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  • Jennifer M Mueller-Phillips
    A Framework for Research on Corporate Accountability...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters 
    Title:
    A Framework for Research on Corporate Accountability Reporting.
    Practical Implications:

    The author shows how the successive incidence of these properties in observed corporate accountability reports can be used to determine whether and how those reports create or destroy value for shareholders and other constituencies. He shows how the hypotheses developed in the skeptical appraisal of corporate accountability reporting section can be used to distinguish across these explanations in observed corporate accountability reports.

    Citation:

    Ramanna, K. 2013. A Framework for Research on Corporate Accountability Reporting. Accounting Horizons 27 (2): 409-432.

    Keywords:
    corporate accountability reporting, social responsibility in business, financial statements
    Purpose of the Study:

    This paper provides an accounting-based conceptual framing of the phenomenon of corporate accountability reporting. In the paper, the author leverages the positive accounting literature’s current understanding of the role of financial reporting in a market economy and its understanding of the properties of financial reports, to develop some basic hypotheses on corporate accountability reporting. Further refinement and tests of these hypotheses are likely to help us better understand some of the fundamental questions in corporate accountability reporting outlined in the Harvard Business School (HBS) conference’s call for papers. 

    Corporate accountability reporting is defined to be broader than corporate accounting in that accountability reporting, unlike accounting, can be used to hold corporations to account for actions with externalities that are not entirely captured in revenues and expenses currently defined. The externalities can be positive (e.g., local community-building initiatives) or negative (e.g., environmental pollution, regulatory capture) relative to the state of the world, where the corporation does not engage in the action, and the internalization of externalities into firm decisions may or may not create value for extant shareholders. In this paper, the author develops a framework to study corporate accountability reporting. In developing the framework, the author explicitly approaches corporate accountability as an observed phenomenon, and avoids speculating on whether companies ought to be held to account to customers, employees, and society, outside of shareholder maximization.

    Design/Method/ Approach:

    The author analyzes the phenomenon of corporate accountability reporting and provides an accounting-based conceptual framing.

    Findings:
    • The author argues that delegation necessitates accountability and that such accountability then involves reporting.
    • The author argues that an accountability reporting system is likely to be more useful to a delegator if it: (1) mitigates information advantages across delegates and delegators, (2) reports both stocks and flows in the measures of account, and (3) has a mutually agreeable due process to match across periods the actions of delegates and the outcomes of those actions.
    • The author provides a skeptical appraisal of corporate accountability reporting. He offers three explanations for observed corporate accountability reports. These are: (1) in Milton Friedman’s words, “window dressing,” i.e., a superficial exercise that does not internalize externalities into firm decisions, (2) an attempt at internalizing negative externalities, as identified by one or more firm constituencies, into firm decisions, and (3) an attempt at internalizing positive externalities, as identified by one or more firm constituencies, into firm decisions.
    Category:
    Corporate Matters
  • Jennifer M Mueller-Phillips
    Abnormal Audit Fees and Audit Quality: The Importance of...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 11.0 Audit Quality and Quality Control, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management.
    Practical Implications:

    This paper provides new evidence on the fee-quality relationship using the propensity to use income-increasing discretionary accruals to meet or beat analysts' forecasts. The evidence in this paper suggests that abnormal audit fees are positively related to audit quality. This result is consistent with concerns raised by regulators that lower audit fees could reflect a lower level of effort provided by the auditor. This is important, given the trend of declining audit fees in recent years. By finding different results using a more focused sample of firms with the incentive and ability to manage earnings, this study highlights the importance of considering the context when performing tests of earnings management. This information is of interest to regulators, such as the SEC.

    Citation:

    Eshleman, J. D., & P. Guo. 2014. Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management. Auditing: A Journal of Practice & Theory 33 (1): 117-138.

    Keywords:
    audit fees, audit quality, discretionary accruals, meet-or-beat, earnings management
    Purpose of the Study:

    In this study, the authors attempt to shed light on the conflicting evidence by performing a study of the relationship between abnormal audit fees and audit quality using a new research design. Specifically, the authors examine whether clients paying abnormal audit fees are more or less likely to use discretionary accruals to meet or beat the consensus analyst forecast.

    A growing body of accounting literature examines the relationship between audit fees and audit quality. Researchers are interested in this relationship because, ex ante, it is not clear whether receiving higher fee revenue from a client will improve audit quality or harm it. On the one hand, it could be argued that an auditor who receives abnormally high audit fees from a client will lose their independence and allow the managers of the client firm to engage in questionable accounting practices. However, it is also possible that audit fees are a measure of audit effort, i.e., higher fees indicate that the auditor worked more hours, signaling greater effort. To the extent that audit fees are a measure of audit effort, low audit fees could harm audit quality.

    Design/Method/ Approach:

    Audit fee and auditor data are obtained from Audit Analytics, financial statement data are obtained from Compustat, and analyst forecast data are obtained from the I/B/E/S database. The authors perform tests on two samples of 4,476 firm-years and 1,670 firm-year observations spanning 2000 to 2011.

    Findings:

    The authors find that clients paying higher abnormal audit fees are significantly less likely to use discretionary accruals to meet or beat the consensus analyst forecast. If abnormal audit fees are held at their mean, a one-standard-deviation increase in abnormal audit fees decreases the client's likelihood of using discretionary accruals to meet or beat the consensus forecast by approximately 5 percent. This is consistent with higher audit fees being indicative of greater auditor effort and, ultimately, better audit quality. The authors obtain similar results whether they use the audit fee model of Choi et al. (2010), the one proposed by Blankley et al. (2012), or their own audit fee model.

    Category:
    Audit Quality & Quality Control, Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Earnings Management
  • Jennifer M Mueller-Phillips
    An Examination of the Effects of Managerial Procedural...
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 14.0 Corporate Matters, 14.02 Corporate Whistle Blowers 
    Title:
    An Examination of the Effects of Managerial Procedural Safeguards, Managerial Likeability, and Type of Fraudulent Act on Intentions to Report Fraud to a Manager.
    Practical Implications:

    This study provides evidence that whistleblowers take report recipient individual differences (i.e., managerial likeability) into account when making reporting decisions. In addition, this is despite that fact that, eventually, the investigation and resolution will involve multiple organizational members. Further, the results highlight the benefits of managerial likeability: employees have higher reporting intentions when faced with a likeable manager than one who is unlikeable.

    Secondly, this study finds that employees have higher reporting intentions when the fraud involves misappropriation of assets as opposed to fraudulent financial reporting, possibly because employees see fraudulent financial reporting as benefiting the organization as a whole, while misappropriation of assets benefits a single employee to the detriment of the organization.

    Finally, the authors suggest that findings indicating that the strength of managerial procedural safeguards to not influence reporting intent could be a result of poor manipulations and need to be further investigated.

    Citation:

    Kaplan, S. E., K. R. Pope, and J. A. Samuels. 2015. An Examination of the Effects of Managerial Procedural Safeguards, Managerial Likeability, and Type of Fraudulent Act on Intentions to Report Fraud to a Manager. Behavioral Research in Accounting 27 (2): 77-94.

    Keywords:
    managerial procedural safeguards, managerial likeability, fraud, reporting intentions
    Purpose of the Study:

    Because only a fraction of employees who discover fraud actually report it, the authors endeavor to obtain a better understanding of factors influencing individuals' intentions to report fraud, particularly to a non-anonymous recipient such as a manager (as opposed to an anonymous recipient, such as a hotline). The authors predict that reporting intentions to a manager will be influenced by 3 factors:

    • Attributes of the firm (i.e., strong managerial procedural safeguards will result in stronger reporting intentions than will weak managerial procedural safeguards)
    • Report recipient (i.e., a likeable manager will result in stronger reporting intentions than will an unlikeable manager)  
    • Type of fraud (i.e., managers are more likely to report misappropriation of assets than fraudulent financial reporting)

    Results indicate that managerial likeability and the type of fraud, but not managerial procedural safeguards or the interaction with managerial likeability, significantly influence reporting intentions to a manager.

    The authors contend that participants are influenced by managerial likeability because it provides specific information about the manager and acts as a signal about how the manager will likely handle a fraud report. In addition, these results suggest that participants make stronger attributions to a person engaging in misappropriation of assets compared to a person engaging in fraudulent financial reporting.

    Design/Method/ Approach:

    The authors execute a 2 x 2 x 2 between-subjects experiment, engaging 171 professional accountants and managers and randomly assigning each to one of eight experimental conditions. Participants had an average of over 26 years of work experience and almost half (47.5%) reported having had discovered a person of greater authority than themselves engaging in questionable or wrongful behavior. Participants were presented with a scenario in which an employee identifies an apparent fraudulent act by his immediate supervisor and asked about their intentions to report the fraud to a manager.

    Findings:
    • Attributes of the firm: Findings do not indicate that variances in managerial procedural safeguards (strong or weak) impact participant intention to report a fraud.
    • Report recipient: Findings indicate that reporting intentions were significantly higher when the manager was described as likeable (as opposed to unlikeable).
      • The authors suggest that this is because likeable managers are perceived as being more approachable, and will be expected to perform well as a recipient of a fraud report.
    • Type of fraud: Findings indicate that participants have significantly higher reporting intentions when the fraud involves a misappropriation of assets (i.e., employees taking company assets) versus when the fraud involved fraudulent financial reporting (i.e., misreporting financial results or financial position).
      • This, the authors posit, is because misappropriation of assets is seen as benefiting the employee only at the expense of the company and its shareholders, while fraudulent financial reporting might be seen as benefiting the company.
    Category:
    Corporate Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Corporate Whistle Blowers, Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Are Seemingly Self-Serving Attributions in Earnings Press...
    research summary posted July 16, 2015 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior, 14.08 Press Release Language and Signaling 
    Title:
    Are Seemingly Self-Serving Attributions in Earnings Press Releases Plausible? Empirical Evidence.
    Practical Implications:

    The finding that investors distinguish the plausibility among seemingly self-serving attributions based on concurrent industry performance and earnings commonality suggests that investors are somewhat sophisticated when interpreting these narrative disclosures. This study should be of interest to policymakers who advocate the importance of narrative disclosures. A potential concern that policymakers face is that managers can use unregulated narrative disclosures to manipulate investor perceptions, particularly if investors accept managers’ self-serving pronouncements uncritically. These findings mitigate this concern because investors appear to be sophisticated enough to use relevant information to distinguish the plausibility of seemingly self-serving attributions. Apparently, providing self-serving attributions purely to mislead investors may not be an effective strategy.

    Citation:

    Kimbrough, M. D., & Wang, I. Y. 2014. Are Seemingly Self-Serving Attributions in Earnings Press Releases Plausible? Empirical Evidence. Accounting Review 89 (2): 635-667.

    Keywords:
    attribution, narrative disclosure, plausibility, earnings announcements
    Purpose of the Study:

    Managers often provide causal explanations for earnings news by linking earnings performance to internal actions or to external causes. These attributions potentially help investors assess the implications of current earnings news, such as earnings persistence. A well-documented pattern from prior research on attributions is that managers are more likely to attribute good news to internal causes (enhancing attributions) and bad news to external causes (defensive attributions). Managers presumably provide such seemingly self-serving attributions to heighten (dampen) investors’ perceptions of the persistence of good (bad) earnings news, thereby increasing (decreasing) the market reward (penalty) for good (bad) earnings news.

    Investors face a challenge when interpreting seemingly self-serving attributions because they may provide unbiased information about future earnings or they may reflect managers’ psychological biases or opportunism. In this study, the authors examine the information that investors appear to rely upon when assessing the plausibility of seemingly self-serving attributions in earnings press releases. Specifically, the authors test whether the market’s reactions to earnings announcements that contain seeming self-serving attributions vary with:
    (1) The concurrent performance of other firms in the same industry, and 
    (2) The commonality of the firm’s earnings with the market and its industry, defined as the historical degree of co-movement between a firm’s earnings and market- and industry-level earnings.

    Design/Method/ Approach:

    Using a sample of earnings press releases from 94 randomly selected firms from 1999 to 2005, the authors document cross-sectional differences in the market’s response to earnings announcements that contain either defensive or enhancing attributions that are consistent with the predictions.

    Findings:

    The authors find that firms that provide defensive attributions to explain earnings disappointments experience less severe market penalties when:
    (1) More of their industry peers also release bad news, and
    (2) Their earnings share higher commonality with industry- and market-level earnings.

    On the other hand, firms that provide enhancing attributions to explain good earnings news reap greater market rewards when:
    (1) More of their industry peers release bad news, and
    (2) Their earnings share lower commonality with industry- and market-level earnings.

    Collectively, the results suggest that investors neither completely ignore seemingly self-serving attributions nor accept them at face value, but use industry- and firm-specific information to assess their plausibility. Further analyses reveal that investors’ use of industry peer performance and earnings commonality information appears justified because investors’ perceptions are consistent with the association between the plausibility measures and the ex post actual persistence of earnings surprises.

    In supplemental analysis, the authors find that the pattern of the effects of the plausibility factors observed for the seemingly self-serving sample does not extend to the non-self-serving sample, indicating that investors use these measures to assess plausibility only when seemingly self-serving attributions exist.

    Category:
    Corporate Matters
    Sub-category:
    Earnings Targets & Management Behavior, Press Release Language & Signaling
  • Jennifer M Mueller-Phillips
    Audit Committee Director-Auditor Interlocking and...
    research summary posted March 2, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.02 Board/Financial Experts, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Audit Committee Director-Auditor Interlocking and Perceptions of Earnings Quality
    Practical Implications:

    This study is important to provide an insight into the personal relationships and familiarity between audit committee directors and external auditors in terms of auditor independence. Furthermore, our examination of AC director-auditor interlocking provides a more complete basis for understanding the effectiveness of corporate governance in guarding earnings quality. The results not only support the view that AC director-auditor interlocking positively affects investors’ perception of earnings quality, but also support the regulatory requirement that audit committees include at least one financial expert.

    For more information on this study, please contact Jeng-Fang Chen.

    Citation:

    Chen, J.-F., Y.-Y. Chou, R.-R. Duh, and Y.-C. Lin. 2014. Audit committee director-auditor interlocking and perceptions of earnings quality. Auditing: A Journal of Practice and Theory 33 (4): 41-70

    Keywords:
    Audit committee director-auditor interlocking, investor perceptions, earnings response coefficients, financial expert
    Purpose of the Study:

    In response to Enron and subsequent financial reporting scandals, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 (SOX, hereafter), which put particular emphasis on the role of audit committees in ensuring financial reporting quality. Although existing regulations stipulate the composition and qualifications of audit committee directors, audit committee director interlocking that arises when an audit committee director serves on more than one audit committee is allowed. Therefore, we analyze how investors perceive reported earnings when companies with interlocking audit committee directors are audited by the same audit firm (hereafter, AC director-auditor interlocking), using earnings response coefficients (ERCs) as a proxy for investor perceptions of earnings quality. The tendency of AC director-auditor interlocking could have positive or negative implications for the audit committee’s effectiveness in guarding earnings quality.

    • A positive influence may result insofar as closer personal relationships enhance the audit committee’s understanding and trust of auditors, thereby making interlocking audit committee directors more likely to support the auditor in accounting and auditing disputes.
    • An opposing argument is that economic incentives may compromise auditor independence. Also, interlocking audit committee directors may be less critical of auditor performance due to personal relationships with the interlocking auditor.

    Besides the relationship between AC director-auditor interlocking and ERCs, this study investigates whether the potential positive impact of AC director-auditor interlocking in improving earnings quality would be outweigh the potential negative influence in the post-SOX period, when shareholders and regulators have higher expectations and heighten liability concerns for both interlocking audit committee directors and auditors. In particular, this study examines if earnings quality is higher when interlocking audit committee directors are financial experts who are better placed to recommend streamlining of audit committee procedures on the financial reporting process.

    Design/Method/ Approach:

    We collect director information through the RiskMetrics database, which covers S&P 1500 companies, from fiscal years 1998 to 2010, while the impact of financial experts is examined by a sample from fiscal years 2003 to 2010. This study uses ERCs from returns-earnings regressions and designs three measures for the degree of a firm’s AC director-auditor interlocking to examine its impact on earnings quality. 

    Findings:
    • This study finds that a greater extent of AC director-auditor interlocking is perceived as associated with higher earnings quality.
    • This study finds that investors’ perceptions of earnings quality are more affected by the extent of AC director-auditor interlocking in the post-SOX era than before it, whatever we use the pre- and post-SOX subsamples or the interaction item of SOX for the test.
    • This study finds that investors perceive AC director-auditor interlocking especially positively when interlocked audit committee directors are financial experts. That is, the results document that the positive impact of AC director-auditor interlocking on the ERCs is more pronounced when interlocking audit committee directors are financial experts.
    Category:
    Corporate Matters, Governance, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Board/Financial Experts, Impact of SOX
  • Jennifer M Mueller-Phillips
    Audit Quality and Analyst Forecast Accuracy: The Impact of...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.04 Industry Experience, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Audit Quality and Analyst Forecast Accuracy: The Impact of Forecast Horizon and Other Modeling Choices
    Practical Implications:

    This paper contributes to research examining the determinants and impacts of audit quality by identifying the limitations of aspects of metrics employed in recent research that could have been utilized by practitioners and suggesting useful alternate metrics for investigating the impact of audit quality on the properties of analysts’ forecasts, including the usefulness of audited financial information and the prediction of future performance. 

    Citation:

    Wu, Y. and Wilson, M. 2016. Audit Quality and Analyst Forecast Accuracy: The Impact of Forecast Horizon and Other Modeling Choices. Auditing: A Journal of Practice and Theory 35 (2): 167-185. 

    Keywords:
    audit quality, auditor industry specialization and analyst forecast accuracy
    Purpose of the Study:

    Many studies examine the influence of auditor characteristics on the properties of analyst forecasts of client firms’ earnings. A common argument is that audit quality affects the accuracy of analyst forecasts or closely associated metrics. However, there is considerable divergence in the posited theoretical association between audit quality and forecast accuracy and in the empirical associations reported. The majority of these studies rely exclusively on measures of forecast accuracy based on analysts’ end-of-year forecasts. The authors argue that metrics drawn from these forecasts are noisy indicators of the impact of audit quality because there are convincing reasons why superior audit quality may affect the accuracy of the metrics in either direction. Financial reports of clients of higher quality auditors may be more useful for forecasting future earnings which in turn may increase forecast accuracy; however, higher quality auditors may be more effective in disallowing client attempts to manage earnings. Thus, if an auditor provides superior quality services to their client, then it is conceivable that these competing effects will offset each other, resulting in no net impact on forecast accuracy. As a result, the authors argue that the properties of analysts’ beginning-of-year forecasts provide superior measures of any of the impacts of auditor characteristics because these forecasts are less likely to induce benchmark-beating incentives for earnings manipulation and because audited financial information has a greater relative impact on analysts’ information set at the beginning-of-year than at the end-of-year. 

    Design/Method/ Approach:

    Focusing on measures of audit firm industry specialization common to papers with competing predictions and results, the authors demonstrate the noisiness and sensitivity to model specification of test based on end-of-year forecast accuracy and show that similar tests based on beginning-of-year forecast accuracy generate predicted results that are consistent over a range of modeling approaches. 

    Findings:
    • The authors find that analysts’ beginning-of-year forecasts are a potentially superior proxy for auditors’ impact on the properties of analyst forecasts because the “decision usefulness” impact of an audit is at its strongest soon after those reports are released and is likely to dominate any effect on audit quality on client benchmark-beating behavior.
    • The authors also identify the importance of other modeling choices facing researchers, such as the deflation of forecast errors and controls for the endogenous selection of industry specialist auditors. 
    Category:
    Audit Quality & Quality Control, Corporate Matters
    Sub-category:
    Earnings Management, Industry Expertise – Firm and Individual
  • Jennifer M Mueller-Phillips
    Audit Quality and the Trade-Off between Accretive Stock...
    research summary posted June 21, 2013 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality, 14.0 Corporate Matters, 14.01 Earnings Management, 14.05 Earnings Targets and Management Behavior 
    Title:
    Audit Quality and the Trade-Off between Accretive Stock Repurchases and Accrual-Based Earnings Management
    Practical Implications:

    This study provides evidence that is important to corporate governance decisions. The results suggest that hiring a high quality auditor to constrain accruals earnings management may result in management’s use of real earnings management as a substitute. Real earnings management involves potentially costly deviations from “business as usual.” Consequently, it may be important to consider other corporate governance measures aimed at constraining real earnings management concurrently with the decision to hire a high quality auditor. 

    Citation:

    Burnett, B., B. Cripe, G. Martin, and B. McAllister. 2012. Audit Quality and the Trade-Off between Accretive Stock Repurchases and Accrual-Based Earnings Management. The Accounting Review 87 (6): 1861-1884.

    Keywords:
    Real earnings management; stock repurchases; audit quality; audit industry specialization
    Purpose of the Study:

    When managers decide to manipulate earnings they must make a choice about how they will achieve their goal. The two broad methods for manipulating earnings are the manipulation of accounting choices and estimates (i.e. accrual earnings management) and the manipulation of real business practices (i.e. real earnings management). The authors of this study argue that either method could be considered questionable because the intent of earnings management is to mislead investors or influence accounting-based contractual arrangements. The choice between the two methods is of interest because governance activities that are taken to constrain one type of earnings management behavior may result in another.

    This study investigates whether audit quality affects management’s choice between accrual earnings management and accretive stock repurchases when firms manage earnings per share (EPS) to meet or beat analysts’ forecasts. The use of accretive stock repurchases to manage EPS is a type of real earnings management that involves the firm repurchasing shares in order to boost EPS figures. The authors believe that, because this form of real earnings management can be done quickly and with little disclosure, it is a good comparison to accrual management in this scenario. The authors make and test the following hypotheses (stated in null form):

    H1: High audit quality is unrelated to the use of accretive stock repurchases to meet or beat consensus analysts’ forecasts.

    H2: High audit quality is unrelated to the trade-off between the use of accretive stock repurchases and accrual-based earnings management to meet or beat consensus analysts’ forecasts.

    Design/Method/ Approach:

    The authors use data on publicly-traded companies that meet or beat analysts’ earnings forecasts but would have missed these forecasts if they had not managed their earnings. Using this subset of firms, the authors compare companies that hired an industry specialist auditor to those that had a non-specialist auditor. The sample period includes data from years 1989-2009.

    Findings:

    The authors document (1) a positive and significant relationship between having a high quality auditor and employing accretive stock repurchases in order to meet or beat EPS estimates, and (2) a negative and significant relationship between having a high quality auditor and employing accrual-based earnings management in order to meet or beat EPS estimates. The authors claim that these results suggest the use of accruals-based earnings management is constrained by high quality auditors and, as a result, when managers are faced with a high quality audit they employ accretive stock repurchases instead of accrual-based earnings management to meet or beat analysts’ EPS forecasts.

    Category:
    Audit Quality & Quality Control, Corporate Matters
    Sub-category:
    Earnings Management, Earnings Targets & Management Behavior
    Home:

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  • Jennifer M Mueller-Phillips
    Auditor Quality and Debt Covenants
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 14.0 Corporate Matters 
    Title:
    Auditor Quality and Debt Covenants
    Practical Implications:

    This paper contains important applications for borrowing firms wanting to have more favorable loan contract terms. By hiring a high-quality auditor this decreases risks for the creditors and therefore oftentimes reduces the stringency of debt covenants. Subsequently, the borrowing firm will violate the debt covenants less.

    Citation:

    Robin, Ashok, Q. Wu, and H. Zhang. 2017. “Auditor Quality and Debt Covenants”. Contemporary Accounting Research 34.1 (2017): 154.

    Purpose of the Study:

    Debt covenants are in place to help mitigate information asymmetry and agency problems between lender and borrower. This study examines whether high-quality auditors decrease the lenders’ demand for strict covenants (contracting effect), therefore reducing the likelihood of covenant violations (violation reduction effect). The assumption is that the information provided by a high-quality auditor would lower information asymmetry and agency problems, and consequently there would be no reason for strict debt covenants. 

    Design/Method/ Approach:

    There was a sample of 35,181 observations from 1996-2007. Compustat was used to gather annual covenant-violation data and Deal Scan was used to gather U.S. loan facility information.  The authors used an ordinary least squared (OLS) regression model in the analysis.

    Findings:

    Overall, the authors find high-quality audits are in fact related with fewer and looser covenants in debt contracts.

    Specifically, the authors find the following:

    • As auditor quality increases the probability of financial covenant violations decrease. The probability is 1.45% lower for firms audited by industry experts and about 4.98% lower for firms audited by the Big 4.
    • High-quality auditors play a role in mitigating the adverse effect of covenant violations on corporate borrowing costs.
    Category:
    Audit Quality & Quality Control, Corporate Matters
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • Jennifer M Mueller-Phillips
    Auditor Resignation and Firm Ownership Structure
    research summary posted October 29, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 13.0 Governance, 14.0 Corporate Matters, 14.09 CEO Tenure and Experience 
    Title:
    Auditor Resignation and Firm Ownership Structure
    Practical Implications:

    The audit profession operates in a highly legal environment, and because of this, audit firms must find ways to manage their risk exposure. One way to reduce the risk of litigation against the firm is to manage the client portfolio and resigning from high risk clients. According to the study, family owned firms are less of a litigation risk to the auditor than non-family owned firms, especially when the CEO of the family-owned firm is not a family member. However, if an auditor does resign from auditing a family-owned firm managed by a non-family CEO, the investing public reacts less negatively to this than if the firm were not family owned.


    For more information on this study, please contact Samer K. Khalil.
     

    Citation:

    Khalil, S., J. Cohen, and G. Trompeter. Auditor resignation and firm ownership structure. Accounting Horizons 24 (4): 703-727.

    Keywords:
    family firms; auditor resignations; corporate governance; market reactions
    Purpose of the Study:

    In order to manage risk exposure, audit firms can choose to resign from high risk clients. Auditor resignations can bring very negative outcomes to the discharged client because of the audit search and startup costs incurred and the investors’ interpretation in the information signaled by the auditor resignation. This study investigates whether the likelihood of auditor resignations and the subsequent stock market reaction in family firms differs significantly from that in non-family firms. Additionally, this study examines whether the identity of the CEO that manages the family firms has an effect on the aforementioned associations. The identity of the CEO refers to whether the CEO is a founder, a descendant, or a non-family CEO.

    Design/Method/ Approach:

    The evidence for this study was gathered using auditor resignations reported on the Audit Analytics database in the U.S over five calendar years, 2004-2008. Sample firms were matched with control firms that did not switch their auditors using four different attributes: firm size, firm industry, auditor type, and auditor tenure to serve as one benchmark.  A random sample of control firms that did not switch their auditors and had publicly available data on their corporate governance was used as a second benchmark.

    Findings:
    • The primary findings of this study were that: 1) auditors of family firms are less likely to resign than those of non-family firms and that 2) auditor resignations are less likely to occur in family firms managed by a founder or non-family CEO. These imply that auditors appear to attribute lower litigation risk to family firms because the family’s concern to preserve their reputation and contribute family wealth to future generations reduces the risk of misappropriation of assets and/or earnings management.
    • Another primary finding was that abnormal return following auditor resignations in family firms are significantly less negative than those in non-family firms. Furthermore, the findings suggest that the investing public places a lower weight on the bad news associated with auditor resignation in family firms managed by a non-family CEO as opposed to non-family firms. The public’s reaction to a resignation did not vary based on whether a family firm was managed by a founder or descendant CEO.
    • Secondary finding indicate that the following variables also have an impact on auditor resignation:
      • Firm audit reports modified for going concern reasons
      • Firms that report weaknesses in internal control over financial reporting
      • Firms that report a loss in the year preceding auditor resignation
      • The presence of an auditor-client mismatch
      • Firms with large variance in abnormal returns
      • Firms with higher likelihoods of bankruptcy and acquisition
      • Corporate governance mechanisms such as number of audit committee meetings, percentage of financial experts serving on the audit committee, and one or more institutional block holders.
         
    Category:
    Client Acceptance and Continuance, Corporate Matters, Governance
    Sub-category:
    CEO Tenure & Experience, Resignation Decisions
  • Jennifer M Mueller-Phillips
    Board Monitoring and Endogenous Information Asymmetry.
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.09 CEO Tenure and Experience, 14.10 CEO Compensation 
    Title:
    Board Monitoring and Endogenous Information Asymmetry.
    Practical Implications:

    The author claims that motivating the CEO to reveal information may or may not be beneficial. The disconnection between compensation and outcomes results from active monitoring. Compensation contracts rely on board evaluation, not on the final outcomes, to provide incentives. The proactive board activity can result in poor firm performance. This proactive activity requires extra care to reign in an expert: the CEO.

    Citation:

    Tian, J. J. 2014. Board Monitoring and Endogenous Information Asymmetry. Contemporary Accounting Research 31 (1): 136-151.

    Keywords:
    boarding monitoring, information acquisition, information asymmetry, project decision, executive compensation, CEO compensation
    Purpose of the Study:

    Boards of directors are frequently questioned pertaining to their monitoring role in executive decision making and compensation. The sequence of financial fraud in the early 2000s called public attention that boards have not done enough to align executive incentives with shareholders’ interests. Since shareholders do not normally observe executives’ actions and may not even know what actions executives should have taken to maximize shareholder value, increasing board effort to reduce such information asymmetry is commonly viewed as desirable.

    The present study challenges this common view that increasing board effort in monitoring is always desirable. This view neglects a key fact in corporate decision making: the information asymmetry between the CEO and shareholders is a result of the CEOs expertise. This study highlights the fact that CEOs are hired for their superior ability to make strategic decisions, particularly for their unique skills to acquire, process and interpret information relevant to these decisions.

    Design/Method/ Approach:

    The authors uses analytical modeling to conclude on the questions of interest.

    Findings:

    If board monitoring eliminates all information asymmetry, the board can easily ensure that decisions are made in the best interest of shareholders. It resolves all uncertainty in the remaining decision problems. However, preserving uncertainty is crucial ex ante in order to motivate a risk-averse CEO to acquire information, as effort need not be expended if there is no concern for uncertainty. Thus, board monitoring creates a time consistency problem for the CEO to acquire information.

    The board should actively engage in monitoring activities only when the board is able to evaluate the information provided by the CEO with high accuracy. That is, when board monitoring is able to produce enough information about the CEO’s effort directly, preserving uncertainty to incentivize the CEO to acquire information is a second-order concern. However, if a project requires special skills for implementation and board evaluation may not be accurate enough, it is better for the board to remain passive and not interfere with the CEO’s decisions.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Board/Audit Committee Oversight, CEO Compensation, CEO Tenure & Experience

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