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  • Jennifer M Mueller-Phillips
    Abnormal Audit Fees and Restatements
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Abnormal Audit Fees and Restatements
    Practical Implications:

    The conclusion that audit fees are associated with the risk of audit failure may impact auditors as they face pressure to reduce audit fees. Auditors should consider this risk based on the client’s position as well as trying to minimize risk related to audit fee reductions. Similarly, client’s audit committee should consider the trade-off between current fees and the risk of restatement. With the changes that SOX introduced, regulators should review how changes in audit fees affects the quality of financial statements over time.

     

     

    For more information on this study, please contact Dr. David Hurtt.

    Citation:

    Alan I. Blankley, David N. Hurtt, and Jason E. MacGregor. 2012. Abnormal Audit Fees and Restatements. Auditing: A Journal of Practice & Theory: 31 (1): 79-96.

    Keywords:
    Restatements, audit fees, audit quality
    Purpose of the Study:

    Overall, this paper investigates whether there is a relationship between audit fees and subsequent financial statement restatements. The authors investigated whether audit firms charged more for audit services prior to a restatement compared to non-restatement clients. Past research finds that this relationship has a positive correlation. However, the authors revisited this relationship for the post-SOX period based on multiple factors:

     

    • The relationship of audit fees to future restatements is unclear since high fees may increase restatement probability due to independence issues, while low fees may increase the probability of future restatement because they potentially reflect lower levels of service or effort.
    • SOX affects the auditor-client relationship through changes such as partner rotation and prohibiting some non-audit services provided to audit clients. Research revealed a shift in firms increasing pricing for risk.
    • With the recent economic downturn, companies trying to decrease audit fees could be focusing on cutting cost instead of focusing on the quality of the financial statements.
    • Past research was inconclusive on the relationship between future restatements and audit fees because of the time frame studied as well as the omission of an internal control strength variable.

     

    Finding a clear relationship between audit fees and future restatements could have implications in how auditors, audit committees, and regulators view audit fees in a post-SOX business environment. As a result, the study could impact fee negotiations from the standpoint of audit quality.

    Design/Method/ Approach:

    Audit fee and restatement data was collected from Audit Analytics for the 2002 through 2009 period. The authors used two statistical models to study the association audit fees may have with future restatements. First, using an audit fee model based on prior research, the authors derived the abnormal or unusual audit fee after controlling for audit risk, client complexity, internal control strength and other influences on fees. In the second model, the authors tested a robust logistic regression model where the variable of interest was the abnormal audit fee derived from the first model. 

    Findings:
    • The authors find that abnormal audit fees are negatively associated with the probability of future financial statement restatements.
    • When audit fees are noticeably high, the likelihood of restatement is low. When audit fees are noticeably low, the likelihood of restatement is high.
    • When audit fees are abnormally low, there may be pressure for auditors to maintain the profitability of the engagement by minimizing hours to complete the audit.
    • This relationship is robust when the model included or excluded a variety of internal control and restatement variables.
    Category:
    Accountants' Reporting, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Restatements
  • Jennifer M Mueller-Phillips
    Accelerated filing deadlines, internal controls, and...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.07 Impact of SEC Actions, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Accelerated filing deadlines, internal controls, and financial statement quality: The case of originating misstatements.
    Practical Implications:

    Given the significant amount of concern regarding the reliability of financial statement reporting under new filing deadlines (movement from 90 days to 75 days in 2003 and then to 60 days in 2006), the authors provide evidence which shows the concern was valid but only temporarily. The authors use originated misstatements to indicate the beginning of a misstatement, showing that accelerated filers experienced higher likelihood of misstatements after the first acceleration, however large accelerated filers did not experience such a change in response to the second acceleration. Additionally, implementation of SOX appears to have increased reliability with fewer originated misstatements upon implementation.

    Citation:

    Boland, C. M., S. N. Bronson, C. E. Hogan. 2015. Accelerated filing deadlines, internal controls, and financial statement quality: The case of originating misstatements. Accounting Horizons 29 (3) 297-331.

    Keywords:
    Accelerated filing, financial statement restatements, Sarbanes-Oxley Act, filing lags, internal controls
    Purpose of the Study:

    The authors investigate whether Government regulationspecifically through changes in filing deadlines and implementation of the Sarbanes Oxley Act (SOX)influence the origination of financial statement misstatements. They specifically focus on the origination of misstatements to determine if firms sacrificed relevance and reliability to comply with accelerated filing dates.

    Design/Method/ Approach:

    The analyses use a sample of 17,216 firm-year observations from 12/15/2002 to 12/14/2007. The authors run a regression analysis predicting the likelihood of a restatement for accelerated filers and large accelerated filers relative to non-accelerated filers. The model incorporates controls for other known determinants of changes in likelihood of restatement.

    Findings:

    The authors find:

    • Accelerated filers had a higher likelihood of a misstatement following the filing deadline shift from 90 to 75 days.
    • Accelerated filers had a reduced likelihood of a misstatement following implementation of SOX.
    • Large accelerated filers did not experience a change in likelihood of a misstatement following the filing deadline shift from 75 to 60 days.

    The results suggest that the concerns of filers and their auditors regarding the potential for lower-quality information resulting from accelerated filing was valid, although only temporarily. In the long run, companies were able to file reports in a timelier manner without a corresponding increase in the likelihood of misstatement.

    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Impact of SEC Actions, Restatements
  • Jennifer M Mueller-Phillips
    Admitting Mistakes: Home Country Effect on the Reliability...
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Admitting Mistakes: Home Country Effect on the Reliability of Restatement Reporting.
    Practical Implications:

    The study highlights that a positive relationship between restatements and financial reporting quality depends on the reliable detection and disclosure of misstatements. Foreign firms are less likely to restate, a finding that has implications for investors and regulators. The results imply that U.S.-listed foreign firms may be under-scrutinized by U.S. public and private enforcement mechanisms. The findings suggest that companies from countries with weaker domestic rule of law are a potential focus area for investors and regulators to better identify firms with opportunistic restatement behavior. Fewer restatements lowers investors’ ability to hold managers and auditors accountable for poor financial reporting through CEO turnover or securities litigation, since restatements are a major trigger for both these mechanisms.

    Citation:

    Srinivasan, S., Wahid, A. S., & Yu, G. 2015. Admitting Mistakes: Home Country Effect on the Reliability of Restatement Reporting. Accounting Review 90 (3): 1201-1240.

    Keywords:
    accounting quality, accounting restatements, earnings management, enforcement, internal control weakness, SOX 404
    Purpose of the Study:

    Accounting rules in the U.S. require firms to issue a restatement correcting prior material errors upon discovery. Timely detection and reporting of accounting errors and irregularities ensure that a firm’s reported financials are free of any misstatements. Without enforcement that ensures the prudent correction of existing misstatements, there will likely be systematic underreporting of restatements, which will allow bad type firms to pool with good type firms and possibly lower investors’ faith in the reported financials. Therefore, understanding the determinants of reporting restatements is important to better assess the reliability of reported financials.

    The authors use the large number of restatements in recent years by both U.S. and foreign firms listed in the U.S. to examine the reliability of restatement reporting in a cross country setting. The self-reported nature of restatements provides a good setting to assess how home country characteristics influence the financial reporting of foreign firms listed in the U.S. Further, since foreign firms are subject to the disclosure requirements set forth by the Securities and Exchange Commission (SEC), this setting allows the authors to examine the effect of home country characteristics on the financial reporting of foreign registrants while generally holding the extent of U.S. regulation constant. In particular, the authors examine whether restatement reporting varies by country-level factors that influence how firms comply with the restatement reporting rules.

    Design/Method/ Approach:

    The sample comprises 7,453 firm-year observations for U.S.-listed foreign firms from 51 countries between 2000 and 2010. The authors include both American Depository Receipts and firms directly listen on U.S. exchanges. To classify firms as foreign, the authors use Compustat to find the headquarters. The restatement sample is obtained from Audit Analytics.

    Findings:
    • Foreign firms report accounting restatements in 4.7 percent of firm-years, compared to 7.3 percent for a matched sample of U.S. firms.
    • Firms from weak rule of law countries are less likely to restate, with 4.2 percent of firms restating, compared to 7.5 percent for the matched sample of U.S. firms. On the other hand, firms from strong rule of law countries show a smaller difference in their restatement frequency compared to matched U.S. firms (5.0 percent versus 7.2 percent of firm-years).
    • Firms from weak rule of law countries are 42 percent less likely to restate compared to firms from strong rule of law countries.
    • The lower frequency of restatements in weak rule of law countries is due to weaker compliance with restatement reporting, rather than an absence of accounting misstatements.
    • Foreign firms, especially those from weak rule of law countries, are less likely to report accounting irregularity restatements than comparable U.S. firms.
    • The sensitivity of earnings management to accounting irregularity restatements is positive and significant only for U.S. firms and foreign firms from strong rule of law countries. For foreign firms from weak rule of law countries, the authors find no relation between earnings management and the likelihood of accounting irregularity restatements. This suggests that avoidance of restatement is not limited to errors; it exists even for accounting irregularities.
    Category:
    Accountants' Reporting
    Sub-category:
    Restatements
  • Jennifer M Mueller-Phillips
    An Intertemporal Analysis of Audit Fees and Section 404...
    research summary posted November 17, 2014 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions 
    Title:
    An Intertemporal Analysis of Audit Fees and Section 404 Material Weaknesses
    Practical Implications:

    The findings suggest that audit fees respond to audit risk changes in the post-SOX environment, however this response is not immediate. These findings have important practical implications for audit regulators and for practicing auditors. These findings imply that audit firms are slow to reduce audit fees in the wake of remediation, which may be due to the documentation requirements imposed by PCAOB Auditing Standard No. 2 (“AS 2”). Notably, the PCAOB issued Auditing Standard No. 5 (“AS 5”) to supersede AS 2 in 2007 in an effort to improve implementation of the internal control requirements. In particular, AS 5 provided refinements to AS 2 meant to make the audit more scalable to a particular client and their corresponding risks. The findings presented in this study could be used as a baseline for evaluating whether AS 5 increased the responsiveness between audit fees and the underlying client risks. Audit practitioners must balance engagement risk management with public perceptions in order to maintain their reputations in the market for audit services. The findings presented here imply that audit fees are the most persistent in the presence of more severe material internal control weaknesses, consistent with predictions extending from the audit risk model.

    For more information on this study, please contact Matthew Hoag.

    Citation:

    Hoag, M. L. and C. W. Hollingsworth. 2011. An intertemporal analysis of audit fees and section 404 material weaknesses. Auditing: A Journal of Practice and Theory 30 (2): 173-200

    Keywords:
    SOX Section 404, internal control opinion, remediation of a material weakness, audit fees
    Purpose of the Study:

    In 2002, the Sarbanes-Oxley Act (“SOX”) was passed, which dramatically changed the financial reporting landscape following a wave of high-profile corporate frauds. Section 404 of SOX was perhaps the most significant reform, requiring that company management report on the effectiveness of internal control over financial reporting (404a), and requiring that the company’s external auditor complete a comprehensive evaluation of the internal controls and render an opinion on their effectiveness (404b). The mandated evaluation(s) of internal controls come at a significant cost to filers, as the initial evidence evaluated post-SOX pointed to a significant increase in audit fees for those companies subject to the provisions of SOX 404. These findings fueled criticism of Section 404 by opponents who argue the costs imposed an overwhelming burden on companies.

    This study investigates the impact of Section 404 on audit fees beyond the initial years of implementation. Specifically, it entails a longitudinal empirical examination of audit fees post-SOX within the theoretical context of the audit risk model. Audit fees should reflect both audit risk and audit effort. Using information provided through the newly mandated internal control opinions, this study tests how audit fees respond following either (1) the remediation of or (2) the failure to remediate internal control weaknesses by a company. The findings presented in this study should be of interest to audit industry regulators, academics performing audit fee research post-SOX, and to audit practitioners.

    Design/Method/ Approach:

    The sample is comprised from the population of accelerated filers subject to the provisions of SOX Section 404 spanning 2004 through 2007. The final sample consists of more than 13,500 company-year observations obtained from the Audit Analytics and Compustat databases with non-missing data necessary to perform the hypotheses tests. These tests employ OLS regression using a traditional audit fee model commonly used in audit pricing research and the test variables for varying types of Section 404 internal control opinions.

    Findings:
    • Using a levels model, audit fees are found to be consistently and significantly higher both in the presence of a material weakness in internal control and for companies that remediate a previous material weakness.
    • In a changes model, the findings suggest that audit fees decline significantly in each of the first two years after the remediation of a material weakness. Thus, the remediation of a material weakness leads to lower audit fees, but the corresponding decline does not occur immediately.
    • Three years after remediating a material weakness in internal control, a company still pays a 19 percent audit fee premium as compared to a company that never reported a material weakness. However, this premium does not differ significantly from the premium paid by these same companies in the year prior to the implementation of SOX 404, suggesting that auditors recognized these companies entailed heightened audit risk even prior to performing the internal control evaluation.
    Category:
    Accountants' Reporting, Internal Control
    Sub-category:
    Consequences of Adverse 404 Opinions, Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Are Auditors Professionally Skeptical? Evidence from...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Are Auditors Professionally Skeptical? Evidence from Auditors’ Going-Concern Opinions and Management Earnings Forecasts.
    Practical Implications:

    The decision process concerning a firm’s going-concern status is a crucial component of the overall audit. The authors provide new empirical evidence showing how auditors use potentially biased management forecasts in their going-concern decision process. Auditor professional skepticism is an important concept in audit practice as evidenced by its prominence throughout auditing standards. The authors show that auditors do not significantly overweight management forecasts on average, and even underweight management forecasts they perceive as being suspicious, indicating that auditors exercise professional skepticism when using management earnings forecasts. Thus, this paper is informative to regulators who are mainly concerned about auditors relying too heavily on what their clients tell them and failing to sufficiently test or challenge the forecasts, views, or representations of management.

    Citation:

    Feng, M., & Li, C. 2014. Are Auditors Professionally Skeptical? Evidence from Auditors' Going-Concern Opinions and Management Earnings Forecasts. Journal Of Accounting Research 52 (5): 1061-1085.

    Keywords:
    going-concern, management forecast, professional skepticism
    Purpose of the Study:

    This paper investigates whether auditors exercise professional skepticism about management earnings forecasts when assessing a client firm’s going-concern status. Professional skepticism is “an attitude that includes a questioning mind and a critical assessment of audit evidence”. Regulators have long been concerned that auditors rely too much on what their clients tell them rather than applying professional skepticism. For example, a lack of professional skepticism is one primary cause of SEC actions against audit firms.

    This paper sheds light on auditor professional skepticism due to the joint effect of three important factors.

    • Prospective financial information provided by managers is an important input to auditors when they evaluate the client’s going-concern status. Among this information, management earnings forecasts are particularly important because, if a financially distressed firm is expected to continue generating losses, the losses are likely to drain the firm’s limited cash resources and increase the firm’s likelihood of going bankrupt.
    • Financially distressed firms tend to issue optimistically biased forecasts. Because the firms to which auditors consider issuing a going-concern opinion are generally financially distressed, professional skepticism could be especially important in this setting.
    • Auditors could obtain management earnings forecasts through private communication with managers and/or public earnings forecasts.
    Design/Method/ Approach:

    The authors obtain data from financially distressed firms that have auditor reports available on Audit Analytics and are covered by the Compustat and First Call database for fiscal years 2000 through 2010. This results in final sample of 1,054 firm-year observations with 39 observations receiving going-concern opinions, and 33 filing for bankruptcy in the 12 months subsequent to the auditor opinion issuance date.

    Findings:

    The authors find that, when management earnings forecasts are higher, the firms are less likely to receive going-concern opinions and to subsequently go bankrupt. Moreover, the coefficient on management forecasts in the going-concern model is not significantly different from the coefficient in the bankruptcy model. Hence, there is no significant evidence showing that auditors, on average, overweight management earnings forecasts and thus fail to apply professional skepticism when evaluating the firms’ going-concern status.

    The authors find that auditors’ going concern decisions are not associated with management earnings forecasts with lower perceived credibility, but significantly and negatively associated with the other management earnings forecasts. In contrast, the likelihood of bankruptcy is significantly related to management earnings forecasts, regardless of auditor-perceived credibility. More importantly, the weight that auditors assign to management forecasts with low perceived credibility is significantly lower than the weight implied in the bankruptcy model. In other words, auditors’ underweight management earnings forecasts that are issued by managers who previously missed their own forecasts and management forecasts that predict high earnings increases or high earnings.

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Are Juries More Likely to Second-Guess Auditors Under...
    research summary posted August 31, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.04 Investigations, 15.0 International Matters, 15.02 IFRS Changes – Impacts 
    Title:
    Are Juries More Likely to Second-Guess Auditors Under Imprecise Accounting Standards?
    Practical Implications:

     The results of this study have implications for regulatory agencies and standard-setting bodies. As regulators contemplate whether to mandate IFRS and standard setters determine the level of implementation guidance for new standards, the litigation consequences of standard precision are an important consideration. Further, these results highlight the importance of regulators developing ways for jurors to evaluate audit judgments under imprecise standards, especially in industries and areas without precise industry reporting norms. Prior discussion on this issue has focused on how professional judgment frameworks are necessary to protect auditors and their clients from second guessing. This study suggests that judgments frameworks, if effective, may help protect auditors who make conservative judgments and also help hold auditors accountable for overly aggressive judgments.

    Citation:

     Kadous, K., and M. Mercer. 2016. Are Juries More Likely to Second-Guess Auditors Under Imprecise Accounting Standards? Auditing: A Journal of Practice and Theory 35 (2): 101-117.

    Keywords:
    audit litigation, standard precision, principles versus rules, second-guessing, jury decision making, IFRS
    Purpose of the Study:

    U.S. Generally Accepted Accounting Principles (GAAP) are generally viewed as more precise than International Financial Reporting Standards (IFRS) in that the former tend to contain more detail about implementation and compliance than the latter. Convergence efforts between U.S. GAAP and IFRS are on going, and have led to greater imprecision in U.S. accounting standards in areas such as lease accounting and revenue recognition. These imprecise standards require increased professional judgment by managers and auditors, which has led to concern that the adoption of less precise standards will result in more second-guessing of auditor judgments by juries and thus greater legal liability. This study seeks to address this concern and examines whether juries are more likely to second-guess auditors’ judgments under an imprecise accounting standard compared to a precise accounting standard. 

    Design/Method/ Approach:

    The authors recruited undergraduate students enrolled in introductory accounting courses at a large university as participants for this study. Two administrations were conducted with the students who participated in a simulated case that lasted 45 minutes during their accounting lab session. Participants acted as jurors in an auditor negligence case involving revenue recognition and were given information related to SFAS No. 66 (Real Estate) to help in their evaluation. The authors manipulated the precision of the accounting guidance as either precise or imprecise. The aggressiveness of the client’s reporting choice was manipulated as either aggressive or conservative.  

    Findings:

    The results of this experiment suggest that auditors’ fear about second-guessing by juries under imprecise accounting standards is warranted. Under an imprecise standard, conservative accounting choices are more likely to be called into question and result in negligence verdicts, ex post.

    • When the client’s reporting is conservative, there appears to be more second guessing of auditor judgments under an imprecise standard compared to a precise standard.
    • When the auditor allows aggressive client reporting, there appears to be less second guessing of auditor judgments under an imprecise standard compared to a precise standard.

    These findings indicate that rather than being overly harsh, juries appear to be overly lenient when auditors allow aggressive accounting under an imprecise standard. A lack of precision appears to make it more difficult for juries to identify whether an auditor’s judgment was reasonable or unreasonable. 

    Category:
    Accountants' Reporting, International Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    IFRS Changes – Impacts, Investigations, Litigation Risk
  • Jennifer M Mueller-Phillips
    Associations between Internal and External Corporate...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance 
    Title:
    Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements
    Practical Implications:

    Prior studies’ conflicting results regarding the association between corporate governance measures and restatements are explained (at least partially) by the time period in which the relationship is examined. The relationship is different before and after Sarbanes Oxley (2002). However, this paper cannot determine whether the change in relationship was caused by Sarbanes Oxley or whether it happened for another reason.

    For more information on this study, please contact William R. Baber.
     

    Citation:

    Baber, W. R., L. Liang, and Z. Zhu. 2012. Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements. Accounting Horizons 26 (2): 219-237.

    Keywords:
    corporate governance; governance regulation; accounting restatements
    Purpose of the Study:

    Prior studies have found conflicting results as to whether corporate governance characteristics are related to accounting restatements. Some of these prior students examine restatements prior to Sarbanes Oxley (2002), and some examine restatements afterwards. This study seeks to reconcile the findings of previous research and determine whether the relationship between corporate governance and accounting restatements has changed over time.

    Design/Method/ Approach:
    • Authors examine corporate governance data from 1997 and 2005 to compare differences in governance over time.
    • Corporate governance characteristics are divided between factors that affect internal governance (defined as characteristics that presumably govern the efficacy of board of director oversight of management) and factors that affect external governance (defined in terms of the ability of shareholders to intervene in decisions by both management and the board of directors)
    • Investigate the association between 1997 corporate governance and the probability that financial statements from 1995-1999 are restated; also investigate the association between 2005 corporate governance and the probability that financial statements from 2003-2007 are restated.
       
    Findings:
    • There is a substantial increase in internal governance during the period when changes were imposed by stock exchanges and by the U.S. Congress in the Sarbanes-Oxley Act (2002). The change in internal governance is offset by a less substantial, yet statistically significant, decrease in external governance which is consistent with the observation that shareholder oversight is recently declining.
    • In 1997, internal and external governance characteristics are substitutes for each other (firms tend to do one or the other); in 2005, however, internal and external governance is not related.
    • Corporate governance characteristics in 1997 (prior to Sarbanes Oxley) are unrelated to the probability of financial statement restatements, whereas the correlation between corporate governance characteristics and restatements is statistically significant in 2005 (after Sarbanes Oxley).
      • Thus, the cross-sectional relationship between governance characteristics and restatement changed between 1997 and 2005.
    • The relationship between corporate governance measures in 2005 and restatements in 2003-2007 is not significant if interactions between internal and external governance measures are omitted from the model.
       
  • Jennifer M Mueller-Phillips
    Audit Fees after Remediation of Internal Control Weaknesses
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions 
    Title:
    Audit Fees after Remediation of Internal Control Weaknesses
    Practical Implications:

    The results of this study are important for companies and regulators that are trying to understand the true costs for firms with an adverse report on internal control. It further informs the continuing debate regarding Section 404 of SOX and provides some evidence that these premiums can be as high as 30 (20) percent in the first(second) year after remediation when compared to firms that only have clean Section 404 reports. Lastly, this provides opportunities for future research investigating how long it takes audit fees to return the level of companies that only receive clean opinions and whether or not this premium relates to additional audit work or a risk premium.

    Citation:

    Munsif, V., K. Raghunandan, D. V. Rama, and M. Singhvi. 2011. Audit Fees after Remediation of Internal Control Weaknesses.  Accounting Horizons 25 (1):  87-105. 

    Keywords:
    internal controls; audit fees; material weakness; remediation
    Purpose of the Study:

    Firms that receive an adverse report on internal control under Section 404 of SOX typically experience significant costs, such as a higher cost of capital. Additionally, these companies reporting material weaknesses also tend pay higher audit fees which is consistent with the belief that ineffective internal controls leads to a higher propensity for misstatements. Conversely, it is logical to expect that these higher fees will return to normalized levels if the weakness is remediated; however, recent evidence in regards to control problems disclosed pursuant to Section 302 of SOX has been contrary to this belief. This study attempts to provide clarification to these findings and investigates whether audit fees return to previous levels after the remediation of material weaknesses disclosed under Section 404 of SOX. It is important to recognize that in contrast to prior research which examines fees in the year of (or year prior to) remediation, this study examines the audit fees in the years following the remediation  in order to determine if the higher fees that the company pays in year of disclosure remain at a premium even two or three years after remediation.

    Design/Method/ Approach:

    The authors use data on SEC registrants and collect information on audit fees and Section 404 disclosures for the first four years of internal control reporting (2004-2007). The authors exclude financial sector companies, as well as, foreign firms and compare audit fees over the four year period of analysis for SEC registrants with fiscal year-ends from November 15 through May 31 of the following calendar year. The authors examine audit fees in years subsequent to the remediation of internal control weaknesses in order to determine whether auditors continue to view firms that had ever received an adverse Section 404 opinion as being “tainted,” such that even after remediating the problem, firms continue to pay an audit fee premium.

    Findings:

    The authors find that remediating firms have lower audit fees when compared to firms that continue to report material weaknesses in internal control. However, the remediating firms continue to pay, in the year of remediation as well as one and two years subsequent to remediation, a significant audit fee premium compared to firms that have clean Section 404 reports in each of the first four years of internal control reporting. The authors also show that general weaknesses have a higher effect on audit fees than only account-specific internal control weaknesses.

    Category:
    Internal Control, Accountants' Reporting
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses, Assessing Remediation of Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Consequences of Adverse 404 Opinions
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  • Jennifer M Mueller-Phillips
    Audit Report Restrictions in Debt Covenants
    research summary posted August 30, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Audit Report Restrictions in Debt Covenants
    Practical Implications:

     Private debt lenders are more likely to include a covenant that prohibits the borrower from receiving an audit report with going-concern modifications (GCAR) when the borrower has poor creditworthiness and the loan term is long. The auditor choice is more likely to be specified in the loan agreement when a GCAR covenant is included. The borrower with a GCAR covenant experiences both increased audit fees and higher probability of getting a GCAR when financial distress occurs. The results imply the GCAR covenant may complement traditional financial covenants in protecting the lenders but comes with a cost borne by the borrowers. It also shows the lenders’ use of audit reports can influence the auditors’ behavior.

    Citation:

     Menon, K., and D. D. Williams. 2016. Audit Report Restrictions in Debt Covenants. Contemporary Accounting Research 33 (2): 682–717.

    Keywords:
    going concern, auditor choice, debt covenants, audit fees, audit reports
    Purpose of the Study:

    Prior studies on debt contracting mainly focus on financial covenants. This paper extends prior research by investigating why lenders put an audit-related covenant – GCAR covenant – into the loan agreement and the effect of this covenant on auditors. The authors argue a GCAR serves as an effective warning for potential defaults even if common financial covenants are not violated. They expect borrowing firms with low credit quality to have a GCAR covenant. They also expect long-term loans to have a GCAR covenant because the lenders face higher probability that the firm’s financial condition deteriorates before the loan matures. To prevent opinion shopping and for insurance purpose, lenders who impose a GCAR covenant are expected to restrict the borrower’s freedom on auditor selection. From the auditor’s stand point, the authors believe the GCAR covenant increases litigation risk to the auditor and/or require additional audit effort. As a result, audit fees are expected to increase and the borrowers are more likely to receive a GCAR.  

    Design/Method/ Approach:

    The initial sample comes from new private debt placement made by public companies between 2003 and 2009. The final sample consists of 7,749 loan contracts (firm-years) from 3,304 unique companies. The authors obtain debt information from DealScan, financial information from COMPUSTAT and audit-related data from Audit Analytics. The authors first test what factors determine the inclusion of a GCAR covenant and then examine the effect of this covenant on audit-related issues.  

    Findings:
    • Private debt lenders are more likely to impose a GCAR covenant in the loan contract when the credit quality of the borrower is poor and/or the debt’s maturity is long. Additional analyses show the GCAR covenant can capture events or situations lead to potential defaults even if traditional covenants are not violated.

     

    • If the loan contract contains a GCAR covenant, it is more likely that the lenders will require the borrower to engage a specific auditor. The auditors accepted by the lenders are usually the Big 4 auditors or at least national auditors. The auditor choice reflects the view that reputable auditors are stricter in going-concern assessment and have deep pockets to settle litigations.

     

    • Auditors charge higher audit fees on and are more likely to issue a GCAR to clients who have loan contracts contain a GCAR covenant, holding the degree of financial distress constant. The results are consistent with the argument that the GCAR covenant increases auditors’ perception on litigation risk and the demand on audit effort. 
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Audit Reporting for Going-Concern Uncertainty: A Research...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Audit Reporting for Going-Concern Uncertainty: A Research Synthesis
    Practical Implications:

    This study provides a summary of the literature examining the auditor’s GCO decisions. Determinants of GCOs include client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), auditor factors (e.g. audit firm size), auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and environmental factors (e.g. changes in regulations, auditing standards and audit market structure). Important findings are that auditors will change the likelihood of issuing GCOs in response to changes in the environment (whether due to changes in regulation or changes in the economy) and that the majority of companies that receive GCOs do not subsequently file for bankruptcy.

    For more information on this study, please contact Elizabeth Carson.

    Citation:

    Carson, E., N. L. Fargher, M. A. Geiger, C. S. Lennox, K. Raghunandan, and M. Willekens. 2013. Audit reporting for going-concern uncertainty: A research synthesis. Auditing: A Journal of Practice & Theory 32 (Supp): 353-384.

    Keywords:
    going-concern; audit reporting; bankruptcy
    Purpose of the Study:

    The global financial crisis in 2007 has resulted in an increased incidence of company failures. This led to renewed interest from regulators, standard setters and investors in the auditor’s assessment and reporting on a company’s ability to continue as a going concern. In order to facilitate the understanding of the role and effectiveness of independent audit, this study conducts a comprehensive review to synthesize and discuss the extant academic literature on auditors’ decisions to issue a modified opinion based on going concern uncertainty (hereafter, GCO).

    Design/Method/ Approach:

    This study synthesizes major findings from audit research since the 1970s. Most of the research reviewed is archival; however, a few studies using experimental designs are also cited. A framework is developed to structure the categorization of the extant GCO literature. Three main themes are identified: (1) Determinants of GCOs, (2) Accuracy of GCOs, and (3) Consequences of GCOs. This study also provides a discussion on issues related to research methodology and identifies areas for further research.

    Findings:

    Under the category of “Determinant of GCOs”, the synthesis shows that:

    • Auditors are more likely to issue GCOs after December 2001, which is in response to the accounting and auditing scandals in early 2000s (e.g. collapse of Enron). Also, smaller companies more likely to receive GCOs.
    • In the ten-year period between 2000 and 2010, 60.10% of bankruptcy filings are preceded by GCOs.
    • Determinants of GCOs include: (1) client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), (2) auditor factors (e.g. audit firm size), (3) auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and (4) environmental factors (e.g. changes in regulations, auditing standards and audit market structure).

    Under the category of “Accuracy of GCOs”, the synthesis shows that:

    • Since the adoption of SAS No.59, 40-50% of bankruptcy firms did not receive a prior GCO.
    • 80-90% of companies receiving a GCO do not file for bankruptcy in the subsequent year.

    Under the category of “Consequences of GCOs”, the synthesis shows that:

    • Issuance of GCOs is associated with negative excess returns, and the reaction is more negative when problems with obtaining financing are cited.
    • In the U.S., the issuance of GCO can be a “self-fulfilling prophecy” and cause the financial demise of company that would have survived if it had not received a GCO.

    With regards to issues in research methods, this study cautions the use of small samples in analysis and the interpretation of interaction variables in the statistical models. The study also finds general limitations in extant research due to the varying sample selection criteria for identifying financial stressed firms and the exclusion of private companies from samples examined.

    This study suggests further research could (1) examine the relations between auditor independence and GCO decisions, (2) investigate auditor’s GCO decisions and the related issues for financial institutions, non-profit organisations and government entities, (3) replicate research on GCO accuracy in different time periods with different samples, (4) examine the information usefulness of GCOs to a wide set of market participants, and (5) properly distinguish between the roles of management, audit committee and auditor in the disclosure and discussion of going-concern. 

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions

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