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  • Jennifer M Mueller-Phillips
    Executive Equity Risk-Taking Incentives and Audit Pricing.
    research summary posted January 19, 2016 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, 14.10 CEO Compensation 
    Title:
    Executive Equity Risk-Taking Incentives and Audit Pricing.
    Practical Implications:

    The study results are important to regulators and audit practitioners as they show an association between executive compensation and auditor compensation. The study results show that high executive risk-taking incentives, as measured by vega, contributes to higher audit fees. These results provide important insights into how incentives designed to compensate and motivate executives can alter the audit fee structure.

    Citation:

    Chen, Y., F. A. Gul, M. Veeraraghavan, and L. Zolotoy. 2015. Executive Equity Risk-Taking Incentives and Audit Pricing. The Accounting Review 90 (6): 22052234.

    Keywords:
    executive compensation, audit fees, vega, misreporting, SOX
    Purpose of the Study:

    This study assesses whether there is an association between executive stock compensation and audit fees. The authors specifically investigate whether the sensitivity of CEO compensation to stock return volatility (vega) and stock prices (delta) are associated with audit fees. Prior literature shows that higher vega leads managers to engage in more financial misreporting. This increase in financial misreporting could in turn influence audit risk assessment and audit fees.  

    The main motivation for this study comes from the PCAOB’s recent related-party standard proposal. The proposed standard requires auditors to perform procedures to evaluate compensation practices when gaining an understanding of relationships between the company and its executive officers. In addition, current audit fee models do not consider executive compensation incentives in the pricing of audit services. Finally, there are extensive literatures on executive compensation and auditor compensation but no evaluation at the intersection of executive compensation practices and their effect on audit fees. This study attempts to address these gaps in the literature.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. They obtain audit fee data from the Audit Analytics database and executive compensation from ExecuComp. The sample period is from 2000-2010. Company financial data is from Compustat Fundamentals Annual File.  

    Findings:
    • The authors show that for clients with a high executive vega, audit firms charge higher audit fees. This follows the logic that clients with higher vega have a higher likelihood to misreport and that auditors consider that likelihood when pricing audit services. The authors also found that the increase in fees is not related to the effort needed to audit expenses related to stock-based compensation.
    • The introduction of the Sarbanes-Oxley Act weakens the association between vega and audit fees.
    • CEO characteristics affect the relationship between vega and audit fees. Specifically, the positive association between vega and audit fees is stronger when the CEO is older and when the CEO is the board chair.
    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, CEO Compensation, Client Risk Assessment
  • The Auditing Section
    Financial Restatements, Audit Fees, and the Moderating...
    research summary posted April 23, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.03 Management Integrity Assessments, 06.06 Earnings Management, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Financial Restatements, Audit Fees, and the Moderating Effect of CFO Turnover
    Practical Implications:

    This study provides evidence that auditors consider a client restatement as an increase in the audit risk of a client for future periods.  This increase in audit risk is factored into the audit fee possibly through additional hours or higher hourly rates.  This study also provides evidence that when a company has a change in CFO, auditors view this positively. 

    Citation:

    Feldmann, D.A., W.J. Read, and M.J. Abdolmohammadi. 2009. Auditing: A Journal of Practice and Theory 28 (1): 205-223.

    Keywords:
    audit fees; financial restatements; executive turnover
    Purpose of the Study:

    Restatements increased in frequency throughout the period 2000-2005.  Companies who restate their financial statements face reputational costs. For example, extant literature has documented an association between restatements and higher costs of capital, stock price declines, and higher likelihood of litigation.  One strategy a company may employ to mitigate negative consequences of a restatement is through termination of the executive officers in place during the restated period (i.e. disassociate the firm from those perceived as responsible for the restatement).  The authors suggest that by replacing the CEO and/or CFO after a restatement the company is providing evidence to outside stakeholders (including auditors) that they are attempting to address the weaknesses that caused the restatement.

    This study examines the effect of restatements on future audit fees, which represent another cost associated with a restatement, and whether terminating executive officers after the restatement moderates an increase in audit fees.

    Design/Method/ Approach:

    The authors collect restatements of the fiscal year 2003 by searching the EDGAR online database during the period January 1, 2004 through March 31, 2005.  For the restating firms identified, the authors gather audit fee and executive turnover information from subsequent proxy statements. 

    Findings:
    • Companies that restate have significantly higher executive turnover after the restatement than firms who do not restate.
    • Companies who restate have significantly higher audit fees after the restatement relative to firms who do not restate
    • Companies who terminate the CFO after a restatement do not experience higher audit fees after the restatement.
    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit fee decisions, Client Risk Assessment, Management Integrity Assessments, Earnings Management, Earnings Management
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  • Jennifer M Mueller-Phillips
    Is the Audit Fee Disclosure a Leading Indicator of...
    research summary posted October 3, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity 
    Title:
    Is the Audit Fee Disclosure a Leading Indicator of Clients’ Business Risk?
    Practical Implications:

    The results of this study have very important implications regarding how stakeholders respond to the disclosed audit fee and business risk. Stakeholders could devote special attention the audit fee disclosure that is mandated by the SEC as it has the potential to reveal risk information. Additionally, the results of this study should warrant increased awareness on the part of the auditors when they price an audit because audit firms should consider what the public believes the audit fee implies about the client’s business risk.

    For more information on this study, please contact Jonathan D. Stanley.
     

    Citation:

    Stanley, J.D. 2011. Is the audit fee disclosure a leading indicator of clients’ business risk? Auditing: A Journal of Practice and Theory 30 (3): 157-179.

    Keywords:
    audit fees; audit pricing; client business risk
    Purpose of the Study:

    Client business risk is defined as the risk that an audit client’s economic condition will deteriorate in the future. This risk is critical in the auditor’s determination of the price of the audit because the client’s business risk also affects the auditor’s business risk as well as audit risk. This study aims to investigate if the audit prices, as revealed through audit fee disclosures made mandatory by the SEC in 2001, provide the public with information of a client firm’s business risk. Although the requirement to disclose audit fees was put in place with regulatory intent, it is suggested that how auditors price the audit reveals the auditor’s perception of the client’s risk which they would otherwise not be able to disclose. The existence of this relationship is examined based on the correlation between audit fees and future changes in the clients’ economic condition. The ability for auditors to foresee future changes in a client’s economic condition display a level of sophistication in auditor judgment that shines a favorable light on auditor competence as expert service providers.

    Design/Method/ Approach:

    This study was conducted using firm-year observations during the 2000-2008 time period. Proxies for client business risk such as earnings, operating cash flows, leverage, and liquidity were used to perform a principal components analysis. The financial data was obtained from Compustat and matched with information from Audit Analytics. 

    Findings:
    • A significant inverse relationship between audit fees and the one-year-ahead change in a measure of client’s operating performance exists.
    • This relationship extends more for changes up to five years ahead and is stronger for negative as opposed to positive changes in performance.
    • Audit fees reflect future changes in a client’s earnings that analysts’ forecast do not identify.
    • Little evidence was found to support the existence of a relationship between audit fees and incremental changes in clients’ solvency.
    • An insignificant relationship between audit fees and a client’s future bankruptcy status was identified.
    • Both solvency and bankruptcy are dimensions of a client’s business risk that the audit fee is unable to capture.
    • The findings suggest that audit fees reflect information that is unknown by even other sophisticated market participants.
    • The results collectively suggest that the audit fee disclosure is a leading indicator of the operating performance and business risk of a client.
       
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Pricing of Risky Initial Audit Engagements.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.04 Predecessor Auditor Factors 
    Title:
    Pricing of Risky Initial Audit Engagements.
    Practical Implications:

    This research contributes to the initial engagement literature by providing evidence that successor auditors charge higher fees to their clients that previously reported disagreements and other reportable events. The authors also contribute to the literature by examining fees over a six-year period surrounding the auditor change. More importantly, they find that only Big 4 auditors appear to charge higher fees following disclosures of disagreements and other reportable events. Finally, the authors add to the existing literature on audit fees for risky clients, especially the internal control weakness literature, by providing evidence that disagreements and other reportable events are priced incremental to internal control issues.

    Citation:

    Elliott, J. A., A. Ghosh, and E. Peltier. 2013. Pricing of Risky Initial Audit Engagements. Auditing: A Journal of Practice & Theory 32 (4): 25-43.

    Keywords:
    audit fees, auditor changes, Big 4 auditors, engagement risk
    Purpose of the Study:

    In this study, the authors reexamine the association between audit fees and risky initial engagements by developing an ex ante client-risk metric that is based on auditor change 8-K filings. They group adverse disclosures embedded in auditor change filings into four categories: clients with 

    1. Internal control weaknesses,
    2. Going concern issues or those filing for bankruptcy,
    3. Disagreements with the predecessor auditor, and
    4. Other reportable events.

    Because prior studies examine internal control weaknesses and going concern opinions, the authors focus on auditor-client disagreements and other reportable events, including restatements, management integrity issues, scope limitations, illegal acts, and reaudits. A fundamental distinction between this study and prior studies on risk and fees is that the authors measure client risk based on public information available to auditors before they accept an engagement.

    The authors investigate the association between an ex ante measure of risk (using information in auditor change 8-K filings) and audit fees for initial engagements. The authors also examine whether the size of the successor/predecessor auditor affects fees. Finally, they examine inter-temporal fee changes, i.e., how fees change subsequent to a switch and how fees change prior to the switch, for both risky and other clients.

    Design/Method/ Approach:

    The auditor change and fee data are obtained from Audit Analytics. Data for the financial variables are from Compustat Annual files.  The final sample consists of 2,396 auditor switches over the years 2001 to 2011. The categorization based on auditor change 8-K filings indicates that 317 auditor switches have a disagreement or other reportable event disclosed in the filings, while the remaining 2,079 observations do not report any such issue.

    Findings:
    • The authors find that firms disclosing reportable events or auditor-client disagreements pay a fee premium of about 23 percent compared to less risky initial engagements.
    • They find that only clients switching to Big 4 auditors pay higher fees when disclosing disagreements or other reportable events in the 8-K.
    • The results indicate that Big 4 auditors charge a fee premium for risky clients, but not non-Big 4 auditors.
    • Over the three years prior to the auditor switch, audit fees for risky Big 4 clients increase by about 36 percent. Following the auditor switch, the fee premium persists for at least three years.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Predecessor Auditor Factors
  • The Auditing Section
    Risk Monitoring and Control in Audit Firms: A Research...
    research summary posted April 16, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 11.0 Audit Quality and Quality Control, 11.02 Engagement Quality Review – Processes and Effectiveness, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    Risk Monitoring and Control in Audit Firms: A Research Synthesis
    Practical Implications:

    While research on “quality-threatening behaviors” by auditors is difficult to perform due to confidentiality constraints, the available findings suggest that audit firms can make a difference in their incidence and severity through careful attention to policies and procedures for assessing, monitoring and controlling risk of violation of professional standards. While there is likely to be greater resistance to higher quality control standards among smaller firms, research shows that audit quality concerns are greater for smaller firms and that larger firms are currently passing smaller and riskier clients to them. The authors suggest that small accounting firms can adopt strategies, like creating alliances or becoming niche providers of certain audit services, to allow them to meet this challenge.

    Citation:

    Bedard, J.C., D.R. Deis, M.B. Curtis, and J.G. Jenkins. 2008. Risk monitoring and control in audit firms: A research synthesis. Auditing: A Journal of Practice & Theory 27 (1): 187-218.

    Keywords:
    Audit firm quality control, risk monitoring, auditing standards, independence risk, whistle-blowing, decision aids
    Purpose of the Study:

    Audit firm quality control is defined as an audit firm’s assessment and control of the risk that auditing standards, professional values or the public interest might be violated. The PCAOB has recently expressed interest in understanding the current status of research related to audit firm quality control as it considers revising the current standards in this area. This paper summarizes the research literature related to audit firm quality control with the following two objectives: (1) to provide information on the current state of knowledge with regard to the ways in which audit firms monitor and control firm-level risk; and (2) to highlight implications for development of new standards and for future research.

    Design/Method/ Approach:

    This paper reviews the literature related to audit firm quality control. Evidence was collected prior to 2006 with much of the data gathered prior to SOX and the founding of the PCAOB.

    Findings:

    Risk Management before the Engagement:

    • Recent research suggests that larger firms are shedding smaller, riskier clients to smaller audit firms as a result of the Andersen demise and Section 404 work. Further, smaller clients often choose smaller firms on the basis of more affordable fees. These findings suggest that client portfolio risk has recently increased among smaller firms.
    • Studies find that audit firms appear to be willing to take on riskier clients if the billing rate allows increased testing and/or assignment of more highly qualified engagement personnel (e.g., specialists). However, smaller audit firms may be less able to price engagement bids to cover increased exposure from riskier clients. 

    Monitoring and Control of Auditor Independence Risk:

    • Audit Firm and Partner Rotation: The archival studies report mixed results on the effect of firm and partner rotation on auditor independence. However, behavioral research provides evidence in support of firm or partner rotation. Behavioral studies generally find that auditors’ tend to make decisions in favor of management’s position and that proposed adjustments are typically smaller when rotation is not required.
    • Employing Former Auditors: Research suggests that the practice of companies employing former auditors is widespread. There is also some evidence of independence impairment and a loss of professional skepticism associated with this practice.
    • Auditor-Provided Nonaudit Services: While results are somewhat mixed, the balance of research does not appear to support the conclusion that auditor independence is compromised by the provision of nonaudit services. 

    Risk Management during the Engagement

    • Electronic Decision Aids: Research shows continuing growth and development of electronic decision aids in audit firms. Potential benefits of auditing decision aids include increased compliance with auditing standards and audit methodology, increased audit efficiency, consistency in audit approaches across clients, easier documentation, and increased control of junior staff.
    • Consultation Units: Accounting firms can control risk by developing specialized internal groups to assist local offices in making decisions. Creating a database of research increases efficiency and improves the consistency of accounting treatments recommended to clients. However, research suggests that the use of consultation units is inconsistent across the profession and declines significantly with firm size.
    • Whistle-Blower Mechanisms: Research suggests that the presence of whistle-blower mechanisms increases the likelihood that reports of wrong-doing will be made. The effectiveness of these programs is enhanced when (1) confidentiality is ensured; (2) employees thoroughly understand the mechanism; and (3) when firms both encourage such reporting and discourage retribution for reporting unethical acts. 

    Internal and External Inspections and Review

    • Internal Engagement Quality Control Reviews: Research indicates that engagement quality control reviews reduce audit risk by improving audit risk assessments and inducing partners to plan higher levels of audit testing.
    • Peer Reviews: Participation in a quality peer review process represents a commitment to quality by the audit firm. In fact, research provides evidence that audit firms participating in a peer review process conduct higher quality audits, and continued participation leads to continued improvements in audit quality over time.
    • Regulatory Quality Control Reviews and Inspections: Overall, a positive link has been found between quality control reviews and audit quality.
    Category:
    Client Acceptance and Continuance, Audit Quality & Quality Control
    Sub-category:
    Client Risk Assessment, Engagement Quality Review – Processes & Effectiveness, Impact of Firm & External Inspection Programs
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  • Jennifer M Mueller-Phillips
    Strategic analysis and auditor risk judgments
    research summary posted March 11, 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, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Strategic analysis and auditor risk judgments
    Practical Implications:

    The results of this study have important implications:

    • First, the results demonstrate that auditor judgments of the risk of material misstatement at the entity (financial statement) level are linked to the performance and documentation of strategic analysis of strategy positioning and the strategy implementation process
    • Second, this study provides preliminary evidence on the association between performing an analysis of the entity’s strategy implementation process and auditors’ judgments of the strength of the control environment
    • Third, the fact that auditors who performed strategic analysis did not identify a greater number of significant business and financial statement risks than auditors who did not perform strategic analysis warrants further research

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

    Citation:

    Kochetova-Kozloski, N., and W. F. Messier Jr. 2011. Strategic analysis and auditor risk judgments. Auditing: A Journal of Practice & Theory 30(4): 149-171.

    Keywords:
    risk assessment; strategic analysis; strategic positioning; strategy implementation.
    Purpose of the Study:

    Conducting a business risk-based audit requires the auditor to develop an understanding of the client and its environment, make risk assessments based on that knowledge, and design appropriate audit procedures to respond to those risks. A significant component of understanding the client and its environment involves conducting a strategic analysis of the client.

    The study investigates whether and how senior auditors’ strategic analysis of a client affects their identification of significant business and financial statement risks, and their risk assessments by addressing these two issues:

    • Whether strategic analysis undertaken by auditors to develop an understanding of the client’s business affects their risk identification
    • How two aspects of strategic analysis (analysis of strategic positioning and the strategy implementation process) influence auditors’ risk assessments
    Design/Method/ Approach:

    The study employed a 3 x 1 between-subjects factorial design with no strategic analysis (‘‘No SA’’) as a control condition, and analysis of strategic positioning (‘‘SA: strategic positioning’’) and analysis of strategy implementation process (‘‘SA: strategic process’’) as treatment conditions.  Experimental materials were delivered to the participants by e-mail or at a national training session. Sixty-seven (67) audit seniors from three Big 4 firms completed the experiment. The experimental materials included a cover letter, Additional Task Instructions, Risk Assessment and Audit Planning and Debriefing Questionnaire.

    Findings:

    The authors find:

    • Auditors who performed guided strategic analysis did not identify more significant business and financial statement risks than auditors who did not perform strategic analysis,
    • Senior auditors who performed strategic analysis of strategic positioning or the strategy implementation process assessed risk of material misstatement at the entity level more consistently with an expert panel than auditors who did not perform such an analysis,
    • Senior auditors’ analysis of the client’s strategy implementation process was associated with assessments of the strength of the control environment that were more consistent with the expert panel than assessments done by auditors who did not perform any strategic analysis or who performed only an analysis of strategic positioning.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment
  • Jennifer M Mueller-Phillips
    The Effect of Corporate Governance on Auditor-Client...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 13.0 Governance 
    Title:
    The Effect of Corporate Governance on Auditor-Client Realignments
    Practical Implications:

    The results of this study are important for audit firms and regulators because it documents a potentially negative outcome of the realignment activity observed in the years surrounding implementation of SOX. Specifically, this realignment activity could have implications for the quality of financial statements if the corporate governance characteristics included in our index –specifically, board and audit committee independence, diligence and expertise are positively associated with financial reporting quality and Big N audit firms provide higher audit quality.  We also note that prior studies that consider these governance characteristics suggest that, on average, clients that exhibit higher scores on these characteristics are less likely to pose significant governance risk for the audit firm.

     

    For more information on this study, please contact Thomas Omer.

    Citation:

    Cassell C. A., G.A. Giroux, L.A. Myers and T.C. Omer. 2012. The effect of corporate governance on auditor-client realignments. Auditing: A Journal of Practice & Theory 31 (2): 167-188

    Keywords:
    Corporate governance, auditor-client realignments, audit risk, financial risk, litigation risk, earnings manipulation risk, discretionary accruals, Sarbanes-Oxley Act of 2002
    Purpose of the Study:

    The purpose of this paper was to investigate the client characteristics associated with auditor-client realignments.  The Sarbanes-Oxley Act of 2002 resulted in a massive restructuring of the audit market and the transfer of large numbers of clients from Big N to Non-Big N audit firms.  The study examines the extent to which corporate governance affected the switch downward from Big N to Non-Big N audit firms and is motivated by the intense media and regulatory scrutiny of corporate governance-related issues during the years leading up to and surrounding the implementation of SOX.

    Design/Method/ Approach:

    Data for the study was collected from publicly available sources for the period 2000-2007 for Big N clients that switched to Non-Big N audit firms and a matched sample of Big N clients that did not switch audit firms.  In addition to including in the model three risk factors considered in decisions to accept or drop clients (litigation, financial and earnings manipulation risk) we construct an index of corporate governance to determine the extent to which corporate governance determined the extent clients changed audit firms before and after the passage and implementation of SOX.

    Findings:
    • Our results suggest that corporate governance is an important mechanism considered by Big N auditors when making decisions about their client portfolio.  Thus, client decisions are based in part on the perceived quality of the clients’ corporate governance with Big N audit firms accepting fewer clients with less desirable governance characteristics.
    • We find the corporate governance effect both pre and post SOX but the effect is somewhat attenuated post SOX but primarily because of the audit committee-related components of corporate governance.
    • We posit that the attenuating affect of the audit committee-related components of corporate governance occurs because SOX reduced the cross-sectional variability in the quality of audit committees.
    Category:
    Client Acceptance and Continuance, Governance
    Sub-category:
    Client Risk Assessment
  • Jennifer M Mueller-Phillips
    The Effects of Clients’ Controversial Activities on Audit P...
    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, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 06.06 Earnings Management 
    Title:
    The Effects of Clients’ Controversial Activities on Audit Pricing
    Practical Implications:

    We focus on the business risk associated with controversial corporate activities. By examining a wider range of controversial corporate activities, we are able to conduct a broader investigation into the association between auditor business risk and audit fees.  Our study finds that adverse social performance arising from controversial activities affects firms’ audit fees. Specifically, our results indicate that auditors charge fee premiums ranging from 5.4% to 13.2% for clients that are involved with controversial activities related to consumers, employees, the community, and the environment.  We also find that corporate controversial activities are associated with higher risks of financial misstatement and adverse financial performance.  These results provide triangulation on our inference that auditors’ raise their assessment of clients’ business risks when their clients are involved in controversial activities, and charge such clients higher audit fees.  

     

    For more information on this study, please contact Kevin Koh.

    Citation:

    Koh, K. and Y. H. Tong. 2013. The Effects of Clients’ Controversial Activities on Audit Pricing. Auditing: A Journal of Practice and Theory 32 (2): 67-96.

    Keywords:
    audit fees; audit pricing; corporate social responsibility (CSR); controversial corporate activities; business risk; financial misstatement
    Purpose of the Study:

    We examine the effects of clients’ involvement in controversial corporate activities on audit pricing. Clients’ involvement in controversial activities raises concerns about management integrity and ethics. Moreover, clients involved in such activities are perceived to have higher risk of adverse financial performance. As a result, there is greater potential for financial misstatement, which increases the auditor’s perceived business risk. We hypothesize that, given the higher perceived business risk, auditors charge higher fees to clients engaged in controversial activities. We also hypothesize that lower corporate social performance is associated with adverse financial performance as these clients can face public criticism, consumer boycotts, reputation loss, fines or other regulatory actions over their controversial activities. Adverse financial performance heightens managerial incentives to manage earnings, increasing the risk of financial misstatement.

    Design/Method/ Approach:

    Our sample spans the period 2000 to 2010, as audit fee data are publicly available only as of 2000.  We obtain audit fee data from the Audit Analytics database and identify audit clients involved in controversial activities related to consumers, employees, the community, and the environment using a unique dataset from Kinder, Lydenberg, and Domini (KLD).   The KLD dataset is the most commonly used database for assessing corporate social performance. KLD rates each firm’s social actions along seven broad dimensions: consumer, employee, diversity, community, human rights, environment, and corporate governance. We use a regression model to examine the relation between controversial activities and audit fees. In order to examine the validity of our assumptions and to triangulate our results, we investigate the association between controversial activities and the risks of financial misstatement and adverse financial performance with regression models.   

    Findings:

    We find evidence consistent with audit firms charging higher audit fees to firms involved in controversial activities. Specifically, our results indicate that auditors charge fee premiums ranging from 5.4% to 13.2% for clients that are involved with controversial activities related to consumers, employees, the community, and the environment.  In comparison, in our sample, the Big 4 and industry-specialist audit fee premiums amount to 29.7% and 10.8%, respectively.  The fee premiums related to the various controversial activities thus appear to be economically significant. 

    We also find that clients involved in controversial activities report higher level of abnormal accruals and are more likely to be issued a going concern opinion compared to clients not involved in such activities. These results strengthen our inference that auditors raise their assessment of auditor business risk for clients engaged in controversial activities and charge higher audit fees.   

    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fee Decisions, Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment, Earnings Management, Earnings Management, Management Integrity
  • The Auditing Section
    The Impact of Management Integrity on Audit Planning and...
    research summary posted April 13, 2012 by The Auditing Section, tagged 02.02 Client Risk Assessment, 02.03 Management Integrity Assessments, 06.04 Management Integrity, 14.01 Earnings Management 
    Title:
    The Impact of Management Integrity on Audit Planning and Evidence
    Practical Implications:

    The results of this study are important because, while severe cases of low integrity may be weeded out during client acceptance, auditor firms tend to retain clients with a wide spectrum of integrity levels that must be managed throughout the audit process. Thus evidence regarding how the integrity of management influences auditors (1) assessment of risk, (2) planning of audit procedures, and (3) identification of misstatements may be useful for developing training materials or best practices for approaching audits on the lower end of the integrity spectrum.

    Citation:

    Kizirian, T.G., B.W. Mayhew, and L.D. Sneathen, Jr. 2005. The impact of management integrity on audit planning and evidence. Auditing: A Journal of Practice & Theory 24 (2): 49-67.

    Keywords:
    Audit risk model, management integrity, evidence
    Purpose of the Study:

    Management integrity (i.e., “tone at the top”) is a key determinant of the client’s risk structure and provides the foundation of internal control. As a result, it is important that auditors incorporate this risk component into their audit judgments. Furthermore, auditors rely on management to provide a great deal of audit evidence. Thus, auditors must carefully evaluate management integrity to assess the credibility of management-supplied evidence. To determine the extent to which auditor judgments are influenced by perceptions of management’s integrity, this study examines the effect of auditor-assessed management integrity on three aspects of the audit: (1) auditors’ assessments of risk of material misstatement (RMM), (2) audit planning, and (3) audit outcomes (i.e., identification of misstatements).

    Design/Method/ Approach:

     The authors collected their data from working papers of 60 clients of a U.S. Big 4 auditing firm. The working papers used were from engagements performed between 1996 and 1999. In all of the selected engagements, the auditors had documented an explicit assessment of management integrity as either “strong,” “moderate,” or “weak.”

    Findings:
    • Auditor-assessed management integrity is negatively related to the auditor’s assessment of RMM (i.e., high integrity is related to low risk assessments). However, the primary driver of auditors’ risk assessments appears to be whether or not the auditors identified a misstatement during the prior year audit (i.e., identification of a prior year error leads to higher assessments of RMM). In the case of a prior year misstatement, management integrity has no additional impact on assessments of RMM.
    • The auditor responds to low management integrity by requiring more persuasive evidence to support audit assertions. Additionally, management integrity was not related to the timing or extent of audit procedures. This suggests that when management integrity is low, the auditor goes outside the client for independent data verification rather than simply increasing the analysis of the client’s information.
    • When the auditor assesses that management is of low integrity, they are more likely to discover misstatements. Furthermore, the authors find that this is not just because the auditor tends to be more diligent in their testing when management is of low integrity. This suggests that management integrity is a good indicator of the likelihood that the financials are misstated.  
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Client Risk Assessment, Management Integrity, Assessing Risk of Material Misstatement, Earnings Management, Earnings Management
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  • Jennifer M Mueller-Phillips
    Voluntary Audits versus Mandatory Audits
    research summary posted March 4, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment 
    Title:
    Voluntary Audits versus Mandatory Audits
    Practical Implications:

    This analysis provides empirical support for the argument that the mandatory requirement suppresses information that is conveyed when companies are allowed to choose whether to be audited. Moreover, additional tests indicate that the opt-out companies were only passively complying with the audit requirement—evident in their attempts to reduce costs through auditor choice and fees—under the mandatory regime. In other words, it is difficult to force companies to privately contract for stringent audits if they would choose not to be audited voluntarily. However, the research on private companies cannot contribute valid insights on the relative merits of voluntary and mandatory audits for public companies.

    For more information on this study, please contact Clive Lennox.

    Citation:

    Lennox, C. S. and J. A. Pittman. 2011. Voluntary Audits versus Mandatory Audits. The Accounting Review 86 (5): 1655-1678. 

    Keywords:
    voluntary audits; mandatory audits; credit ratings
    Purpose of the Study:

    Exploiting a natural experiment in which voluntary audits replace mandatory audits for U.K. private companies, we analyze whether imposing audits suppresses valuable information about the types of companies that would voluntarily choose to be audited. Companies should be compelled to have their financial statements audited to ensure that outsiders have access to reliable accounting information. In the other direction, requiring audits suppresses the signal that is conveyed when companies exercise their discretion in choosing whether to be audited. This study provides empirical evidence on the merits of these competing arguments by analyzing economic outcomes for private companies stemming from a regime switch from mandatory to voluntary audits. The purpose of our analysis is to isolate whether this regime change permitted firms to signal new information about their types.

    Design/Method/ Approach:

    The authors compile the sample from the Financial Analysis Made Easy (FAME) database. By design, each company in the sample was required to have an audit in 2003, but not in 2004. There are two observations per company, with the first pertaining to the final year of the mandatory audit regime (2003) and the second to the initial year of the voluntary regime (2004).

    To gauge whether voluntary audits reveal new information about borrowers’ types, the authors examine the changes in credit ratings after the transition from mandatory to voluntary audits in a natural experiment. They control for the assurance benefits of auditing to isolate the role signaling plays by focusing on companies that are audited under both regimes. These companies experience no change in audit assurance, although they can now reveal for the first time their desire to be audited. The study also tests whether the companies that would choose to avoid an audit under the voluntary regime were privately contracting for a relatively low level of audit assurance during the mandatory regime.

    Findings:
    • The authors find that credit ratings rise for companies that continue being audited during the first year of the voluntary regime, and they interpret this evidence as implying that these companies enjoy ratings upgrades because their decision to remain audited conveys an incrementally positive signal about their credit risk. The level of audit assurance appears stable for these companies during the transition from mandatory to voluntary audits, as their audit fees and auditor choices do not change following the regime switch.
    • The authors also examine the impact of the regime switch on credit ratings for the companies that choose to opt out of the audit, and find that credit ratings drop when companies abandon the audit, which conveys a negative signal about their type and reduces financial reporting credibility; i.e., both signaling and the drop in assurance are responsible for their ratings falling.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Client Risk Assessment

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