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  • 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
    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
    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
    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
  • The Auditing Section
    Revenue Manipulation and Restatements by Loss Firms
    research summary posted April 16, 2012 by The Auditing Section, tagged 06.06 Earnings Management, 14.0 Corporate Matters, 14.01 Earnings Management, 14.05 Earnings Targets and Management Behavior 
    Title:
    Revenue Manipulation and Restatements by Loss Firms
    Practical Implications:

    This study’s results provide auditors and regulators with another potential indicator of managerial incentives to manipulate reported revenues (i.e., continued losses or negative cash flows) and how managers might achieve this result.  The authors demonstrate that this manipulation incentive applies across the general spectrum of firms and is not limited to young or internet-based businesses.

    Citation:

    Callen, J., S.W.G. Robb, D. Segal 2008. Revenue Manipulation and Restatements by Loss Firms. Auditing: A Journal of Practice & Theory 27 (2): 1-29.

    Keywords:
    revenue manipulation; earnings management; auditing; restatements
    Purpose of the Study:

    Regulating entities (such as the SEC and FASB) and auditors recognize managers have incentives to manipulate revenue accounts to achieve certain financial statement-related goals and perceptions with analysts and investors.  Although management can also manipulate earnings and financial data using expense-related accounts, accounting violation investigations by the SEC, FBI, and U.S. Attorney General’s office suggest that management is more likely to manipulate results using revenue-related items.  Survey evidence indicates management’s use of revenue items to increase earnings is more common, and studies show that firms have capital market incentives to provide positive revenue surprises.  Academic studies examining SEC enforcement actions support this perception.  Studies also indicate that individual firm characteristics could lead to a greater tendency to manipulate revenue-related line items.  For instance, studies suggest that young firms and internet-related businesses are more likely to manipulate earnings using revenue accounts.

    One reason why firms are more likely to manipulate revenue-related accounts is that firms with repeated losses or negative cash flows cannot be valued accurately using traditional valuation models such as the discounted cash flow and discounted residual earnings models.  In these cases, analysts use other models and ratios, such as the price-to-sales ratio, to value the firm.  Manipulating revenues in these situations help management project positive expectations concerning future growth and induce higher market capitalization.

    Although prior studies and enforcement actions suggest that firms, in particular young and/or internet-based firms, are more likely to manipulate revenues, the purpose of this study is to examine a broad spectrum of firms to determine whether repeated losses and anticipated future losses are an indicator of firms’ likelihood to manipulate revenues in violation of GAAP.

    Design/Method/ Approach:

    The authors use restatement data on U.S. publicly-traded firms for the years 1992-2005 to examine the relationship between revenue misstatements and past and expected future loss or negative operating cash flows.

    Findings:
    • Consistent with prior research, revenues appear relevant to the market valuation of loss and negative cash flow firms, but earnings and operating cash flows do not.
    • The authors find a positive association between the number of anticipated loss years and a firm’s accounts receivables, even after controlling for the firm’s credit policy.
    • The authors find a positive association between the number of actual and anticipated loss years and the probability of a firm manipulating revenue.
    • The authors find that the probability of revenue manipulation is positively related to the level of a firm’s accounts receivable balance.
    Category:
    Corporate Matters
    Sub-category:
    Earnings Management, Earnings Management, Earnings Targets & Management Behavior
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  • Jennifer M Mueller-Phillips
    Revenue Recognition, Earnings Management, and Earnings...
    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, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Revenue Recognition, Earnings Management, and Earnings Informativeness in the Semiconductor Industry
    Practical Implications:

    The results of this study suggest that manufactures that sell products through the distribution channel should defer revenue recognition until products until product return and pricing adjustment uncertainties are resolved. This information is potentially informative for regulators and standard-setters. This study also extends upon a growing stream of research that examines the implications of revenue recognition for firms in different industries and can help students, practitioners, and other financial statement users better understand revenue recognition methods and their associations with earnings management and earnings informativeness.

    For more information on this study, please contact Stephanie J. Rasmussen.
     

    Citation:

    Rasmussen, S. J. 2013. Revenue Recognition, Earnings Management, and Earnings Informativeness in the Semiconductor Industry. Accounting Horizons 27 (1).

    Keywords:
    distributors; earnings informativeness; earnings management; manufacturers; revenue recognition
    Purpose of the Study:

    Revenue recognition is often one of the most important and complex accounting topics and it is imperative for financial statement users to have a strong understanding of revenue recognition and its implication for evaluating firm performance. For the manufacturing industry, product sales to distributors experience product return and pricing adjustment uncertainties until the products and resold to end-customers. Such manufacturers recognize revenue when products are delivered to distributors (sell-in), when distributors resell products (sell-through), or under some combination of these methods. This study examines the implications of these revenue recognition methods for firms in the semiconductor industry.

    Design/Method/ Approach:

    The following hypotheses were first developed for testing:

    H1a: The incidence of earnings management is less likely for sell-through firms compared to sell-in firms

    H1b: The incidence of earnings management is less likely for combination firms compared to sell-in firms.

    H2: Earnings informativeness does not differ among sell-in, sell-through, and combination firms.

    A series of regression models were used to test all three hypotheses. The sample used is quarterly data for all semiconductor firms in the Compustat Fundamentals Quarterly database during 2001-2008. The sample begins in 2001 because SAB 101, which offered additional guidance on revenue recognition disclosures, became effective in that year. The final sample includes 80 unique semiconductor firms with required data for 1,572 firm-quarters.
     

    Findings:
    • Firms deferring revenue recognition until product return and price adjustment uncertainties are partly or fully resolved are less likely to meet or beat analysts’ consensus earnings forecast than firms immediately recognizing revenue for sales to distributors.
    •  Earnings management is more likely when firms recognize revenues before all uncertainties are resolved.
    • Earnings are more informative for firms that defer revenue recognition until products are resold to end-customers.
       
    Category:
    Corporate Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Earnings Management
  • Jennifer M Mueller-Phillips
    Revenue Recognition, Earnings Management, and Earnings...
    research summary posted May 21, 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 
    Title:
    Revenue Recognition, Earnings Management, and Earnings Informativeness in the Semiconductor Industry
    Practical Implications:

    The results of this study suggest that manufactures that sell products through the distribution channel should defer revenue recognition until product return and pricing adjustment uncertainties are resolved. This information is potentially informative for regulators and standard-setters. This study also extends upon a growing stream of research that examines the implications of revenue recognition for firms in different industries and can help students, practitioners, and other financial statement users better understand revenue recognition methods and their associations with earnings management and earnings informativeness.

     

    For more information on this study, please contact Stephanie J. Rasmussen.

    Citation:

    Rasmussen, S. J. 2013. Revenue Recognition, Earnings Management, and Earnings Informativeness in the Semiconductor Industry. Accounting Horizons 27 (1).

    Keywords:
    distributors; earnings informativeness; earnings management; manufacturers; revenue recognition
    Purpose of the Study:

    Revenue recognition is often one of the most important and complex accounting topics, and it is imperative for financial statement users to have a strong understanding of revenue recognition and its implication for evaluating firm performance. For the manufacturing industry, product sales to distributors experience product return and pricing adjustment uncertainties until the products are resold to end-customers. Such manufacturers recognize revenue when products are delivered to distributors (sell-in), when distributors resell products (sell-through), or under some combination of these methods. This study examines the implications of these revenue recognition methods for firms in the semiconductor industry. 

    Design/Method/ Approach:

    The following hypotheses were first developed for testing:

     

    H1a: The incidence of earnings management is less likely for sell-through firms compared to sell-in firms

     

    H1b: The incidence of earnings management is less likely for combination firms compared to sell-in firms.

     

    H2: Earnings informativeness does not differ among sell-in, sell-through, and combination firms.

     

    A series of regression models is used to test all three hypotheses. The sample used is quarterly data for all semiconductor firms in the Compustat Fundamentals Quarterly database during 2001-2008. The sample begins in 2001 because SAB 101, which offered additional guidance on revenue recognition disclosures, became effective in that year. The final sample includes 80 unique semiconductor firms with required data for 1,572 firm-quarters. 

    Findings:
    • Firms deferring revenue recognition until product return and price adjustment uncertainties are partly or fully resolved are less likely to meet or beat analysts’ consensus earnings forecast than firms immediately recognizing revenue for sales to distributors.
    • Earnings management is more likely when firms recognize revenues before all uncertainties are resolved. 
    • Earnings are more informative for firms that defer revenue recognition until products are resold to end-customers. 
    Category:
    Corporate Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Earnings Management
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  • Jennifer M Mueller-Phillips
    Risk-Based Auditing, Strategic Prompts, and Auditor...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.06 Earnings Management, 08.0 Auditing Procedures – Nature, Timing and Extent 
    Title:
    Risk-Based Auditing, Strategic Prompts, and Auditor Sensitivity to the Strategic Risk of Fraud
    Practical Implications:

    This study has implications for accounting firms as well as audit standard setters.  The results suggest that prompting auditors to consider how management might anticipate and exploit the auditor’s risk assessments and resource allocations may help decrease the number of undetected misstatements.  That is, prompting auditors to consider management’s strategic attempts to conceal fraud may direct the auditor’s attention to ostensibly low-risk accounts where fraud may have been intentionally concealed.  This research also suggests that improved audit effectiveness in terms of the increased detection of fraudulent reporting can be obtained without a corresponding loss in audit efficiency.

    For more information on this study, please contact Kendall Bowlin.
     

    Citation:

    Bowlin, K. 2011. Risk-Based Auditing, Strategic Prompts, and Auditor Sensitivity to the Strategic Risk of Fraud. The Accounting Review 86 (4): 1231-1253.

    Keywords:
    audit resource allocation; strategic reasoning; fraud risk; risk-based auditing; experimental economics.
    Purpose of the Study:

    Risk based auditing instructs the auditor to focus audit attention and resources on accounts that are deemed to be high-risk for a given audit engagement.  However, because fraud is strategic in nature and not random, management may intentionally target low-risk accounts for concealing fraudulent activity.  If auditors fail to consider the potential that management may intentionally target low-risk accounts for perpetrating fraud, the auditor may fail to detect the fraud due to a lack of audit procedures for the low-risk audit areas.
    This study uses an experiment to determine if:

    • Management is likely to act strategically by targeting low-risk accounts to conceal misstatements.
    • Auditors fail to detect misstatements in low-risk accounts because audit resources have been allocated to high-risk accounts.
    • If prompting auditors to consider management’s strategic concealment of fraud results in fewer undetected misstatements and changes in audit resource allocation.
       
    Design/Method/ Approach:

    132 accounting students enrolled in upper-division classes participated in a computer based simulation analogous to an audit engagement whereby students were paired such that one participant represented a manager and the other an auditor.  In the game, two buckets representing general ledger accounts were filled with 100 marbles (200 total) by a machine.  Participants were told that one of the buckets was susceptible to an odd-colored marble (representing a misstatement) being included by the machine during the filling process by chance.  The bucket with the chance misstatement occurrence represents a high-risk account existing during the audit process.  Additionally, the manager could override the machine filling either bucket to strategically and intentionally include an odd-colored marble in either of the buckets, representing fraud. 

    The auditor participant was provided a finite number of marbles they could pull from both buckets combined in search of the odd-colored (misstatement) marble.  This guessing distribution is analogous to the allocation of audit resources in an actual audit engagement.  One group of auditors had 101 guesses while another group of auditors could use up to 181 guesses.  After the manager had made their override decision and the auditor had made their resource allocation decisions, the computer informed the participants if a misstatement had been detected by the auditor. 

    In the game, the manager was rewarded for successfully having an undetected misstatement and auditors were penalized for failing to identify misstatements.  Additionally, auditors were incentivized to use few available resources when searching for misstatements.  Finally, some auditors were prompted to consider management’s strategic nature by reporting what they believed the manager assumed about the auditor’s resource allocation, and what the manager would likely do to in response to the anticipated allocation of audit resources.  The remaining auditors received no such prompt.
     

    Findings:
    • In the audit simulation game, managers anticipate that the auditor will allocate more resources to the high-risk account and override existing processes to intentionally include the misstatement in the low-risk account.
    • Auditors who were not prompted to consider how management might strategically anticipate the auditor’s resource allocation process used significantly fewer resources in searching for misstatements in the low risk account resulting in undetected misstatements.
    • Auditors who were prompted to state what they believed the manager assumed about the auditor’s resource allocation and what the manager would likely do to in response to the anticipated allocation of audit resources allocated more of their available, unused resources to the low-risk account but did not allocate more unused resources to the high-risk account.  This suggests that the prompt did not merely increase resource consumption in all audit areas, but only in the low-risk account.  This result held in both the low available resource group as well as the high available resource group.  The increased allocation of unused resources to the low-risk account resulted in fewer undetected misstatements.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Fraud 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
  • Jennifer M Mueller-Phillips
    The Impact on Auditor Judgments of CEO Influence on Audit...
    research summary posted May 25, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 09.0 Auditor Judgment, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    The Impact on Auditor Judgments of CEO Influence on Audit Committee Independence
    Practical Implications:

    The results of this study show that auditors consider the influence that the CEO has over the audit committee in determining whether the audit committee is likely to support the audit team when resolving issues with management. To the extent that auditors feel that CEO influence decreases audit committee support of the external auditor this undermines the independent reporting line that the audit committee should provide. Current audit standards do not address this situation.

    Citation:

    Cohen, J.R., L.M. Gaynor, G. Krishnamoorthy, and A.M. Wright. 2011. The Impact on Auditors Judgments of CEO Influence on Audit Committee Independence. Auditing: A Journal of Practice and Theory 30 (4): 129-147.

    Keywords:
    Audit committee; audit judgments; independence corporate governance; CEO influence; management incentives
    Purpose of the Study:

    Although an audit committee meets regulatory requirements of independence, it is still possible that the CEO of a company has influenced the appointment of its members. This study investigates whether knowledge of the CEO’s prior relationships with audit committee members, either professional or personal, influences the magnitude of an audit adjustment that they anticipate will be waived.

    Design/Method/ Approach:

    Evidence was collected prior to September of 2010. This study is an experiment that was distributed via email. Participants consisted of 65 auditors with ranks ranging from manager to partner. The case materials provided a brief case related to inventory obsolescence and asked participants to determine the audit adjustment they believed should be recorded as well as the audit adjustment they believed would actually be recorded by the hypothetical client

    Findings:

    This study examined jointly the effects of management incentives for earnings management and CEO relationship with the audit committee on waived audit differences, which was measured as the difference between what participants thought the adjustment should be ideally versus what it would be after negotiations with the client.

    • Auditors estimated smaller amounts of the proposed adjustment would be waived if posting the full adjustment would cause the company to miss EPS targets. In other words, auditors are more conservative and waive smaller amounts of proposed adjustments when management has a high incentive to manage earnings.
    • When incentives to manage earnings are low (adjustment would not cause the company to miss EPS targets) then the relationship of the CEO with the audit committee does not influence the amount of the adjustment that is waived.
    • When incentives to manager earnings are high (adjustment would cause the company to miss EPS targets) and the CEO has a relationship with audit committee member(s) auditors anticipate less of the adjustment being waived than when the CEO has no relationship with audit committee member(s). The study attributes this effect to the auditors perceiving greater bargaining power when the CEO has no relationship because the audit committee is more independent and therefore more likely to support the auditor.
    Category:
    Auditor Judgment, Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Board/Audit Committee Composition, Earnings Management, Earnings Management
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