do not seem to accurately incorporate volatility of OCI in pricing, so it is an empirical question whether auditors can incorporate it into their risk assessment.
The authors use a sample of S&P 500 firms from 2002 to 2006 and supplement this sample with a comparable sample from 2008 to reinforce their findings. Data on OCI was hand collected from the SEC’s EDGAR database and combined with financial information from Compustat and auditor data from Audit Analytics. The authors exclude financial sector firms, resulting in a final sample of 1,858 firm-year observations.
The authors find:
The existing research is unclear about the mechanism behind the higher audit fees charged by the industry specialist auditors (ISAs). The fee premium can be explained either by higher audit hours or by higher audit fees per hour. Using Korean data, this study provides direct evidence of the source of the ISA fee premium. The results show ISAs spend more audit hours while charge lower unit price than non-ISAs, which indicates the ISA fee premium mainly comes from additional audit work performed by ISAs. One limitation of this study is the authors cannot differentiate the two potential explanations for the low unit price: cost savings arising from economies of scale or additional work performed by cheap audit labor.
Bae, G. S., S. U. Choi, and J. H. Rho. 2016. Audit Hours and Unit Audit Price of Industry Specialist Auditors: Evidence from Korea. Contemporary Accounting Research 33(1): 314-340.
Prior audit research documents the total audit fees charged by industry specialist auditors (ISAs) are higher than those charged by non-industry specialist auditors (non-ISAs). There are different explanations of this finding. Some argue ISAs charge higher fees for more audit work they conduct. Others argue ISAs charge higher fees because they have greater bargaining power over client. This paper is to explore the source of audit fee premiums associated with ISAs. In particular, the authors compare total audit hours and audit price per hour between similar audit engagements of ISAs and non-ISAs. By decomposing total audit fees into total audit hours and audit price per hour, the authors would at least identify one source of the ISA audit fee premium. A higher total audit hours spent by ISAs would imply ISAs exert greater audit effort and their audit quality is higher. In contrast, a higher audit price per hour charged by ISAs would imply ISAs can extract market power rents or expertise rents from their clients.
The sample comprises audit engagements of Korea listed companies from 2000 to 2010. In Korea, audit hours are required to be disclosed in the companies’ annual reports. The authors first compare total audit fees and total audit hours between audit engagements of ISAs and non-ISAs, controlling for other engagement characteristics. Next, they compare the unit audit prices charged by ISAs and non-ISAs.