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  • Jennifer M Mueller-Phillips
    Audit Market Concentration and Auditor Tolerance for...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.08 Impact of SEC Rules Changes/SarbOx, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
    Title:
    Audit Market Concentration and Auditor Tolerance for Earnings Management.
    Practical Implications:

    Given that auditor concentration is an important topic that has seen relatively little empirical research, this study contributes to the literature by providing more complete evidence on the relation between auditor concentration and audit quality. Concentration reduced the opportunity for Big 4 clients to switch auditors particularly given the new auditor independence requirements following the 2002 Sarbanes-Oxley Act. Reduced choice is seen as increasing auditor entrenchment and complacency, and potentially contributing to a more lenient and less skeptical audit for clients.

    Citation:

    Boone, J. P., I. K. Khurana, and K.K. Raman. 2012. Audit Market Concentration and Auditor Tolerance for Earnings Management* Audit Market Concentration and Auditor Tolerance for Earnings Management. Contemporary Accounting Research 29 (4): 1171-1203. 

    Keywords:
    industrial concentration, earning management, auditor independence, auditing-quality control
    Purpose of the Study:

    The relation between market concentration and audit quality remains an important public policy issue. This study examines whether concentration in U.S. local audit markets affects the auditor’s tolerance for earnings management by audit clients. In recent years, policy makers have expressed concern about the risks posed by auditor concentration (i.e., the market dominance of the Big 4 audit firms) for audit quality. The concern is that market concentration limits a company’s choice of auditory, particularly if they are a large company. Having only four large auditors reduces a client’s opportunity to switch auditors and thereby entrenches the incumbent auditor. To the extent that auditor entrenchment contributes to auditory complacency and a more lenient and less skeptical approach to audits, auditor concentration could lower service quality. To the extent that audit entrenchment strengthens auditor independence and allows for greater “pushback” by the auditor, concentration could have a beneficial effect on audit quality. The authors examined a restrictive sample of observations based on clients that have the incentive and means to manage earnings to meet or beat earning benchmarks.

    Design/Method/ Approach:

    The sample is formed from the merged COMPUSTAT annual industrial files, including the primary, secondary, tertiary, and full coverage research files. The sample consists of 4,779 observations for which client’s nondiscretionary earnings fell short of analysts’ consensus earnings forecast from 2003-2009. The authors also examine a reduced sample of 2,988 observations where they exclude clients with nondiscretionary earnings that fall short of the analysts’ consensus earnings forecast by more than 5 percent of total assets.

    Findings:

    The results indicate that higher concentration (as measured by the Herfindahl index) is associated with an increased likelihood of the client having sufficient positive discretionary accruals that together with the nondiscretionary earnings is equal to or greater than the analysts’ consensus earnings forecast. Utilizing a more focused definition of earnings management, thefindings suggest that higher concentration is associated with lower audit quality. The results hold across alternative measures of the Herfindahl index based on all auditors or Big 4 auditors only, and based on audit fees, client size, or number of clients. However, the authors are unable to detect a relation between Big 4 market share and auditor tolerance for earnings management to meet or beat the earnings forecast. In a separate analysis the authors find evidence that clients in more concentrated audit markets are more likely to just beat (rather than just miss) the earnings benchmarks. Overall, the evidence is consistent with auditor concentration manifesting itself in increased auditor tolerance for earnings management by clients.

    Category:
    Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Impact of SEC Rules Changes/SarBox
  • Jennifer M Mueller-Phillips
    Auditors’ Consideration of Material Income-Increasing v...
    research summary posted April 28, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.06 Earnings Management – Detection and Response, 11.0 Audit Quality and Quality Control, 11.09 Evaluation of Evidence 
    Title:
    Auditors’ Consideration of Material Income-Increasing versus Material Income-Decreasing Items during the Audit Process
    Practical Implications:

    The results of this study suggest that auditors spend a greater effort on analyzing income-increasing items compared to income-decreasing items. They also suggest that auditors compensate for greater risk associated with income-increasing items by requiring greater verification of such items. Because of the limitations placed on the results of this study due to the specific context of the experiment, future research should try and examine such differences in auditors’ decision-making processes.

    For more information on this study, please contact Naman K. Desai.
     

    Citation:

    Desai, N. K., and G. J. Gerard. 2013. Auditors’ Consideration of Material Income-Increasing versus Material Income-Decreasing Items during the Audit Process. Auditing 32 (2).

    Keywords:
    accruals; auditing; conservatism; memory; risk
    Purpose of the Study:

    The purpose of this study is to examine whether auditors’ consideration of material items, as evidenced by recognition memories, is influenced by the direction of material items. During the gathering of audit evidence, auditors come across evidence in support of material items that affect earnings in a positive or negative manner. Because earnings can be managed upward or downward depending on management’s objectives and incentives, auditors should be sensitive to both material increasing and deceasing items. Prior research indicates that auditors face greater litigation risk for non-detection of fraudulent income-increasing items compared to income-decreasing items. Therefore, the expectation is that auditors will spend greater cognitive effort evaluating material income-increasing items, resulting in superior memories for such items.

    Design/Method/ Approach:

    The experimental design is a 2 x 2 mixed design with data collected using a signal detection theory paradigm. The participants were randomly assigned to treatments. A total of 60 experienced auditors (all CPAs) participated in the experiment. The participants had an average of 9.83 years of auditing experience. The minimum experience was two years and the maximum was 19 years. The experiment was conducted on site during firm training sessions. 

    Findings:
    • Auditors’ memories for income-increasing items are significantly greater than that for income-decreasing items when auditors are not asked to form expectations about the future effects of the items.
    • This difference above is not observed when auditors are asked to form expectations about future effects of each item.
    • Auditors are less likely to refer back to the work papers to verify the accuracy of income-decreasing items compared to income-increasing items.
       
    Category:
    Audit Quality & Quality Control, Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Earnings Management, Evaluation of Evidence
  • Jennifer M Mueller-Phillips
    Board Interlocks and Earnings Management Contagion.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.05 Board/Audit Committee Oversight 
    Title:
    Board Interlocks and Earnings Management Contagion.
    Practical Implications:

    The evidence on the firm-to-firm spread of financial reporting behavior via board networks contributes to a little-studied area in accounting that should be important. The authors contribute to the corporate governance literature by offering evidence that contagion effects vary with board positions. They show that board supervision of management is important for ensuring high-quality financial reporting and that board linkages affect the success of this supervision. Regulators concerned about improving financial reporting quality should consider the board connectivity of companies.

    Citation:

    Chiu, P. C., S. H. Teoh, and F. Tian. 2013. Board Interlocks and Earnings Management Contagion. Accounting Review 88 (3): 915-944.

    Keywords:
    board interlocks, board networks, contagion, earnings management, governance, restatements, social networks
    Purpose of the Study:

    In the corporate world, behavior may spread through board of director networks. A board link exists between two firms whenever a director sits on both firms’ boards. A typical board in the sample has nine directors, and the median number of interlocks with other boards is approximately five. In this way, firms are widely connected by their board networks, which potentially serve as conduits for spreading behaviors from firm to firm.

    In this study, the authors investigate whether financial reporting behavior spreads through interlocking corporate boards. The test design emphasizes contagion of bad financial reporting choices, specifically, earnings management that results in a subsequent earnings restatement, although it also allows for inferences about good reporting contagion. The authors use restatements to identify firms that have managed earnings and the period when the manipulation occurred. They refer to a firm that later restates earnings as contagious. The authors define the contagious period as starting in the first year for which earnings are restated and ending two years after. Any firm that shares an interlocked director with the contagious firm during the contagious period is therefore exposed to an earnings management infection via the board network. They consider a multiyear contagious period to allow the earnings management infection to incubate, which is analogous to an epidemiological setting for viral infections. The key test investigates whether an exposed firm is more likely to manage earnings during the contagious period as compared to an unexposed firm.

    Design/Method/ Approach:

    The authors use the U.S. Government Accountability Office’s (GAO) first release of restatements between January 1, 1997 to June 30, 2002 to identify contagious firms and their contagious periods. They keep only the earliest restatement within the sample period when a firm has multiple restatements. The authors obtain director names from Risk Metrics. In the 19972001 sample period the authors identify a sample of 118 observations.

    Findings:
    • The authors find strong evidence that a firm is more likely to manage earnings when exposed within a three-year period to earnings management from a common director with an earnings manipulator. The contagion effect is economically substantial.
    • The regression odds ratio suggests that a board link to a manipulator doubles the likelihood that the firm will manage earnings.
    • The authors also find evidence for good financial reporting contagion. A board link to a non-manipulator significantly decreases the likelihood of the firm being a manipulator.
    • Both bad and good accounting behaviors are contagious across board networks.
    • Earnings management contagion is stronger when the shared director has a leadership position as board chair or audit committee chair, or an accounting-relevant position as an audit committee member, in the exposed firm.
    • The contagion is also stronger when the linked director is the board chair or CEO of the contagious firm, but not when the linked director is the CEO of the exposed firm.
    • Earnings management contagion is exacerbated when the exposed firm is located within 100 miles of the contagious firm and shares a common auditor with the contagious firm.
    • The evidence supports the proposition that earnings manipulation spreads through board networks.
    Category:
    Accountants' Reporting, Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Board/Audit Committee Composition, Board/Audit Committee Oversight, Earnings Management, Earnings Management, Restatements
  • 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
    Client Risk Management: A Pecking Order Analysis of Auditor...
    research summary posted November 5, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
    Title:
    Client Risk Management: A Pecking Order Analysis of Auditor Response to Upward Earnings Management Risk
    Practical Implications:

    Earnings management has received significant attention in the business press and from regulators and investors. Auditors are expected to constrain earnings management and, more generally, to enhance the quality of financial reporting. The passage of the 2002 SOX Act has substantially increased the legal liability for auditors and, therefore, has influenced their mindset toward conservative reporting. The results of this study show how auditors respond to earnings management risk via audit pricing and client retention decisions in a sequential way. The type of strategies that auditors employ varies with the level of earnings management risk. If the trade-off between return and risk is acceptable, auditors are willing to retain clients that engage in upward earnings management by charging higher audit fees. However, if the risk exceeds an acceptable level, auditors will choose to resign. The study provides evidence that a pecking order of auditors’ strategies exists in response to various risk levels in the post-SOX period.

     

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

    Citation:

    Krishnan, G., L. Sun, Q. Wang, and R. Yang. 2013. Client Risk Management: A Pecking Order Analysis of Auditor Response to Upward Earnings Management Risk. Auditing: A Journal of Practice and Theory 32 (2): 147-170.

    Keywords:
    Earnings management, discretionary accruals, audit fees, auditor resignations, client risk management
    Purpose of the Study:

    Managing engagement risk, the overall risk of an auditor’s association with a particular client, is a paramount objective for all auditors. Successful management of client risk is important to preserve an auditor’s reputation and mitigate the risk of litigation. The demise of Arthur Andersen is a sad testimony to the significance of client risk management. Despite the obvious importance of this issue, empirical evidence on how auditors employ systematic strategies to mitigate engagement risk is sparse. In particular, most prior research has used a piecemeal approach to study auditor responses to high-risk clients. The objective of this study is to provide empirical evidence on a dual strategy of charging higher audit fees and resigning from clients with the risk of upward (i.e., income-increasing) earnings management. Specifically, the authors conduct a pecking order analysis of these two possible strategies using a large sample of client-observations audited by Big 4 auditors in the post-Sarbanes-Oxley (SOX) era.

    Design/Method/ Approach:

    The authors use a sample of 8,513 observations from 2002 through 2008 in the post-SOX era. Performance-adjusted signed discretionary accruals are used to measure upward earnings management. The authors first conduct background analyses of the associations of accruals and audit fees with the likelihood of auditor resignations, then, conduct a pecking order analysis. The pecking order analysis uses a discrete dependent variable capturing the auditor’s ordered responses, assigning a value of 2 for firms with auditor resignations and a value of 1 and 0 for firms with large and small abnormal audit fees, respectively.

    Findings:
    • Audit fees are positively associated with signed discretionary accruals.
    • The likelihood of auditor resignation is positively associated with the level of signed discretionary accruals.
    • An auditor’s decision to resign from a risky client hinges on prior-period abnormal audit fees. If the auditor is already charging higher fees, then the auditor has less flexibility to increase fees in the future, leading to a higher possibility of auditor resignation.
      • The following order of strategies is used in response to upward earnings management. First, abnormal audit fees are increased when the trade-off between risk and return is at an acceptable level. Second, auditor resignation is likely when the trade-off exceeds the acceptable level.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Earnings Management
  • Jennifer M Mueller-Phillips
    Discontinuities and Earnings Management: Evidence from...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 14.0 Corporate Matters, 14.01 Earnings Management, 14.05 Earnings Targets and Management Behavior 
    Title:
    Discontinuities and Earnings Management: Evidence from Restatements Related to Securities Litigation
    Practical Implications:

    The results of this study provide important evidence to the earnings management literature. Recent studies provide several plausible alternative explanations for the discontinuities in earnings distributions near earnings benchmarks. Though the findings of this study cannot readily be extrapolated to a broader sample of firms, the authors found evidence that firms commit less egregious earnings management in order to meet earnings benchmarks. This study is therefore important in considering whether earnings management plays a role in the discontinuities in various earnings distributions documented by prior studies.

    For more information on this study, please contact Dain C. Donelson.
     

    Citation:

    Donelson, D. C., J. M. McInnis, and R. D. Mergenthaler. 2013. Discontinuities and Earnings Management: Evidence from Restatements Related to Securities Litigation. Contemporary Accounting Research 30 (1).

    Keywords:
    earnings management; financial restatements; class action lawsuits; descriptive statistics.
    Purpose of the Study:

    A heated debate exists as to whether discontinuities in earnings distributions are indicative of earnings management. Many executives indicate that they would manage earnings within GAAP principles to achieve earnings benchmarks. This study examines the impact of earnings management on the discontinuity in earnings distributions near important benchmarks for a sample of firms where the amount of earnings is measurable. The authors look to find evidence linking earnings management to discontinuities in earnings distributions of this sample.

    Design/Method/ Approach:

    To determine the appropriate sample, this study utilizes the Securities Class Action Services (SCAS) database of historical class action data from RiskMetrics Group. From this database, the authors selected lawsuits that (1) settle and allege fraudulent GAAP violations and (2) involve restatements by firms for periods during which the alleged accounting fraud occurred. To identify and measure earnings management, the study utilizes the COMPUSTAT Point-in-Time database and uses descriptive statistics to compile evidence.

    Findings:
    • Earnings management drives the discontinuities in distribution of analyst forecast errors and earnings changes for sample firms.
    • Discontinuity is linked to earnings management.
    • The sensitivity to the scaling variable could indicate that factors other than earnings management contribute to the discontinuity in the sample.
    • Actual instances of earnings management do create sizable discontinuities in firms’ earnings distribution.
       
    Category:
    Corporate Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Earnings Management, Earnings Targets & Management Behavior
  • Jennifer M Mueller-Phillips
    Dividend Policy at Firms Accused of Accounting Fraud
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.06 Earnings Management 
    Title:
    Dividend Policy at Firms Accused of Accounting Fraud
    Practical Implications:

    The results of this study greatly contribute to the literature on the relation of earnings quality to dividends. Companies that report fraudulent financial statements have caused significant problems for financial markets and economies, and additional research in this are remains vital. The evidence found in this paper is consistent with the notion that dividend-paying firms are less likely to engage in fraud because they know they cannot maintain their same dividend policies if earnings are fraudulent. Fraud firms cannot keep pace with non-fraud firms in terms of dividend policy and fraud firms’ dividends are less related to earnings that are non-fraud firms.

    For more information on this study, please contact Judson Caskey.
     

    Citation:

    Caskey, J., and M. Hanlon. 2013. Dividend Policy at Firms Accused of Accounting Fraud. Contemporary Accounting Research 30 (2).

    Keywords:
    dividends; accounting fraud; earnings management; earnings manipulation
    Purpose of the Study:

    Recent studies and some policy experts have posited that dividends constrain financial misreporting. The premise behind this idea is that managers committing fraud cannot maintain the same dividend policy as managers of firms that achieve similar reported performance without manipulating earnings. Using this logic, managers at dividend paying firms would be less likely to commit fraud, and if management at a dividend-paying firm does commit fraud, the fraudulent reporting would alter dividend changes for that firm. This study attempts to investigate the relation between accounting fraud and firms’ dividend policies.

    Design/Method/ Approach:

    The authors examine the relationship between dividends and accounting fraud by comparing firms subject to an Accounting and Auditing Enforcement Release (AAER) from the SEC, to a matched sample of firms not accused of fraud and all firms in the same industries as the AAER firms. The primary sample was obtained from the 544 firms for which the SEC issued AAERs. The original sample was narrowed to 330 and tested with a conditional logit model. Descriptive statistics were also used to test the original hypotheses.

    Findings:
    • Dividend-paying status is negatively associated with fraud, which is consistent with dividends constraining fraud and indicating higher earnings quality.
    • Earnings-dividends relation is weaker for the fraud firms relative to the non-fraud firms during the fraud period.
    • Propensity score-matched tests indicate that the commission of fraud leads to the firm being 11 to 17 percent less likely to increase dividends. 
       
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Do Abnormally High Audit Fees Impair Audit Quality?
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 11.0 Audit Quality and Quality Control 
    Title:
    Do Abnormally High Audit Fees Impair Audit Quality?
    Practical Implications:

    The study provides useful insight into current regulatory debates on the auditor’s economic dependence on the client and increases understanding to the reasons why previous research provides mixed evidence on the association between various fee metrics and the extent of earnings management. If the association between abnormal fees and the magnitude of discretionary accruals is conditioned on the sign of abnormal fees, examining the association without reference to the sign of abnormal fees most likely leads to observations of insignificant associations, as also reported in most previous studies. This study’s findings suggest that future research on similar issues should take into account the asymmetric nonlinearity in the fee-quality relation.

    Citation:

    Choi, J. H., J. B. Kim, and Y. Zang. 2010. Do Abnormally High Audit Fees Impair Audit Quality? Auditing: A Journal of Practice & Theory 29 (2): 115-140.

    Keywords:
    audit quality, abnormal audit fees, earnings management
    Purpose of the Study:

    This study examines whether the association between audit fees and audit quality is asymmetric and thus nonlinear in the sense that the association is conditioned upon the sign of abnormal audit fees. The authors define abnormal audit fees as the difference between actual audit fees (i.e., actual fees paid to auditors for their financial statement audits) and the expected, normal level of audit fees. Actual audit fees consist of two parts: (1) normal fees that reflect auditors’ effort costs, litigation risk, and normal profits, and (2) abnormal fees that are specific to an auditor-client relationship. Normal fees are mainly determined by factors that are common across different clients, such as client size, client complexity, and client-specific risk, while abnormal fees are determined by factors that are idiosyncratic to a specific auditor-client relationship. As noted by Kinney and Libby, abnormal fees “may more accurately be likened to attempted bribes” and can better capture economic rents associated with audit services or an auditor’s economic bond to a client than normal fees or actual fees.

    Design/Method/ Approach:

    The authors obtain audit and nonaudit fee data from the Compustat audit fees file and all other financial data from the Compustat Industrial Annual File. The sample period for this study is restricted to the four-year period from 2000 to 2003. The full sample consists of 9,815 firm-years over the four-year sample period. They also construct a reduced sample of 7,061 observations that meet the data requirements for computing two additional variables. 

    Findings:

    The regression results reveal the following:

    • The proxy for audit quality is insignificantly associated with abnormal audit fees for the total sample of client firms with both positive and negative abnormal audit fees.
    • When the authors split total observations into those with positive abnormal fees and those with negative abnormal fees, the results change dramatically.
    • When the abnormal fees are positive, the magnitude of absolute discretionary accruals (an inverse measure of audit quality) is positively associated with abnormal fees, suggesting a negative relation between audit quality and positive abnormal fees.
    • In contrast, the association is insignificant when the abnormal fees are negative.
    • These findings imply that positive and negative abnormal fees create different incentive effects, for clients with positive abnormal fees, auditors are more likely to acquiesce to client pressure as abnormal audit fees increase, whereas for clients with negative abnormal fees, auditors are unlikely to compromise audit quality.
    • In contrast to the findings on the asymmetric association between abnormal audit fees and audit quality, the authors find no significant, comparable relation when abnormal nonaudit service (NAS) fees or abnormal total fees are used as a measure of auditor-client economic bond in lieu of abnormal audit fees.
    Category:
    Audit Quality & Quality Control, Engagement Management, Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fees & Fee Negotiations, Earnings Management, Earnings Management, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Do changes in audit actions and attitudes consistent with...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism, 10.0 Engagement Management, 10.04 Interactions with Client Management 
    Title:
    Do changes in audit actions and attitudes consistent with increased auditor scepticism deter aggressive earnings management? An experimental investigation
    Practical Implications:
    • Regulators and standard setters have been concerned that we do not know which audit actions most likely detect fraud.  An understanding of what audit procedures are likely to discourage managers from committing fraud is valuable. 
    • Specifically, the study shows that changes in the nature and extent of audit procedures combined with increased skepticism via critical inquiry are helpful in deterring potentially fraudulent behavior. 
    • Similar changes in audit procedures also affect management’s judgment about the ethicality of potentially fraudulent behavior. 
       
    Citation:

    Chen, Q., K. Kelly, and S. Salterio. 2012. Do changes in audit actions and attitudes consistent with increased auditor scepticism deter aggressive earnings management? An experimental investigation. Accounting, Organizations and Society 37 (2): 95-115.  

    Keywords:
    Fraud, Audit Procedures, Professional Skepticism, Earnings Management
    Purpose of the Study:

    Recent years have brought increased focus on the financial statement audit as not just a means of detection but a deterrent to fraud.  The link between detection and deterrence is made in practice because an increase in the ability to detect fraud on the part of the auditor (if widely known) should also lead to an increase in the ability of the audit process to deter fraud.
    The current study seeks to identify whether different audit procedures and attitudes toward management deter aggressive earnings management that is possibly fraudulent.  Using the experimental research approach allows the authors to focus on a scenario where the increase in deterrence is not due to an increase in the probability of detection but is most likely due to the specific changes in the audit approach tested. 
     

    Design/Method/ Approach:

    Corporate managers were placed in different experimental conditions to examine differences in their assessments about potentially fraudulent behavior.  Participants were told they were the manager of a firm for which rotational audits are performed.  In the current year, the manager’s division was not being audited, but they were made aware of the audit procedures being performed in other divisions.  In one condition, the procedures were the same as last year (SALY).  In another condition, the extent or quantity of evidence collected would be increased.  In the third condition the nature of evidence collected was increased (i.e. confirmations rather than internal documentation).  Within each of these three conditions half of the participants would also note an increase in auditor skepticism via more critical inquiry procedures while the other half would not.  Managers were then asked to assess a level of potential earnings management in their division as well as the ethicality of any potential earnings management.  The experiment was web-based.

    Findings:
    • When managers find out about a change in the nature of audit work being performed at other divisions, they respond by reducing earnings management in their own division as compared to the condition where procedures were the same as last year or where the change in procedure is an increase in audit evidence only. 
    • Managers exhibited this behavior even though the changes in procedures did not affect their division. 
    • Combining a more skeptical auditor attitude toward a manager with a change in the nature of audit evidence, the extent of evidence collected, or a change in the nature of the evidence, reduces earnings management as compared to the same as last year condition
    • An increase in evidence collected alone, or more critical inquiry alone does not significantly deter earnings management relative to the condition where procedures were the same as last year.
    • The results of management’s assessment of the ethicality of potential earnings management mirrors the results for the planned level of earnings management described above.  These results hold, even after considering manager ethical disposition.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Engagement Management, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Auditors’ Professional Skepticism, Earnings Management, Interactions with Client Management
  • Jennifer M Mueller-Phillips
    Earnings Smoothing Activities of Firms to Manage Credit...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior 
    Title:
    Earnings Smoothing Activities of Firms to Manage Credit Ratings
    Practical Implications:

    This paper provides fresh empirical evidence on long-term financial reporting strategies that managers use to impact perceptions of credit risk. It is among the first to examine reporting strategies in a setting where companies with stronger incentives to manage earnings to affect debt ratings can be identified. The authors find evidence that earnings smoothing activities appear to be affectively employed by managers to improve firm credit ratings.

    For more information on this study, please contact Boochun Jung.
     

    Citation:

    Jung, B., N. Soderstrom, and Y. S. Yang. 2013. Earnings Smoothing Activities of Firms to Manage Credit Ratings. Contemporary Accounting Research 30 (2).

    Keywords:
    credit ratings; risk assessment; rating agencies; financial disclosure
    Purpose of the Study:

    This study focuses on earnings smoothing, a long-term strategy that is available to a broad range of credit rated firms, as one way in which bond issuers affect credit ratings. Credit rating agencies such as Standard & Poor’s (S&P) and Moody’s evaluate credit risk and assign credit ratings to issues, issuers, or both. These ratings can have significant implications for companies by impacting the cost of future borrowing and affecting stock and bond valuation. Rating agencies often examine the earnings volatility of firms to identify credit risk. Firms can often improve or maintain their credit ratings by reducing the volatility of their earnings. This study attempts to identify mangers’ efforts to alter the rating agencies’ perception of credit risk through these earnings smoothing activities.

    Design/Method/ Approach:

    To test the hypotheses developed, the authors examine discretionary earnings smoothing activity by firms relative to their notch ratings (e.g. AA+, AA-, etc.). The primary measure of earnings smoothing activity is based on earnings smoothness associated with discretionary accruals. Earnings smoothness is measured as the standard deviation of earnings scaled by the standard deviation of cash flows from operating activities. The earnings smoothing activity is measured by subtracting smoothness based on earnings adjusted for performance-matched discretionary accruals from smoothness based on reported earnings. To test additional hypotheses, similar techniques are used in conjunction with descriptive statistics.

    Findings:
    • Earnings smoothing via earnings management is more concentrated in firms with a plus notch rating, particularly in investment grade firms.
    • Earnings smoothing activity increases the likelihood of a subsequent rating upgrade for firms with a plus notch rating.
    • Earnings smoothing activities appears to be an effective tool in managing credit ratings.
       
    Category:
    Corporate Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Earnings Targets & Management Behavior

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