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  • Jennifer M Mueller-Phillips
    Are Capitalized Software Development Costs Informative About...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment 
    Title:
    Are Capitalized Software Development Costs Informative About Audit Risk?
    Practical Implications:

    In general, the results of this study provide empirical evidence that capitalized software development costs are incrementally informative about the client’s business risk and the overall audit risk.

    • First, although intangible assets play an increasing role in firm valuation, very little is known about whether and how auditors regard these assets in assessing audit risk. Thus it fills a void in the literature on the auditor’s assessment of capitalized software development costs.
    • Second, this study examines a setting that mitigates the client’s business risk. It is important in that while economic models predict that audit fees reflect business risk, there is some evidence that audit practice does not support a relation between business risk and audit fees
    • Third, this study could be viewed as a ‘‘bridge’’ between the limited literature on investor valuation of capitalized software assets and auditing
    • Fourth, this study also shed light on how auditing under certain circumstances could potentially enhance the informativeness of recognized assets that are subject to a high degree of information asymmetry and managerial discretion

    For more information on this study, please contact Gopal V. Krishnan.

    Citation:

    Krishnan, G. V., and C. Wang. 2014. Are Capitalized Software Development Costs Informative About Audit Risk? Accounting Horizons 28(1): 39-57.

    Keywords:
    audit fees; SFAS No. 86; business risk; software development costs; earnings management.
    Purpose of the Study:

    Capitalization of software research and development costs (SDC) is controversial and is the only exception to SFAS No. 2 that calls for immediate expensing of R&D costs. The purpose of this study is to examine whether capitalized SDC are informative about audit risk. Audit risk is the risk that the auditor renders an incorrect opinion on whether the financial statements are in compliance with GAAP.

    Design/Method/ Approach:

    This sample consists of 564 firm-year observations representing 157 software firms (SIC code 7372) for the period 2004 through 2009. The authors estimate a regression of the log of audit fees on a variety of determinants of audit fees and two measures of lagged capitalized SDC.

    Findings:
    • The authors find that on average capitalized SDC has a negative impact on audit fees after controlling for traditional measures of client risk (e.g., negative return on assets, high leverage, going concern opinions, accounting restatements, and internal control problems).
    • The results hold for firms where capitalization is inconsequential to beating analysts’ forecasts, firms that are older or have low analysts’ following.
    • The study does not find a significant association between audit fees and capitalized software development costs for firms that meet or beat analysts’ forecasts or have high analysts’ following.

    The authors claim their results support the notion that capitalized software development costs signal lower business risk—especially for firms with low earnings management risk or high private information (information asymmetry).

    Category:
    Auditor Selection and Auditor Changes, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Auditor business process analysis and linkages among auditor...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Auditor business process analysis and linkages among auditor risk judgments
    Practical Implications:

    The results of this study have implications for public accounting firms that have adopted business-risk audit methodologies and for regulators that have incorporated ideas and concepts from business-risk audit methodologies into promulgated standards

    • Public accounting firms adopting business-risk methodologies have broadened, deepened, and reemphasized the long-standing requirement in auditing standards to understand the client business so as to use this understanding as a source of information about possible material misstatements to the financial statements.
    • Firms and regulators should be encouraged by the support found in this study for the relationship and connections between, for instance, the significant business risks identified and the magnitude of the assessments of the risk of material misstatement at the entity level; the performance of business process analysis and the conservatism of entity- and process-level assessments of the risk of material misstatement; and the significant business risks identified and the risk of material misstatement at the process level.

    For more information on this study, please contact Natalia Kochetova-Kozloski.

    Citation:

    Kochetova-Kozloski, N., T. M. Kozloski, and W. F. Messier Jr. 2013. Auditor business process analysis and linkages among auditor risk judgments. Auditing: A Journal of Practice & Theory 32(3): 123-139.

    Keywords:
    business process analysis; risk assessment; risk of material misstatement; business risk identification
    Purpose of the Study:

    This research note examines two important and related issues:

    • Whether performance of a business process analysis assists auditors’ identification and assessment of significant business risks and the risk of material misstatement at a core process level.
    • Whether auditors link their entity-level risk assessments to their core business process risk assessments

    Based on review of the current literature, there has been relatively little research that has specifically examined how these two issues affect auditors’ risk-related judgments. Therefore, the current study examines the linkage between business risk identification, taking into account severity of each risk at the entity and process level, and the assessment of the risk of material misstatement at both the entity and process level in a more direct and externally generalizable fashion than was done previously—i.e., by focusing on efficacy of the process described by the auditing standards worldwide. 

    Design/Method/ Approach:

    The study employed a between-subject experimental design to test the hypotheses. The experiment was administered at training sessions of the Big 4 accounting firms held in the United States and Norway. The authors obtained usable responses from one hundred thirty-four (134) audit seniors after they completed a detailed case where performing or not performing a business process analysis was manipulated as a between-subject factor. The case used in this study was a hypothetical grocery retailer - National Foods, located in the Southeastern United States.

    Findings:

    The authors find:

    • A significant positive association between the identification of significant process-level business risks and the identification of significant business risks at the entity level for auditors who performed a business process analysis of the core business process.
    • Performing a business process analysis led to higher assessments of the risk of material misstatement at the core process level.
    • Auditors linked their assessments of misstatement risk at the process level with similar assessments made at the entity level, taking into account significant process-level risks.

    The authors stipulate that taken together, these results suggest that auditors link their entity-level identified business risks and assessments of the risk of material misstatement to risks and related assessments at the process level.

    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Auditor Resignation and Risk Factors.
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 02.06 Resignation Decisions, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
    Title:
    Auditor Resignation and Risk Factors.
    Practical Implications:

    This study sheds light on why auditors choose to resign from auditing particular clients. The authors find that public information about audit risk, business risk, and litigation risk as well as private information about audit risk and business risk all play a role in the auditor’s resignation decision. This is useful for audit firms and regulators to consider. 

    Citation:

    Ghosh, A. and C.Y. Tang. 2015. Auditor Resignation and Risk Factors. Accounting Horizons 29 (3): 529-549.

    Keywords:
    auditor resignations, litigation risk, audit risk, business risk
    Purpose of the Study:

    While prior research has suggested litigation risk as the main reason for auditor resignations, the competing explanations of audit risk and business risk have not been tested concurrently to discover their incremental importance. Furthermore, prior research has not been able to isolate the auditor’s private information from public information about these risks. The authors attempt to close this gap in the literature by studying whether and how much the auditor’s private information about future audit risk, business risk, and litigation risk impacts the auditor’s resignation decision.

    Design/Method/ Approach:

    The authors use data from publicly-traded companies that switched auditors during the 1999-2010 time period. First, they compare auditor resignations to auditor dismissals based on pre-switch audit risk, business risk, and litigation risk. Then they test whether auditor resignations predict post-switch audit risk (e.g. internal control problems), business risk (e.g. delisting from stock exchange), and litigation risk (e.g. class-action lawsuits).

    Findings:
    • Compared to clients from which auditors have been dismissed, clients from which auditors resigned tend to have greater litigation risk, audit risk, and business risk before the change in auditors, but greater audit risk and business risk after the change.
    • The litigation risk, business risk, and audit risk existing before an auditor chooses to resign from an engagement all impact the auditor’s resignation decision, with litigation risk having the largest impact and audit risk the smallest.
    • Clients whose auditors have resigned are more likely to experience class-action lawsuits, internal control problems, and delisting from a stock exchange.
    • Auditor resignations reveal no private information about future litigation risk.
    • Auditor resignations reveal private information about future audit risk and future business risk, especially when one of the Big 4 audit firms resigned.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment, Litigation Risk, Resignation Decisions
  • Jennifer M Mueller-Phillips
    CEO and CFO Equity Incentives and the Pricing of Audit...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 14.0 Corporate Matters, 14.01 Earnings Management, 14.07 Executive Compensation 
    Title:
    CEO and CFO Equity Incentives and the Pricing of Audit Services
    Practical Implications:

    Our study highlights the importance of taking into account executive incentive plans in improving the understanding of auditors’ risk assessment and pricing decisions, in support of the current professional audit standards. The findings that auditors respond to CEO and CFO equity incentives differently have significant implications for the corporate governance reforms and the design of optimal corporate executive compensation policies. Following the accounting scandals in the early 2000s, there has been increased regulatory and legislative scrutiny on corporate governance. Especially, regulators have recognized CFOs as the individuals bearing responsibilities for the integrity of financial information. Our paper lends support to the regulatory inclusion of CFOs as accountable individuals, and to concerns that firms should exercise caution in compensating CFOs using equity-based tools.

     

    For more information on this study, please contact Yonghong Jia.

    Citation:

    Billings, B. A., X. Gao, and Y. Jia. 2014. CEO and CFO Equity Incentives and the Pricing of Audit Services. AUDITING: A Journal of Practice & Theory 33 (2): 1-25

    Keywords:
    Audit fees; auditor risk assessment; equity incentive; accounting manipulation
    Purpose of the Study:

    The alleged perverse role of managerial incentives in accounting scandals and the distinctive role of auditors in identifying and intervening in attempted earnings manipulation, highlight the importance of explicitly considering executive incentive plans by auditors in the auditing process. However, there is little systematic evidence on auditors’ responses to the sizable holdings of equity by executives, a phenomenon that is particularly common in US public companies. In this paper, we investigate the association between executive equity incentives and auditors’ risk assessment and consequently audit pricing decisions. We examine auditors’ responses to equity incentives for CEOs and CFOs separately and jointly and inquire whether the responses are different.  

    Design/Method/ Approach:

    We gather information on audit fees, non-audit fees, auditors, internal control information from AuditAnalystics, executive compensation data from ExecuComp, and financial variables from Compustat, for the years 2002 through 2009. We estimate standard audit fee regression models that include variables to capture executive equity incentives and control variables that are identified to be determinants of audit fees by prior studies. 

    Findings:

    Using different measures of executive equity incentives and following standard audit service pricing research designs, we document compelling evidence that auditors adjust the price of their audit services upward in response to CFO equity incentives, suggesting that auditors perceive heightened audit risk associated with CFO equity incentives. We find some evidence that auditors view CEO equity incentives as innocuous or even beneficial in term of audit risk. We further demonstrate that the presence of internal control problems augments the positive relation between CFO equity incentives and audit fees, suggesting particularly elevated risk concerning CFO equity incentives perceived by auditors when internal controls are flawed. 

    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Earnings Management, Executive Compensation
  • Jennifer M Mueller-Phillips
    CEO Equity Incentives and Audit Fees.
    research summary posted September 15, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
    Title:
    CEO Equity Incentives and Audit Fees.
    Practical Implications:

    According to the authors, stock options and restricted stocks are important components in CEO compensation. This study shows that auditors do perceive greater audit risk due to CEO equity compensation adjust pricing decisions accordingly. Auditors appear more concerned about CEO’s incentives to increase a company’s risky behavior so as to the CEO’s equity based compensation as opposed to increasing stock price specifically. As a CEO’s vega (i.e. change in value of a manager’s equity portfolio due to a change in stock return volatility) increases, a manager becomes less risk averse and more willing to engage in risky behavior such as earnings management. This study offers additional insights into the cost/benefits of equity based compensation.

    Citation:

    Kim, Y., H. Li, and S. Li. 2015. CEO Equity Incentives and Audit Fees. Contemporary Accounting Review 32 (2): 608-638.

    Keywords:
    Stock Option Compensation, Audit Fees, Earnings Management
    Purpose of the Study:

    This study examines the relationship between CEO equity incentives and audit risk assessment and pricing. More specifically, it examines whether/how auditors perceive CEO equity as a risk factor and incorporate into their audit pricing decisions. The authors also seek to start reconciling prior mixed evidence regarding equity incentives and earnings management and determine whether earnings management risk is due to equity compensation’s (i.e. manager’s wealth) relationship with stock return volatility (i.e. risk) or stock price. This study refines insights into the determinants of audit risk/pricing decisions and links two literatures, executive compensation and auditor compensation.

    Design/Method/ Approach:

    Sample: S&P 1500 companies over 20002009
    Source: Audit Analytics (Audit Fees), COMPUSTAT’s ExecuComp (CEO compensation)
    ModelOLS with Log Audit Fees regressed on Log CEO Vega, Log CEO Delta, Audit Fee determinants from previous studies, and year/industry fixed effects

    Findings:

    Findings show that a CEO’s portfolio vega (i.e. change in value of a manager’s equity portfolio due to a change in stock return volatility) is the important determinant of audit risk/pricing and subsumes the effects found in the previous research of a CEO’s portfolio delta (i.e. change in value of a manager’s equity portfolio due to a change in stock price) on audit risk/pricing.

    Additional analyses/results include:  

    • Repeat main analysis for CFO equity incentives. No association found.
    • Examining “direct” effect of equity incentives on audit fees (i.e. general complexity of auditing stock-based compensation) by exploring post SFAS 123R period requirements to fair value nonexecutive employees’ stock options. No association found.
    • Alternative measures of CEO equity incentives including total options held by CEO, percent of CEO equity compensation of total CEO compensation, and broader measures of CEO equity compensation. Similar results to main results.

    Results are robust to several endogeneity tests including:

    • First time options grants and changes in audit fees model
    • Inclusion of firm fixed effects
    • Instrumental variables approach
    • Dynamic panel GMM estimation (Arellano-Bond system GMM estimator)
    • Additional controls for riskiness of firm investment and financial policies
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Earnings Management, Earnings Management
  • Jennifer M Mueller-Phillips
    CEO Turnover and Audit Pricing.
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment 
    Title:
    CEO Turnover and Audit Pricing.
    Practical Implications:

    Voluntary turnover of a CEO does no effect the audit fees of a company. Forced CEO turnover causes the business risk of both the client and the auditor to increase. Thus, audit fees increase. The study has practical implications for companies, by estimating the extra audit costs associated with forced CEO turnover.

    Citation:

    Huang, H., Parker, R. J., Yan, Y., & Lin, Y. 2014. CEO Turnover and Audit Pricing. Accounting Horizons 28 (2): 297-312.

    Keywords:
    audit fees, audit risk, CEO turnover
    Purpose of the Study:

    Accounting researchers have expended considerable resources over the last thirty years investigating factors that influence the audit fees charged by accounting firms. Researchers have found that accounting firms consider the risks of an audit in determining the audit price and that higher risk results in higher prices.

    This study examines the relationship between CEO turnover in client companies and the fees charged by their audit firms. According to the proposed theoretical framework, forced turnover is associated with higher risk for the auditing firm and, consequently, higher audit prices. The authors propose that forced CEO turnover (such as dismissals) pose higher business and audit risks for the audit firm than voluntary turnover (such as retirements); further, greater risk leads to higher audit prices. Forced CEO turnover often is a signal that the board of directors believes that corporate leadership and strategy need to change. This change, in turn, results in uncertainties regarding the competency of a new CEO and the effectiveness of a new strategy. The business risk of both the client and the auditor increases.

    Design/Method/ Approach:

    The authors develop two related regression models to examine audit fees. From the Audit Analytics database, the authors obtain a final sample of 13,692 firm-year observations with audit fees from 2004 to 2011. Of these, there were 1,030 cases with a CEO turnover (7.5 percent of total observations), including 166 observations with forced CEO turnover and 864 observations with voluntary turnover. Voluntary retirement is classified as a CEO who is 60 or older.

    Findings:

    Results for both models indicate that firms with forced CEO turnover have significantly higher audit fees than firms with either voluntary turnover or no turnover. Further, the authors find no difference in audit fees between companies with voluntary turnover and companies without turnover.

    Firms with forced CEO turnover have higher audit fees than both firms with voluntary turnover (mean difference of $763,000, p , 0.001) and firms with no turnover (mean difference of $858,000, p , 0.001); these results suggest forced CEO turnover has a meaningful economic difference. The authors find similar results in a model that examines change in audit fees from the prior year. Firms with forced CEO turnover have a larger increase in audit fees than both firms with voluntary turnover ($956,000 difference, p , 0.001) and firms with no turnover ($1,135,000 difference, p , 0.001).

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment
  • The Auditing Section
    CFO Intentions of Fraudulent Financial Reporting
    research summary posted April 13, 2012 by The Auditing Section, tagged 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.04 Management Integrity 
    Title:
    CFO Intentions of Fraudulent Financial Reporting
    Practical Implications:

    The results of this study call into question the legitimacy of compensation structure as a red flag for fraud risk and introduce company size as a new (and easily assessed) indicator of financial statement fraud. CFO attitude emerged as the most influential factor in the formation of intentions to misreport. This indicates that it is important that auditors attempt to assess client management’s attitude toward fraudulent financial reporting. Although directly assessing management’s attitude may not be possible, auditors can subjectively assess management attitude based on ongoing personal interactions with the client. More formal audit decision aids to assess management attitudes toward fraudulent financial reporting might also be valuable for successfully detecting fraud.

    Citation:

    Gillett, P.R. and N. Uddin. 2005. CFO Intentions of Fraudulent Financial Reporting. Auditing: A Journal of Practice and Theory 24 (1): 55-75.

    Keywords:
    Financial statement fraud, reasoned action model, company size, compensation
    Purpose of the Study:

    Many studies have examined whether the fraud risk factors or “red flags” listed in Statement on Auditing Standards (SAS) No. 99 are effective for predicting fraud. However, one limitation of this prior work is that it examines whether red flags were present after a fraud has already occurred. To address this limitation, this study identifies factors which influence the intentions of CFOs to report fraudulently and examines the predictive value of those factors. Thus, a CFO who expresses an intention to misreport will be more likely to actually do so. The following four factors are investigated to determine their respective influence on CFO intentions to fraudulently misreport: 

    •  Attitude: This refers to the CFO’s attitude toward fraudulent financial reporting. An attitude toward a behavior is formed based on the expected positive and negative consequences of the action. For example, if fraudulently overstating revenue will result in a management bonus, then the CFO’s attitude toward overstating revenue might be more positive.
    •  Subjective Norms: This refers to the CFO’s perception of the expectations of specific referents (e.g., coworkers, family, and friends) and the motivation to comply with those expectations. For example, a CFO who perceives that his/her coworkers, family and friends approve of fraudulent financial reporting will be more likely to misreport, especially if the CFO tends to comply with others’ expectations.
    •  Compensation Structure: When the compensation structure is highly contingent upon company performance, it is expected that managers are more likely to participate in fraudulent financial reporting. SAS No. 99 considers earnings-based compensation to be an incentive for fraud.
    •  Company Size: There is mixed evidence about the effect of company size on unethical or illegal activity. Therefore, the authors investigate whether company size influences CFO intentions of fraudulent financial reporting.
    Design/Method/ Approach:

    The authors collected their evidence by mailing surveys to the CFOs of domestic firms selected from the Compact Disclosure database as of July 1998. CFOs were provided with a fraud scenario, followed by questions measuring their intention to fraudulently misreport. The CFOs also answered questions measuring their attitude toward misreporting, subjective norms, their personal compensation structure, and the size of the firm for which they currently work. Once this data was collected, the authors used structural equation modeling (SEM) to determine the factors that influence CFO intentions of fraudulent financial reporting.

    Findings:
    • The authors find that a CFO’s attitude toward fraudulent financial reporting has the strongest influence on their intention to misreport. CFO attitudes toward fraudulent financial reporting appear to be driven primarily by the negative consequences expected if they misreport.
    • The authors find that larger firms are more likely to participate in fraudulent financial reporting.
    • Compensation structure and subjective norms did not influence CFO intentions to misreport in the manner expected by the authors. The finding that CFOs’ compensation structure does not influence intentions to misreport runs counter to SAS No. 99, which contends that earnings-based management compensation is a fraud red flag.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Management Integrity
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  • Jennifer M Mueller-Phillips
    Client Engagement Risks and the Auditor Search Period.
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment 
    Title:
    Client Engagement Risks and the Auditor Search Period.
    Practical Implications:

    This paper contributes to the auditing literature in three ways. First, it sheds light on whether or not perceived engagement risks affect the ASP, a previously unaddressed question. Second, it provides greater insight into the client acceptance decision. This decision has become increasingly important because of auditor litigation, insurance costs, reputational damage, and regulatory review of the auditing profession in the post-SOX era. Third, it contributes to the understanding of whether the provision of nonaudit services alters auditor decision making by documenting that the potential to provide nonaudit services does not necessarily alter the attractiveness of a prospective client or shorten the search period.
     

    Citation:

    Khalil, S. K., J. R. Cohen, and K. B. Schwartz. 2011. Client Engagement Risks and the Auditor Search Period. Accounting Horizons 25 (4): 685-702.

    Keywords:
    audit risk, auditor search period, client acceptance
    Purpose of the Study:

    The past decade has witnessed an increased interest in the auditor’s client acceptance decision and in the way audit firms evaluate potential clients. The interest arises, in part, from litigation against auditors, competitive market forces, and recent advances in information technology that have affected and redefined the attestation process. Audit firms assess the risks associated with a prospective client (also known as engagement risks or client acceptance risks), the profitability and billing rate, and the risk/return relationship before submitting a formal engagement proposal and entering into fee negotiations.

    The authors investigate whether risk lengthens the acceptance phase for audit firms and results in a longer auditor search period for their clients. The authors posit that the auditor search period (ASP) following auditor resignations is significantly longer for riskier clients because of the additional time needed to collect and analyze information and to obtain required approvals within the audit firm. They focus on auditor resignations since the ASP, which is essentially unobservable, can be more accurately approximated for auditor resignations than auditor dismissals. Firms whose auditors resign may know about the resignation decision at or just before the resignation date. As such, the audit search process formally starts at or a short time before the auditor resignation date reported on a registrant’s Form 8-K filing. In contrast, firms planning to dismiss their auditor are aware of the dismissal decision long before the dismissal date. Hence, the auditor search period may start long before the dismissal date reported on the Form 8-K filings.

    Design/Method/ Approach:

    The authors test the hypotheses using a sample of auditor resignations obtained from the Audit Analytics database. The final sample includes 216 auditor resignations in firms (1) listed on major U.S. stock exchanges (NYSE, AMEX, NASDAQ), (2) with a ticker available, and (3) reporting at least one auditor resignation over the period 20032008.

    Findings:

    Findings support the client business risk hypothesis by documenting a longer ASP for firms that are in financial distress. Results also support the audit risk hypothesis, given that the ASP is longer for firms that report internal control weaknesses issues. Findings further support the auditor business risk hypothesis by showing a shorter ASP for firms hiring an industry specialist audit firm.

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Conditional Conservatism and Audit Fees.
    research summary posted July 24, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment 
    Title:
    Conditional Conservatism and Audit Fees.
    Practical Implications:

    The results should be of interest to regulators, standard setters, auditors, and firms. Regulators and standard setters may benefit from the results as they consider promulgating accounting rules and standards, particularly those involving fair value measures. Auditors and the firms’ managers may also benefit from the results by knowing the possible effect of accounting conservatism on audit fees and the moderating effect of the quality of corporate governance as they select auditors and accounting policies.

    Citation:

    Lee, H. S., Li, X., & Sami, H. 2015. Conditional Conservatism and Audit Fees. Accounting Horizons 29 (1): 83-113.

    Keywords:
    audit fees, conditional conservatism, corporate governance, litigation risk
    Purpose of the Study:

    Accounting conservatism is an important characteristic of the accounting information system. As a fast-growing literature, academic accounting research has developed measures of conservatism to capture this characteristic and has investigated the role of accounting conservatism in debt contracts and corporate governance quality. However, very little is known about the impact of conservatism on audit risk. In this paper, the authors first investigate whether the level of a company’s accounting conservatism affects audit risk, which they proxy with audit fees. More importantly, the authors investigate how corporate governance quality influences the relationship between conditional conservatism and audit fees. Higher corporate governance quality could lead to lower litigation risk, and hence lower audit risk. When the audit risk is low because of better corporate governance, higher conservatism is less likely to further reduce audit fees.

    Design/Method/ Approach:

    The sample includes 16,455 firm year observations in the annual Compustat Xpressfeed files with fiscal year-ends included in the years 20032009 with valid total assets, sales, and fiscal year-end stock price data. The authors obtain corporate governance data from Risk Metrics, which reduces the sample size to 4,814.They use three different models to estimate firm-year conditional conservatism: (1) the Basu standard regression, (2) the accruals-cash-flows-based model, and (3) the current and lagged earnings-changes model.

    Findings:

    The authors document that firms benefit from conservative reporting because higher conservatism decreases audit fees. The results indicate that higher levels of conditional conservatism are associated with lower audit fees. They find that the audit fee reduction associated with more conservative reporting is attenuated when corporate governance is stronger. The findings are consistent with the explanation that both better corporate governance and conservatism can reduce uncertainty. Therefore, firms with low corporate governance quality have more to gain from conservative reporting.

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Does Incentive-Based Compensation for Chief Internal...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 04.02 Impact of Fees on Decisions by Auditors & Management, 08.11 Reliance on Internal Auditors 
    Title:
    Does Incentive-Based Compensation for Chief Internal Auditors Impact Objectivity? An External Audit Risk Perspective
    Practical Implications:

    The results of this study suggest that companies who offer incentive-based compensation to chief internal auditors, especially through equity, are more likely to be perceived as having a higher audit risk by external auditors. Consequently, external auditors may charge a higher fee for their services. This study gives a basis for the benefit/cost analysis of providing incentive-based compensation for chief internal auditors. While it is possible internal auditors will respond positively to an IBC and bring extra value to the organization, there is a risk that an external auditor could raise audit fees cancelling out this added benefit.   

    Citation:

    Chen, Lucy Huajing, H. H. Chung, G. F. Peters., and J. P. Wynn. (Jeannie).2017. Does Incentive-Based Compensation for Chief Internal Auditors Impact Objectivity? An External Audit Risk Perspective. Auditing, A Journal of Practice and Theory 36 (21): 21-44

    Keywords:
    Incentive-based compensation; internal auditor objectivity; audit fees
    Purpose of the Study:

    The internal audit function (IAF) is increasingly seen as a key component of corporate governance. The extent to which external auditors can rely on information from the IAF depends largely on the internal auditor’s objectivity. The researchers question whether receiving incentive-based compensation (IBC) linked to company performance threatens internal audit employees’ objectivity. Subsequently, this threat would lead to a higher assessment of client audit risk and therefore higher audit fees. The authors also consider whether external auditors view stock- and option-based compensation differently from cash incentives. Finally, the authors examine whether the objectivity threat from IBC depends on the company’s financial reporting risks, alignment of IAF compensation with CEO compensation, and presence of any internal audit outsourcing arrangements.

    Design/Method/ Approach:

    The authors surveyed chief internal auditors of NYSE-listed firms in 2007. The participants were asked to rank the performance measures in order of their emphasis and to indicate the form of IBC payment. By asking survey respondents to provide their company names, the authors could match the financial, audit fee, governance, and incentive data from various databases (Compustat, Audit Analytics, proxy statements, etc.). The final sample included 183 companies. Authors used multivariate regression to analyze their research questions.

    Findings:

    The overall finding is that when a company offers incentive-based compensation to a chief internal auditor, external audit fees increase. This finding suggests that external auditors do consider IBC for chief internal auditors as a threat against objectivity.

     

    Additionally, the authors find that:

    • External auditors are more likely to charge higher fees for stock- and option-based compensation compared to cash bonuses. They attribute this result to employees placing more of an emphasis on personal wealth rather than firm value.
    • There is a stronger positive effect of chief internal auditors receiving IBC and external auditor fees increasing when inherent risk is higher in the audit. Specifically, the authors focused on inherent risk related to inventory levels.
    • In situations where the CEO’s equity incentives are aligned with IAF’s equity incentives there is an even greater rise in external auditor fees.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Client Risk Assessment

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