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  • 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
    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
    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
    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
    Managing Audits to Manage Earnings: The Impact of Diversions...
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 06.06 Earnings Management 
    Title:
    Managing Audits to Manage Earnings: The Impact of Diversions on an Auditor’s Detection of Earnings Management.
    Practical Implications:

    Diversions can have important practical implications beyond the setting of deliberate earnings management. Managers may divert auditors from higher risk areas to accounts that they believe are not at risk of misstatement. The findings suggest that auditors would be susceptible to these diversions as well. However, to the extent that errors can occur anywhere, managers might mistakenly direct auditors’ attention to an area with errors, which could backfire on managers. Even more broadly, managers may inadvertently direct auditors’ attention from an account that materially misstates earnings to another account that does not. No matter the cause of the diversion, the results demonstrate that such diversions significantly influence an auditor’s detection of a material misstatement of earnings elsewhere in the financial statements. 

    Citation:

    Luippold, B. L., Kida, T., Piercey, M. D., & Smith, J. F. 2015. Managing audits to manage earnings: The impact of diversions on an auditor’s detection of earnings management. Accounting, Organizations & Society (41):39-54.

    Keywords:
    earnings management, audit management, decision making, material misstatements
    Purpose of the Study:

    This study discusses an aspect of earnings management called audit management. The authors define audit management as a client’s strategic use of diversions to decrease the likelihood of auditors discovering managed earnings during the audit. Evidence from prior studies suggests that managers strategically attempt to conceal earnings management. This study investigates whether managers who manipulate earnings can successfully employ diversions to influence auditors’ detection of unusual fluctuations during analytical review. That is, the authors investigate whether diversionary statements made by the client (i.e., identifying areas of risk in the financial statements to lure the auditor away from managed earnings) affect an auditor’s detection of managed earnings contained elsewhere in the financial statements.

    Managers may be motivated to divert auditors to areas that contain, or do not contain, other errors. If managers point auditors to ostensibly risky areas that are clean, auditors may conclude that the client’s accounts are likely to be accurate in other areas as well. Conversely, management may want to direct auditors to areas that contain other errors, thinking that these other errors may occupy their attention, leading auditors to feel satisfied that they are detecting misstatements, resulting in auditors feeling less compelled to discover other errors. However, auditors are also trained to practice professional skepticism, and the diversion to the other errors should elevate their sensitivity to the risk of material misstatement in the remainder of the financial statements, resulting in greater overall audit effort and a greater likelihood that they would find the earnings manipulation. The authors therefore investigate the impact of management intentionally directing auditors to both clean accounts and accounts containing errors.

    Design/Method/ Approach:

    A representative from each of the Big Four and other audit firms identified auditors with sufficient knowledge to perform the task. Seventy-six auditors, with an average of four years of audit experience, took part in the study. The experiment required that auditors complete analytical review procedures on the financials statements of a hypothetical client. The study employed a 2x2 experimental design. The evidence was collected prior to February 2015.

    Findings:

    The results suggest that diversions to clean accounts and diversions to accounts containing other errors have different effects on auditors’ detection of earnings management. The authors find that auditors’ detection of earnings management was worst when they were diverted to clean financial statement accounts, and best when they were diverted to accounts containing other errors, with earnings management detection in between these levels when no diversions were used (whether other errors were present or not). Overall, these results suggest that if management directs auditors to accounts that contain errors, the discovery of those errors heightens their sensitivity to errors in other areas of the audit. However, if auditors are directed to clean accounts, the use of diversionary statements can deter auditors from finding earnings management. Managers can potentially exploit an audit management tactic as simple as a diversion to a clean area because such a diversion reduces auditors’ effectiveness at detecting earnings management elsewhere in the financial statements.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Earnings Management
  • Jennifer M Mueller-Phillips
    Tone Management.
    research summary posted July 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 06.06 Earnings Management 
    Title:
    Tone Management.
    Practical Implications:

    The evidence indicates that tone manipulation succeeds in misleading investors, and that this effect is incremental to the effect of accruals management. An abnormally positive tone incites an overly optimistic immediate stock price response to the earnings announcement and a subsequent return reversal. The evidence indicates that abnormal positive tone contains negative information about future firm fundamentals, that firms tend to engage in tone management particularly when incentives to manipulate investor perceptions are high, and that investors are misinformed by tone management.

    Citation:

    Huang, X., Teoh, S. H., & Zhang, Y. 2014. Tone Management. Accounting Review 89 (3): 1083-1113.

    Keywords:
    behavior finance, earnings management, market efficiency, qualitative disclosure, tone management, management integrity
    Purpose of the Study:

    The tone of the qualitative text in earnings press releases can be too optimistic or pessimistic relative to concurrent disclosures of quantitative performance. The authors call the choice of the tone level in qualitative text that is incommensurate with the concurrent quantitative information tone management. The authors investigate whether managers engage in tone management for informative or strategic purposes, and whether and to what extent the capital market discounts for strategic motives, if any, when reacting to earnings announcements.

    Earnings press releases, being voluntary, are not subject to explicit rules about the disclosure, so management has wide latitude in the qualitative presentation of the quantitative information. The authors are interested in studying how the tone of the press release affects readers’ response to the communication, and whether and how tone can be used as a tool to affect investors’ perception about the firm. As the old adage goes, “It’s not what you say; it’s how you say it.”

    A key goal for this paper is to test whether tone management in earnings press releases informs or misinforms investors. The authors examine how abnormal positive tone relates to future firm performance, whether abnormal tone is more likely used in situations where managerial strategic incentives to manipulate investor perception are present, and whether and how investors react to tone management at the time of, and subsequent to, the earnings announcements.

    Design/Method/ Approach:

    The authors obtain a sample of 14,475 observations of firm-year abnormal positive tone from the text of annual earnings press releases from PR Newswire and Business Wire, historical financial data from Compustat, stock returns from CRSP, analysts’ earnings forecasts data from I/B/E/S, seasoned equity offering (SEO) and merger and acquisition (M&A) effective dates from SDC, and option grants data for CEOs from ExecuComp. The sample period was 19972007.

    Findings:

    The evidence indicates that abnormal positive tone is associated with a more positive immediate market response to the earnings announcement and a more negative market response in one and two quarters subsequent to the announcement. The return reversal in the post-announcement period is strong evidence of an over-reaction to abnormal positive tone at the earnings announcement. Among firms that use both accruals and tone management in a consistent direction, the authors find that tone management is more likely in older firms and firms facing higher balance sheet bloat, as proxied by lagged assets scaled net operating assets, and so are more constrained in further upward accruals management. Abnormal positive tone is usually higher when firms just meet or beat past earnings or analysts’ consensus forecasts, when earnings are upwardly biased to such an extent as to require a future restatement, and before a new equity issuance or a merger or acquisition activity. When firms award stock options to CEOs, with an associated managerial incentive to reduce the share price, they prefer to manipulate abnormal tone downward. Overall, the evidence suggests that managers use tone management to mislead investors and other financial statement users.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Management Integrity
  • Jennifer M Mueller-Phillips
    Monitoring by Auditors: The Case of Public Housing...
    research summary posted December 1, 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 
    Title:
    Monitoring by Auditors: The Case of Public Housing Authorities
    Practical Implications:

    While prior research has investigated audit effects in for profit industries, this study investigates audit effects at nonprofit organizations. Nonprofits in general and PHAs in particular are largely served by smaller auditors frequently classified in prior research as lower quality. Further, nonprofits in general represent low litigation risks for the auditors and the threat of litigation and associated economic loss is generally considered one motive for an audit firm to perform a high quality audit. The evidence suggests that audits matter in the nonprofit industry. So even in a setting where research would suggest there would be low audit quality, when the auditor is smaller and the risk of litigation is low, auditors make significant adjustments to pre-audited data and help to constrain management bias toward meeting pre-established financial thresholds.

    For more information on this study, please contact Barbara Grein.

    Citation:

    Grein, B. M., and S. L. Tate. 2011. Monitoring by Auditors: The Case of Public Housing Authorities. The Accounting Review 86 (4):1289-1319.

    Keywords:
    auditor monitoring; audit adjustments; earnings management; management incentives; public housing authorities; nonprofit organizations; auditing procedures; risk
    Purpose of the Study:

    Audits are widely believed to be a means of improving financial reporting and mitigating management bias, although determining the actual effect of an audit is exceptionally difficult. In most cases, only the final results – audited financial statements and the audit report – are available. The authors take advantage of the unique setting of Public Housing Authorities (PHAs) where both pre-audit and post-audit data at the general ledger level are available. The study investigates

    • the number, dollar amount, and direction of audit adjustments to common financial statement line items and to financial ratios that were integral in the monitoring system established by the Department of Housing and Urban Development (HUD), PHA overseer;
    • whether audits result in significant adjustments to pre-audited data, both in terms of numbers of engagements with adjustments and the dollar amount of adjustments;
    • whether auditors’ adjustments act to reduce potential management bias when PHAs have greater incentives to meet financial targets that were part of the HUD monitoring system; and
    • whether auditors constrain overstatement bias differently than understatement bias.
    Design/Method/ Approach:

    The pre- and post-audit general ledger level data for nonprofit public housing authorities used in this study was obtained from HUD under the Freedom of Information Act. The study uses data from September 2001 through December 2007 as this was the period during which HUD enforced this specific monitoring system, Public Housing Assessment System.

    Findings:
    • The authors find that for key accounts and ratios (e.g., total expenses, tenant revenue, current ratio) the percentage of observations with audit adjustments ranges from a low of 15% to a high of 69%.
    • Further the study finds that audits result in material (economically significant) adjustments in PHA audit engagements.
    • Overall, audit adjustments are consistent with auditors attempting to reduce management bias in the financial statements.
    • In addition, the authors find that auditors appear to attend more to potential overstatements of quality scores than understatements.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Earnings Management
  • Jennifer M Mueller-Phillips
    Was Dodd-Frank Justified in Exempting Small Firms from...
    research summary posted November 26, 2014 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, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.05 Evaluating Accruals/Detection of Abnormal Accruals, 08.06 Earnings Management – Detection and Response, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance?
    Practical Implications:

    Our study evaluates a provision of Dodd-Frank which provided permanent exemption from Section 404b compliance to non-accelerated filers. Our results show that these small firms did not improve their reporting quality to the same extent as large firms implying that the Dodd-Frank exemption will probably serve to keep the reporting quality of the exempted firms at lower than achievable levels.

    We also note that as part of the Dodd-Frank legislation, the SEC was given a mandate to investigate raising the Section 404b exemption requirements from $75 million to $250 million in market capitalization (Dodd Frank 2010). While the SEC eventually decided to leave the exemption criterion at $75 million, this matter is still considered to be an open topic (SEC 2011). Our study informs this ongoing debate.

    For more information on this study, please contact

    Anthony D. Holder, PhD, CPA

    Assistant Professor, Department of Accounting - MS 103

    University of Toledo

    Toledo, OH 43606-3390

    Email: Anthony.Holder@utoledo.edu

    Web:    http://homepages.utoledo.edu/aholder4/

    Phone: 1.419.530.2560

    Fax: 1.419.530.2873 

    Citation:

    Holder, A., K. Karim, and A. Robin. 2013. Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance? Accounting Horizons 27 (1): 1-22.

    Keywords:
    Sarbanes-Oxley; Dodd-Frank; earnings management; exempt filers
    Purpose of the Study:

    A major component of the Sarbanes-Oxley Act of 2002 (SOX) is Section 404b, which requires auditor certification of internal controls. However, not all firms were required to comply with this section. Fearing that compliance costs may be prohibitive, SOX allowed a temporary exemption to small firms called non-accelerated filers (typically those firms with market capitalizations under $75 million). Later, the Dodd-Frank Act of 2010 made this exemption permanent.

    Needless to say, both 404b itself and the small-firm exemption, remain controversial. At the heart of the issue, as with any regulation, is the cost-benefit tradeoff. In this particular instance, what are the potential benefits small firms would have obtained had they been subject to SOX Section 404b? By focusing just on the costs of compliance, we may be overlooking these benefits. We consider these foregone benefits an opportunity cost.

    The purpose of our study is to estimate this opportunity cost. We estimate the benefits lost by small firms, because they were not subject to SOX Section 404b.

    Design/Method/ Approach:

    Our sample contains listed firms (subject to SOX), divided into the large (accelerated) and small (non-accelerated) categories. Our data span the SOX period and are from 1995-2009. We measure reporting gains using two standard approaches, one measuring the extent of earnings management and the other measuring accrual quality.

    The reporting benefits foregone by small-firms can be understood by comparing the following two quantities:

    • Post-SOX reporting gains achieved by large firms (accelerated filers).
    • Post-SOX reporting gains achieved by small firms (non-accelerated filers). If these gains (or losses) are smaller than those achieved by large firms, we know there is an opportunity cost.
    Findings:

    We detect a significant deterioration in reporting quality for non-accelerated filers but not for accelerated filers. The result is invariant to whether we compare non-accelerated filers with all accelerated filers or only with small accelerated filers.  Our findings suggest a significant opportunity cost for the exemption. Although the consideration of the cost of Section 404b compliance is outside the scope of our study, our result concerning the opportunity cost suggests that it may have been premature to grant permanent exemption to the non-accelerated filers. This result is especially important, considering contemporaneous discussions to grant Section 404b exemption to even larger firms (up to a market capitalization of $500 million).

    Category:
    Auditing Procedures - Nature - Timing and Extent, Corporate Matters, Independence & Ethics, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Earnings Management, Evaluating Accruals/Detection of Abnormal Accruals, Impact of 404 on Fees and Financial Reporting Quality, Impact of SEC Rules Changes/SarBox
  • 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
    Real Activities Manipulation and Auditors’ C...
    research summary posted October 22, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
    Title:
    Real Activities Manipulation and Auditors’ Client-Retention Decisions
    Practical Implications:

    The results of this study are important for auditors, investors, clients’ audit committees, and regulators. Disclosure about auditor resignations may reveal useful information about clients’ financial reporting practices. Since auditor resignations potentially signal risk arising from clients’ opportunistic financial reporting behavior, investors can make more informed decisions when they understand the linkage between RAM and auditor resignations. The findings of this study also have an important implication for clients’ audit committees, because these committees can help to avoid potential negative consequences associated with RAM and auditor resignations by overseeing management reporting practices. Further, the results of this study are important for regulators because they are concerned about auditor changes that are triggered by management opportunism.

     

    For more information on this study, please contact Yongtae Kim.

    Citation:

    Kim, Y., and M. Park. 2014. Real Activities manipulation and auditors’ client-retention decisions. The Accounting Review 89 (1): 367-401.

    Keywords:
    Real activities manipulation; auditors’ client retention decision; auditor resignation
    Purpose of the Study:

    Although earnings management through accounting choices is receiving considerably more attention in the literature, survey results show that executives are more willing to take real actions than accounting actions to meet earnings benchmarks. Despite the pervasiveness of real activities manipulation (RAM) and considerable attention to auditor switches, especially in the post-SOX era, there is little evidence for the implication of RAM for auditors’ client-retention decisions.

    Auditors are concerned about client’s abnormal operating practices for the following reasons. First, RAM has a negative impact on cash flows and future performance. Deterioration of the client’s performance and financial health limits an auditor’s future business opportunities with the client. Second, clients’ poor financial performance often leads to auditors being held liable for clients’ stakeholder losses, even if the auditors are not directly responsible. Thirds, RAM can result in inventory build-up and increase in receivables, both of which increase audit risk. Finally, aggressive RAM reflects the management’s opportunism in financial reporting and the discovery of opportunistic operating decisions that dissipate firm value casts doubt on the integrity of management and its financial statements.

    Facing resource constraints, auditors may drop clients with limited future opportunities and greater risk. Since auditors cannot effectively control the clients’ RAM, they attempt to adjust their client portfolios by resigning from risky engagements. The authors examine whether auditors are more likely to resign when clients engage in RAM aggressively.

    Design/Method/ Approach:

    The research evidence is collected from a sample of auditor changes between 2000 and 2010. Following prior literature, the authors estimate and examine three types of activities manipulation: (1) sales manipulation, (2) overproduction, and (3) reduction of discretionary expenses. To mitigate the concern that clients’ financial performance may explain the relation between RAM and auditor resignation, the authors construct performance-adjusted RAM measures, explicitly control for the client’s financial performance by including several proxies of the client’s financial performance in the regressions, and employ a performance-matched control sample.

    Findings:
    • Clients’ opportunistic operating decisions, proxied by abnormal cash flows and abnormal discretionary expenses, are positively associated with the likelihood of auditor resignations.
    • Abnormal production costs are not significantly associated with the likelihood of auditor resignations.
    • The results are robust to three sets of control samples: client-initiated auditor changes, all continuing audit clients, and performance-matched continuing audit clients.
    • Clients whose auditors resign tend to engage in RAM more aggressively to meet or beat earnings benchmarks prior to auditor changes. Auditors are especially sensitive to clients’ RAM to just meet or beat earnings benchmarks in their client-retention decisions, with the exception of RAM through overproduction.
    • Clients whose auditors resign from engagements tend to employ non-Big 4 auditors as successor auditors and that these clients engage in RAM more actively than other clients whose incoming auditors are Big 4.
    • The association between RAM and the likelihood of auditor resignation is especially prevalent for small clients and during the post-Sarbanes-Oxley Act of 2002 period.
    • Clients’ abnormal cash flows and abnormal discretionary expenses are significantly associated with litigations against auditors.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Resignation Decisions

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