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  • The Auditing Section
    Mandatory Audit Partner Rotation, Audit Quality, and Market...6
    research summary posted May 7, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 15.0 International Matters, 15.03 Audit Partner Rotation 
    Title:
    Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan and Discussion of “Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan”
    Practical Implications:

    The adoption of mandatory partner rotation in many countries suggests that regulators believe that the benefits of rotation outweigh the costs and thus a policy of mandatory rotation enhances audit quality. The results of this study provide initial evidence of the effects of mandatory partner rotation on audit quality. Contrary to regulators’ beliefs, the findings do not support the assumption that audit partner rotation will lead to audit quality increases. One caveat to these findings is whether the findings will generalize to other countries with different regulatory and legal regimes.

    Citation:

    Chi, W., H. Huang, Y. Liao, and H. Xie. 2009. Mandatory audit partner rotation, audit quality, and market perception: Evidence from Taiwan. Contemporary Accounting Research 26 (2): 359-391. 

    Bamber, E.M., and L.S. Bamber. 2009. Discussion of “Mandatory audit partner rotation, audit quality, and market perception: Evidence from Taiwan”. Contemporary Accounting Research 26 (2): 393-402.

    Keywords:
    audit quality; audit partner rotation
    Purpose of the Study:

    The Sarbanes-Oxley Act of 2002 (SOX) reduced the period that an audit partner is allowed to serve a particular client from seven consecutive years (required by the AICPA since the 1970s) to five years. The assumption behind the mandatory rotation requirement is that rotating the audit partner will improve auditor independence and audit quality. Research on audit firm rotation in the U.S. suggests that longer audit firm tenure with a client increases audit quality.  Although, as Bamber and Bamber point out, the results of audit firm rotation may be different than audit partner rotation because the costs and benefits are quite different.  For example, in rotating audit firms, the new firm brings an entirely new audit team and a new audit methodology. In rotating an audit partner, many factors continue to be the same under the new partner (the team, the overall audit methodology, the firm’s history with the client, etc.). Due to the lack of audit partner data in the U.S., this study utilizes audit partner data from Taiwan to assess the effect of mandatory audit partner rotation on audit quality. More specifically, the authors address two primary issues:

    • The authors examine whether a sample of firms subject to mandatory rotation have higher audit quality as compared to three benchmarks: 1) a sample of firms not subject to mandatory rotation, 2) the mandatory sample in the year prior to adoption, and 3) a sample of firms with voluntary audit partner rotation.
    • The authors examine whether investors perceive higher audit quality for the firms subject to the mandatory rotation requirements relative to the three benchmark samples mentioned above.
    Design/Method/ Approach:

    The authors use data for publicly-listed firms in Taiwan from the 2004 Taiwan Economic Journal database.  Mandatory audit partner rotation became mandatory for firms listed on the two major stock exchanges in 2004.  For the 2004 firms, some companies had partners that were required to rotate off the engagement (firms subject to mandatory rotation in that year) whereas other companies did not have partners required to rotate as they had not been on the engagement long enough yet (a non-rotation sample). 

    Findings:
    • Audit quality is not significantly different when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of Taiwan firms not subject to mandatory rotation in 2004.  They also find no significant difference in audit quality when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of Taiwan firms whose audit partner voluntarily rotated in years before 2003.  
    • The audit quality provided by new partners for Taiwan firms subject to mandatory rotation in 2004 is lower than the audit quality of those same Taiwan firms one year earlier, when the audit was led by the prior partner.
    • The authors find that perceived audit quality is not significantly different when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of Taiwan firms not subject to mandatory rotation in 2004.  They also find no difference in perceived audit quality when comparing the sample of Taiwan firms subject to mandatory rotation in 2004 to the sample of those same Taiwan firms one year earlier.  They find that perceived audit quality is significantly higher for firms subject to mandatory rotation in 2004 compared to firms where audit partners voluntarily rotated prior to 2003. 
    Category:
    Independence & Ethics, International Matters
    Sub-category:
    Audit Firm Rotation, Audit Partner Rotation, Audit Firm Rotation
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  • Jennifer M Mueller-Phillips
    The Influence of Process Accountability and Accounting...1
    research summary posted October 22, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 15.0 International Matters, 15.02 IFRS Changes – Impacts 
    Title:
    The Influence of Process Accountability and Accounting Standard Type on Auditor Usage of a Status Quo Heuristic
    Practical Implications:

    The results of this study are important for both audit firms and regulators to consider as standards change to become more principles-based (or as firms move towards using IFRS). The evidence indicates that auditors will sometimes fixate on the prior year accounting treatment, even if the applicable accounting standard has changed, and/or there are changes in the scenario. However, this bias towards maintaining the status quo can be mitigated by holding auditors accountable for their decision making process, particularly through a partner asking about the auditors’ decision making process.

     

    For more information on this study, please contact Scott Vandervelde.

    Citation:

    Messier, Jr., W. F., L. A. Quick, and S. D. Vandervelde. 2014. The influence of process accountability and accounting standard type on auditor usage of a status quo heuristic. Accounting, Organizations and Society 39 (1): 59-74

    Keywords:
    International Financial Reporting Standards, principles-based standards, status quo bias, accountability, auditor judgment
    Purpose of the Study:

    There has been considerable discussion about the U.S. reporting standards becoming less rules based, similar to International Financial Reporting Standards (IFRS). One proposed advantage of a change to IFRS is increased comparability across multinational and non-U.S. companies. Additionally, some believe that IFRS afford greater flexibility in its principles, thereby enabling firms’ accounting choices to better reflect the true economic nature of any given transaction. With fewer rules, both financial statement preparers and auditors would be expected to adjust to having more options with regards to financial reporting. However, some proposed changes leave the option open to implement IFRS (or other principles-based standards) in ways that still follow rules in U.S. GAAP. This paper investigates whether prior year accounting treatments influence the judgment for current year treatments when one way to implement the standard is to follow the prior year treatment.

    The authors motivate their expectations based on status quo theory and accountability theory. Status quo theory suggests that individuals often choose to maintain a prior decision when faced with a new choice. Accountability theory suggests that when individuals are held accountable for their decision making process, this will reduce the bias towards the status quo. 

    Design/Method/ Approach:

    The research evidence is collected in 2010 through 2013. The authors use an experiment to collect data from auditors, mainly at the senior and manager level, from Big 4 and large national accounting firms in the United States and Norway.

    Findings:
    • The authors find that some auditors fixate on prior year scenarios and judgments, even if the current year scenario and applicable accounting standards are different.
    • The authors find that holding auditors accountable for their decision making process reduces the likelihood of sticking with the prior year treatment, most notably when the prior year standards were U.S. GAAP.
    Category:
    Auditor Judgment, International Matters
    Sub-category:
    IFRS Changes – Impacts
  • Jennifer M Mueller-Phillips
    The Effect of Joint Auditor Pair Composition on Audit...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 05.0 Audit Team Composition, 11.07 Attempts to Measure Audit Quality, 15.0 International Matters 
    Title:
    The Effect of Joint Auditor Pair Composition on Audit Quality: Evidence from Impairment Tests
    Practical Implications:

    Regulators are constantly trying to find ways to improve audit quality. The findings in this paper are useful to policymakers in understanding the benefits of a joint audit. It is also useful to companies and investors who are interested in what audit pairs provide a superior audit. 

    Citation:

    Lobo, Gerald J., L. Paugam, D. Zhang, and J. Francois Casta. 2017. “The Effect of Joint Auditor Pair Composition on Audit Quality: Evidence from Impairment Tests”. Contemporary Accounting Research 34.1 (2017): 118.

    Purpose of the Study:

    Regulators across the globe have been trying to find ways to increase audit quality, and one idea that has been proposed is requiring joint audits. Currently, joint audits are mandatory in France for any company preparing consolidated financial statements. This paper examines whether the auditor pair composition is related to audit quality. The three auditor compositions are Big4-Big 4 (BB), Big4-non-Big 4 (BS), and non-Big 4 non-Big 4 (SS). For the purposes of this study only BB and BS pairs are analyzed. The impairment of goodwill is examined to measure audit quality. This is due to management’s large discretion for the impairment of goodwill. The way auditor’s handle the impairment of goodwill often highlights how well they are maintaining objectivity and transparency of the auditor’s tests. It is important to note in BS pairs the Big 4 firm is most likely to be the one performing the impairment test.

    Design/Method/ Approach:

    The sample includes French firms from the SBF 250 index for the years 2006-2009. There were a total of 551 observations for the BB and BS pairs. The authors examined how the auditor pair type affected recognition of economic impairment and transparency of impairment-related disclosures.

    Findings:

    Overall, the authors find that BS audit pairs are associated with having a higher audit quality when compared to BB audit pairs. The authors believe this is due to a better coordination and development of a hierarchy in BS audit pairs and a higher incentive for better audit quality from the Big 4 firm in BS audit pairs. This is because the Big 4 firm in BS audit pairs are at a higher risk of reputational harm, than if they are paired with another Big 4 auditor in a BB audit pair.

    Specifically, the authors find the following:

    • In situations where low-performance indicators are present, BS audit pairs are more likely to recognize an impairment loss and recognize a larger impairment loss than BB pairs.
    • BS audit pairs are more likely to be more transparent in the disclosure of impairment for goodwill. On the other hand, BB pairs are more likely to show reductions in impairment-related disclosures when they book an impairment.
    Category:
    Audit Quality & Quality Control, Audit Team Composition, International Matters
    Sub-category:
    Attempts to Measure Audit Quality
    Home:

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

  • Jennifer M Mueller-Phillips
    Audit Fee Differential, Audit Effort, and Litigation Risk:...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 02.01 Audit Fee Decisions, 15.0 International Matters 
    Title:
    Audit Fee Differential, Audit Effort, and Litigation Risk: An Examination of ADR Firms
    Practical Implications:

    There are numerous factors that go into a firm’s decision to cross-list on foreign stock exchanges. One factor firms should consider regarding entrance into the U.S. stock exchange is an increase in audit fees. The evidence from this study indicates this increase can be traced back to costs from the legal environment and increased audit effort. 

    Citation:

    Bronson, Scott N., A. Ghosh, and C. E. Hogan. 2017. “Audit Fee Differential, Audit Effort, and Litigation risk: An Examination of ADR Firms”. Contemporary Accounting Research 34.1 (2017): 83.

    Purpose of the Study:

    U.S. investors rely on financial statements by foreign firms cross-listed on U.S. stock exchanges. Therefore, these financial statements must comply with accounting standards from the entity’s home country and U.S. standards. Previous studies have identified that audit fees are higher for cross-listed firms and attributed this to added litigation costs. This study examines if there are additional factors causing the audit fees to be higher for cross-listed firms. Specifically, about whether an increase in audit effort is incrementally related to price increases and if audit effort varies based on the stringency of an entity’s home country regulations. The authors presume the additional audit effort will result from the attestation of U.S. GAAP reconciliations and foreign auditor attestation of U.S. audit and independence standards.

    Design/Method/ Approach:

    The final sample consists of 36,646 observations and only includes entities audited by Big 4 firms. Compustat was used to find U.S.-based publicly traded firms, a list of foreign firms cross-listed in the United States was obtained from Bank of New York Mellon, and foreign non-cross listed publicly traded firms was listed in Worldscope and Compustat Global. The analysis was run using a regression of audit fees.

    Findings:

    The authors find the following:

    • Cross-listed firms in the United States do in fact pay significantly higher fees relative to other firms.
    • This total fee difference includes both incremental costs in legal environment and audit effort. The authors attributed 29% to 48% of this additional incremental costs as the additional audit effort required.
    • Cross-listed firms in countries with more stringent audit oversight pay a lower incremental audit fee compared to cross-listed firms in countries with more lax audit oversight.
    Category:
    Client Acceptance and Continuance, International Matters
    Sub-category:
    Audit Fee Decisions
    Home:

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

  • Jennifer M Mueller-Phillips
    Corporate Sustainability Reporting and Stakeholder Concerns:...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 15.0 International Matters, 15.05 Sustainability Services 
    Title:
    Corporate Sustainability Reporting and Stakeholder Concerns: Is There a Disconnect?
    Practical Implications:

    Sustainability is important to the accounting industry. Accountants have a responsibility to help integrate sustainability into areas such as budgets, resource allocations, and capital expenditure decisions. The evidence from this study indicates what CS activities consumer find important. Management can use this information in developing their business strategies related to CS. 

    Citation:

    Bradford, Marianne, J. B. Earp, D. S. Showalter, and P. F. Williams. 2017. “Corporate Sustainability Reporting and Stakeholder Concerns: Is There a Disconnect?”. Accounting Horizons. 31 (1): 83-102.

    Keywords:
    corporate sustainability; Global Reporting Initiative; sustainability reporting; stakeholder theory; content analysis; survey; factor analysis
    Purpose of the Study:

    There has been an increasing number of companies reporting their corporate sustainability (CS) in recent years. Traditionally, CS refers to measures companies take against environmental issues. However, in recent years it is often viewed as the balance between environmental, social, and economic outcomes, also known as the triple bottom line. This expanded definition of CS has caused companies to emphasize different outcomes, and subsequently to have vastly different CS reports. The current guidelines for CS reporting, the Global Reporting Initiative (GRI) framework, is consistently updated to account for this expanded view. Additionally, consumers are increasingly being viewed as primary stakeholder groups. This study examines whether the CS information being reported through the GRI framework is adequately addressing consumer stakeholder interests.

    Design/Method/ Approach:

    The sample contained 505 participants that responded to an online survey in 2013. The link to the survey was posted on the Institute of Management Accountants (IMA) website and also onto North Carolina State University’s website. The participants assumed the role of consumers and took the survey which contained 40 scale items and 6 demographic items.

    Findings:

    The authors find the following:

    • There is a disconnect between the dimensions that consumer stakeholder groups view as important and the GRI dimensions. The GRI based framework is broad, and therefore the reported measures may not satisfy the precise concerns that all stakeholder groups have.
    • Specifically, consumer stakeholder group consider Risk and Compliance to be of high importance. The stakeholders are concerned with the company’s ethical behavior, accountability standards, audits, and accounting policies. On the other hand, Economic activities were viewed as less important.
    Category:
    Corporate Matters, International Matters
    Sub-category:
    Sustainability ServicesTraining & General Experience
  • Jennifer M Mueller-Phillips
    Costs and Benefits of Requiring an Engagement Partner...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.05 Training and General Experience, 15.0 International Matters, 15.01 Audit Partner Identification by Name 
    Title:
    Costs and Benefits of Requiring an Engagement Partner Signature: Recent Experience in the United Kingdom
    Practical Implications:

    Requiring engagement partners to sign their names to audit reports appears to result in increased audit quality, earnings informativeness, and audit fees, suggesting that the signature requirement emphasizes personal accountability for engagement partners. Requiring the identification of engagement partners in audit reports would likely have similar effects. Thus, there are both costs and benefits that the PCAOB should consider in making its decision regarding partner identification.

    For more information on this study, please contact Chan Li: chanli@katz.pitt.edu.

    Citation:

    Carcello, J. V. and C. Li. 2013. Costs and benefits of requiring an engagement partner signature: Recent experience in the United Kingdom. The Accounting Review 88 (5): 1511-1546.

    Keywords:
    PCAOB; engagement partner signature; United Kingdom; audit quality; audit fees; costs and benefits.
    Purpose of the Study:

    The Public Company Accounting Oversight Board (PCAOB) is considering requiring the identification of the engagement partner in audit reports. Proponents of the proposal argue that it will increase accountability and transparency, which will result in improved audit quality. Opponents argue that engagement partner identification is unnecessary, as audit firms’ quality control systems and the threats of sanctions by regulators and private litigation are sufficient to hold partners accountable. Identifying engagement partners is similar to them signing audit reports in their own name, which the U.K. began requiring in 2009. Because of the similarities between the U.K. and the U.S., it is likely that the effects of requiring engagement partner identification in the U.S. will be similar to the effects of requiring the engagement partner to sign the audit report in the U.K. Therefore, the authors investigate the benefits and costs of requiring partner signatures in the U.K. in the form of changes in audit quality and audit fees. The results are likely informative of the benefits and costs of requiring partner identification in the U.S.

    Design/Method/ Approach:

    Using publicly-disclosed data on companies listed on the London Stock Exchange (LSE) between 2008 and 2010 (the years surrounding the implementation of the signature requirement), the authors examine audit quality changes using the following measures:

    • Abnormal accruals
    • Likelihood of meeting earnings thresholds
    • Earnings informativeness
    • Likelihood of qualified opinions

    The authors also examine the change in audit fees following the implementation of the signature requirement.

    Findings:

    The authors find that following the implementation of the signature requirement, abnormal accruals and the likelihood of meeting earnings thresholds decrease in the U.K. These results suggest that audit clients’ earnings management declines due to the signature requirement. Further, the association between return on assets and stock market returns increases following the signature requirement, implying that reported earnings becomes more informative of firm value to investors following the implementation of the signature requirement. The likelihood of audit clients receiving a qualified audit opinion following the signature requirement also increases, suggesting that audit reporting becomes more conservative with the signature requirement. Finally, audit fees increase with signature requirement. Thus, signature requirement appears to result in higher fees for audit clients. These changes do not occur for U.S. firms or other European firms during the same period and do not occur for the U.K. in the period prior to the introduction of the signature requirement, providing evidence that the changes in the U.K. are the result of the signature requirement.

    Category:
    Accountants' Reporting, International Matters
    Sub-category:
    Audit Partner Identification by Name, Changes in Reporting Formats
  • Jennifer M Mueller-Phillips
    Auditor-Client Compatibility and Audit Firm Selection
    research summary posted February 27, 2017 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 15.0 International Matters, 15.04 Audit Firm Rotation 
    Title:
    Auditor-Client Compatibility and Audit Firm Selection
    Practical Implications:

     The authors’ results may be of interest to policy makers for two important reasons. First, regulatory discussions on mandatory audit firm rotation could have implications for the cost and quality of auditing if a client is forced to switch from a compatible auditor to one that is less compatible. Second, proposals to expand the auditor’s reporting responsibilities might mitigate the loss of audit quality when similarity arises in unaudited disclosures.

    Citation:

     Brown, S. V. and W. R. Knechel. 2016. Auditor-Client Compatibility and Audit Firm Selection. Journal of Accounting Research 54 (3): 725-775.

    Purpose of the Study:

     A great number of factors affect the complicated process of a client selecting an auditor. The factors that might affect the degree of compatibility between an auditor and a client include pricing, expertise, location, interpersonal associations and the extent of agency problems in the client. Research in the past has looked into some of these attributes and how they are relevant in determining the overall quality of the resulting audit. A limited amount of research has examined alignment between clients and certain types of auditors based on factors such as the size of the audit firm or degree of industry specialization. However, there is less research on the compatibility of specific auditors and specific clients. The authors define auditor-client compatibility as the ability of the auditor to satisfy a client’s preferences, given the auditor’s own preferences, abilities and constraints. With this in mind, the authors examine the narrative disclosures included in the text-based parts of the financial statements that provide information about a company, its operations and its accounting choices. Next, they develop a unique measure of auditor-client compatibility for Big 4 firms based on the similarity of their financial disclosures rather than their financial results.

    Design/Method/ Approach:

     The authors focus on three narrative disclosures separately and together: the company’s business description, the accounting footnotes, and management discussion and analysis. They also compare the similarity of an individual client to all of the current clients within an industry of a specific auditor to generate a proxy for how well that company fits into each auditor’s client base.

    Findings:
    • The authors find that clients clustered within an industry at the audit firm level tend to have higher similarity scores when compared to clients of other auditors in the same industry and time period; this suggests that the authors’ proxy is capturing information about the compatibility between an individual client and an individual audit firm.
    • The authors find that the poorer the fit with an existing auditor, the greater the probability the client will choose to switch to a new auditor.
    • The authors find that the successor auditor is generally the non-incumbent firm that has the best relative fit.
    • The authors find that discretionary accruals are lower when auditor-client compatibility is better, suggesting higher audit quality; however, they find a higher incidence of accounting restatements when the similarity of the unaudited MD&A and client business description is high but not when the similarity of the audited footnotes is high.
    • The authors find that financially distressed firms that are more similar are less likely to receive a going concern opinion, but similarity is also associated with increased accuracy in going concern opinion reporting. 
    Category:
    Audit Quality & Quality Control, International Matters
    Sub-category:
    Audit Firm Rotation
  • Jennifer M Mueller-Phillips
    Do Audit Clients Successfully Engage in Opinion Shopping?...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 15.0 International Matters, 15.01 Audit Partner Identification by Name, 15.03 Audit Partner Rotation 
    Title:
    Do Audit Clients Successfully Engage in Opinion Shopping? Partner-Level Evidence
    Practical Implications:

     These findings should be of interest to policy makers in China because, among other implications, the results suggest that Chinese regulators should pay attention to the switching of audit partners before they reach tenure limit for mandatory rotation. Partner-level opinion shopping could be more difficult to detect in markets in which the identity of the engagement partner is not disclosed, and it may therefore be prevalent in those markets, such as the United States.

    Citation:

     Chen, F., A. Peng, S. Xue, Z. Yang, and F. Ye. 2016. Do Audit Clients Successfully Engage in Opinion Shopping? Partner-Level Evidence. Journal of Accounting Research 54 (1): 79-112.

    Purpose of the Study:

    Opinion shopping refers to the practice by which audit clients seek alternative auditors willing to give a clean audit opinion when the incumbent auditor is likely to issue an unclean opinion. Existing studies examine whether companies successfully engage in opinion shopping through switching audit firms using data from such countries as China, the United Kingdom, and the United States. In this study, the authors examine evidence of switching audit partners within the same firm rather than switching to another firm for clean audit opinions, which they term “partner-level opinion shopping.” Statements from the PCAOB suggest that partner-level rotation shopping has become a regulatory concern and the regulators believe that this practice may be more prevalent if the names of engagement partners are not publicly disclosed; however, there is no empirical evidence on the existence and extent of partner-level opinion shopping to the best of the authors’ knowledge. Consequently, the authors attempt to fill this gap in the auditing literature by testing whether companies successfully engage in partner-level opinion shopping.

    Design/Method/ Approach:

    The authors decided to use data from China because engagement partners in China are required to sign the audit report, which enables the authors to identify partner switches before partners reach their mandatory rotation limit. The sample consists of observations from 1998 to 2012. They use an audit reporting model to determine a company’s probability of receiving a modified audit opinion (MAO) with and without a partner switch. 

    Findings:
    • The authors find consistent results for partner-level opinion shopping for both field partner and review partner switching.
    • The authors’ findings support the notion that partner-level opinion shopping is less likely to be successful for companies audited by firms organized as partnerships.
    • The authors find no evidence suggesting that outgoing audit partners are overly conservative compared with an average audit partner with an expected conservatism score of zero; the authors do not find evidence that incoming partners are less conservative than outgoing partners.
    • The authors find evidence that Chinese companies successfully engage in partner-level opinion shopping.
    • The authors find that the extent of success in opinion shopping is affected by client importance and the organizational forms of audit firms.
    • The authors’ results show that companies that successfully engage in opinion shopping report significantly lower-quality earnings, as indicated by higher discretionary accruals and a higher likelihood of reporting small profits.
    • The authors find direct evidence that incoming audit partners, for companies that obtain more favorable audit opinions after a partner switch, have a higher propensity to issue clean opinions than outgoing partners.
    Category:
    International Matters
    Sub-category:
    Audit Partner Identification by Name, Audit Partner Rotation
  • 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
    Cross-Country Evidence on the Importance of Auditor Choice...
    research summary posted August 30, 2016 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 15.0 International Matters 
    Title:
    Cross-Country Evidence on the Importance of Auditor Choice to Corporate Debt Maturity
    Practical Implications:

     This paper provides new evidence on how higher-audit quality benefit companies in debt contracting. Specifically, the authors show that Big 4 audit clients enjoy a longer debt maturity than non-Big 4 clients. This audit quality effect on debt maturity exists worldwide but varies with each country’s legal institutions governing property rights and creditor rights. This paper helps to resolve the mix views in prior literature on the role of Big 4 auditors and stresses the importance of considering legal institutions in analyzing the link between auditor choice and economic outcomes.

    Citation:

     Ghoul, S. E., O. Guedhami, J. A. Pittman, and S. Rizeanu. 2016. Cross-Country Evidence on the Importance of Auditor Choice to Corporate Debt Maturity. Contemporary Accounting Research 33 (2): 718–751.

    Keywords:
    Audit quality, corporate governance, legal institutions, debt maturity
    Purpose of the Study:

     Prior research finds audited financial statements provide useful information to lenders and help lenders to better monitor the borrowing companies. However, there is little empirical evidence on how higher-audit quality affects the lender’s choice on monitoring mechanisms. The authors intend to provide the initial and international evidence on how lenders weigh the monitoring from auditors against their own monitoring through shorter debt maturity. Because the Big 4 auditors is generally accepted in academic literature as a proxy for higher-audit quality, the authors examine whether engaging Big 4 auditors benefits the companies in debt contracting. The degree of legal institutions governing property rights and creditor rights various across countries. The authors argue strong legal institutions can amplify the effect of audit quality on debt maturity because monitoring from the Big 4 auditors is more rigorous and borrowers are ex ante incentivized to be honest. Therefore, the authors next investigate whether legal institutions mediate the link between auditor choice and debt maturity.

    Design/Method/ Approach:

     The initial sample consists of all public companies from 42 countries around the world, including the U.S., the U.K., Canada, Malaysia, Hong Kong, and so on, for 10-year period from 1994 to 2003. The company financial and audit data are from COMPUSTAT Global database. The authors first examine whether companies with Big 4 auditors have higher proportion of long-term debt in their capital structure. They then test whether legal institutions have a mediating effect on the relationship between audit quality and debt maturity.

    Findings:

    The initial sample consists of all public companies from 42 countries around the world, including the U.S., the U.K., Canada, Malaysia, Hong Kong, and so on, for 10-year period from 1994 to 2003. The company financial and audit data are from COMPUSTAT Global database. The authors first examine whether companies with Big 4 auditors have higher proportion of long-term debt in their capital structure. They then test whether legal institutions have a mediating effect on the relationship between audit quality and debt maturity.  

    Category:
    Audit Quality & Quality Control, International Matters

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