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  • Jennifer M Mueller-Phillips
    Do Financial Restatements Lead to Auditor Changes?
    research summary posted March 9, 2015 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 12.05 Changes in Reporting Formats 
    Title:
    Do Financial Restatements Lead to Auditor Changes?
    Practical Implications:

    Since the reasons for auditor changes are rarely publicly revealed, the authors acknowledge that this study only shows an association, and not a causal relationship, between restatement announcements and subsequent auditor changes. While the authors attempt to control for all known determinants of auditor changes in the empirical testing, it is possible that the results are biased due to omitted variables.

    For more information on this study, please contact Vivek Mande.

    Citation:

    Mande, V. and M. Son. 2013. Do Financial Restatements Lead to Auditor Changes? Auditing: A Journal of Practical & Theory 32 (2): 119-145. 

    Keywords:
    restatement; auditor switch; dismissal; resignation; abnormal market returns
    Purpose of the Study:

    This study examines whether financial restatements are associated with subsequent auditor changes. A financial restatement represents a breakdown in a company’s financial reporting, but, importantly, also of its audit. The paper argues that in response to pressure from capital markets, restating firms will dismiss their auditors to increase audit quality and restore reputational capital lost when the restatements are announced to the investing public. 

    Design/Method/ Approach:

    The sample includes 3,492 auditor changes. The authors model the likelihood of an auditor change as a function of one-period lagged restatements and a set of predetermined lagged control variables used by previous studies. The research relates auditor changes to restatements in the previous year rather than the current year to rule out the possibility that the restatements may have occurred at the urging of the new auditor.

    The first set of control variables relates to auditor characteristics. It is expected that auditor changes occur more frequently when: audit opinions are not clean, auditor tenure is either short or long, audit fees are high, and the auditor does not have industry expertise. The study also includes controls for clients’ financial risks and mergers and acquisitions (M&A). Year and industry dummies are included as controls in the model.

    Findings:

    Using a large sample of restatements and auditor changes, the study finds that the likelihood of auditor-client realignments increases after firms announce restatements. It is also found that the positive association between restatements and auditor turnovers is more pronounced when restatements are more severe and the quality of corporate governance is high. Finally, the study finds that stock market returns surrounding auditor changes increase as the severity of restatements increases. 

    Category:
    Accountants' Reporting
    Sub-category:
    Changes in Reporting Formats, Changes in Reporting Formats, Restatements
  • Jennifer M Mueller-Phillips
    Extreme Estimation Uncertainty in Fair Value Estimates:...
    research summary posted February 19, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.03 Adequacy of Evidence, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    Extreme Estimation Uncertainty in Fair Value Estimates: Implications for Audit Assurance
    Practical Implications:

    The increasing use of uncertain fair value measurements and other estimates in financial statements place an increasingly difficult burden on auditors, who are required to provide a high level of positive assurance that financial statements—including those containing items subject to enormous inherent estimation uncertainty such as those described above—are fairly stated in all material respects. The authors state that auditors are doing their best within the requirements imposed by standard setters and regulators, but also suggest that it is time for those who set and regulate standards to consider ways to more clearly convey where extreme estimation uncertainty exists within financial statements, and to reconsider auditors’ ability to provide positive, high level audit assurance on these inherently uncertain estimates.

    For more information on this study, please contact Steven M. Glover.

    Citation:

    Christensen, B. E., S. M. Glover, and D. A. Wood. 2012. Extreme Estimation Uncertainty in Fair Value Estimates: Implications for Audit Assurance. AUDITING: A Journal of Practice & Theory 31 (1):127-146.

    Keywords:
    Financial statements, audit report, fair value, estimates, materiality, estimation uncertainty
    Purpose of the Study:

    The prevalence of fair value and other estimates in financial statements, as well as their inherent estimation uncertainty, has increased dramatically in recent years. Auditors are placed in a difficult position, as no amount of auditing can remove the underlying estimation uncertainty in reported values that are determined by management-derived estimation models that are hypersensitive to small changes in inputs. Despite the increase in uncertainty, the content of the audit report and the information conveyed on the face of the financial statements have changed relatively little. The study discusses how recent events have seemingly resulted in higher expectations and tighter constraints, thus placing a potentially unrealistic burden on auditors, essentially requiring them to provide a product that may be beyond their reach. Finally, the study questions whether auditing and financial reporting standards provide for effective conveyance of the uncertainty contained in financial statements.

    Design/Method/ Approach:

    The study uses estimates reported by Wells Fargo and General Motors to illustrate how changes in estimation model inputs impact fair value point estimates. The authors compare estimation uncertainty in the point estimates, as reported by management, to audit materiality for the financial statements taken as a whole.  The level of estimation uncertainty highlights potential challenges that auditors face in providing assurance on account balance estimates with uncertainty ranges that often are many times larger than materiality for the financial statements taken as a whole.

    Findings:

    Analysis of disclosures from Wells Fargo and GM show that:

    • Changes to the interest rate input as small as 3.70 and 27.04 basis points (bps) in 2008 and 2007, respectively, would yield material swings in the reported value of Wells Fargo’s mortgage-backed securities—changes that directly impact other comprehensive income. Such small changes are within a reasonable range of interest rates.
    • A 75 bps change to GM’s expected return on pension plan assets resulted in an overstatement of pretax earnings by $510 million and an understatement of the pension obligation by over 42 times audit materiality.

    The Wells Fargo and GM cases highlighted in the study demonstrate the extreme estimation uncertainty in some significant accounting estimates. Hypersensitivity to small changes in unobservable inputs, the large number of such inputs, the large number of estimates in the financial statements of complex entities that involve such inputs, and the level of management discretion involved in accounting estimates all add to the burden placed on auditors in providing assurance surrounding these estimates.

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Adequacy of Evidence, Changes in Reporting Formats
  • Jennifer M Mueller-Phillips
    Investors’ Response to Revelations of Prior Uncorrected M...
    research summary posted April 1, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.03 Impact of New Accounting Pronouncements, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 11.0 Audit Quality and Quality Control, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    Investors’ Response to Revelations of Prior Uncorrected Misstatements
    Practical Implications:

    The results of this study are important in realizing the investor’s perception of audit quality as it relates to SAB No. 108 disclosures. Investors respond negatively to the quantification of prior period misstatement disclosures. The investor also distinguishes between misstatements that are waived by previous auditors and misstatements waived in the current year. Investors react negatively to misstatements that are disclosed in the current year. The investors also react to the importance of the client as it relates to the misstatements that are waived. Investors understand and react to the correlation between client importance, waived misstatements, and client retention. The results are important to understand that investors react to disclosures made under SAB No. 108.

    Citation:

    Omer, T. C., M. K. Shelley, and A. M. Thompson. 2012. Investors' Response to Revelations of Prior Uncorrected Misstatements. AUDITING: A Journal of Practice & Theory 31 (4):167-192.

    Keywords:
    materiality decisions; Staff Accounting Bulletin No. 108; client importance; audit quality; misstatements.
    Purpose of the Study:

    Staff Accounting Bulletin (SAB) No. 108 requires the disclosure of prior-period waived misstatements as well as the use of multiple methods of quantifying misstatements. The rollover method quantifies misstatement on a current year income statement effect, while the iron curtain method quantifies misstatement based on the balance sheet effect. The two methods can differ in terms of the resulting misstatement amounts. The authors of this study examine:

    • Investor responses to the new disclosures under SAB No. 108. Previously waived misstatements that were deemed immaterial by one quantifying method, but then deemed material by the other must now be disclosed.
    • Investor responses to misstatements waived by a predecessor auditor compared to misstatements waived by a current year auditor.
    • Investor perceptions of audit quality based on the new disclosures.
    • Whether client importance is a factor in relation to SAB No. 108 disclosures. 
    Design/Method/ Approach:

    The authors identified 420 firms that disclosed misstatements under SAB No. 108 using EDGAR and Morningstar Document Research. Of these firms, a sample of 272 firms were chosen to complete market return tests on the data. Multivariate regression analysis was employed on firm disclosures from filings made after November 15, 2006. 

    Findings:
    • The authors find that investors respond negatively to SAB No. 108 disclosures. The findings provide evidence that the information affects how the investor views the financial statement information and biases perceptions of audit quality.
    • The authors find that cumulative abnormal returns exist in relation to misstatements initially waived by current auditors. The findings suggest that investors react negatively to waived misstatements by auditors in the current year. Investors distinguish these misstatements from those of waived misstatements by predecessor auditors.
    • The authors find a negative trend of cumulative abnormal returns associated with the investor’s perception of client importance. The findings suggest that investors react according to the perception that misstatements are waived for important clients in order to retain their business. 
    Category:
    Accountants' Reporting, Audit Quality & Quality Control, Auditor Judgment, Standard Setting
    Sub-category:
    Audit Scope & Materiality Judgements, Changes in Reporting Formats, Changes in Reporting Formats, Impact of New Accounting Pronouncements
  • Jennifer M Mueller-Phillips
    Modification of the Audit Report: Mitigating Investor...
    research summary posted July 20, 2015 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    Modification of the Audit Report: Mitigating Investor Attribution by Disclosing the Auditor's Judgment Process.
    Practical Implications:

    This study provides a number of contributions to auditing research. It is the first study to consider the efficacy of modifying the audit report to mitigate negative attributions of auditor performance. This mitigation technique responds to recent calls for changes in the audit report to improve communications to users. Further, examining the efficacy of this technique addresses the validity of claims that the use of an auditor judgment framework will enhance investor confidence. Finally, this study investigates investor assessments of the quality of auditor judgments. This focus is important given the significant role that investor confidence in the audit process plays for the effective and efficient functioning of the capital markets. 

    Citation:

    Wright, A. M., & Wright, S. 2014. Modification of the Audit Report: Mitigating Investor Attribution by Disclosing the Auditor's Judgment Process. Behavioral Research In Accounting 26 (2): 35-50.

    Keywords:
    attribution theory, audit report modifications, auditing
    Purpose of the Study:

    There is a large body of research documenting the prevalence of an outcome effect. That is, once an event occurs, people ascribe the causes to factors they can readily associate with the event. The outcome effect is of particular relevance to the field of auditing in that auditors must often make difficult professional judgments, such as assessing the allowance for doubtful accounts, asset impairment, revenue recognition, and whether to issue a going-concern modified opinion for a company with financial difficulties, which investors, regulators, or juries may later question once the outcome is known.

    The Advisory Committee on Improvements to Financial Reporting (CIFR 2008) expressed significant concerns that preparers and auditors are often second guessed after making difficult judgments when subsequent events lead to questions about the validity of previous judgments, such as an earnings restatement.  CIFR argued that professional judgments are essential to reflect the economic substance of transactions and, thus, enhance the quality of financial reporting and auditing.

    The purpose of this study is to examine the efficacy of modifying the auditor’s report to provide decision-process information as a means to mitigate unfavorable investor auditor attributions.

    Design/Method/ Approach:

    This study entails an experiment with two conditions manipulated between-subjects: judgment process information (JPI PRESENT) and no judgment process information (JPI ABSENT). Seventy-two nonprofessional investors, MBA students from a large public university in the Northeast, participated in an experiment where they were randomly assigned to a judgment process information condition (JPI PRESENT), as suggested by CIFR, and a no judgment process information condition (JPI ABSENT). The evidence was gathered prior to November 2013. 

    Findings:

    The findings indicate that subsequent to a bankruptcy, the disclosure of the auditor’s careful decision process significantly enhanced auditor performance attributions in terms of lower assessments of the extent to which auditor’s actions contributed to investor losses, greater perceived auditor competence and diligence, and increased beliefs that the auditor made the right decision. In all, the results suggest that the disclosure of the auditor’s decision process is a promising tool to mitigate investors’ unfavorable auditor attributions. The findings lend credibility to the claims by CIFR that the establishment of a professional judgment framework can be an effective means to address the outcome effect and thereby promote auditors’ and preparers’ exercise of professional judgment.

    Category:
    Accountants' Reporting
    Sub-category:
    Changes in Reporting Formats
  • Jennifer M Mueller-Phillips
    Office-Level Characteristics of the Big 4 and Audit Report...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual, 05.08 Impact of Office Size, 10.0 Engagement Management, 10.01 Budgeting and Audit Time Management, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    Office-Level Characteristics of the Big 4 and Audit Report Timeliness.
    Practical Implications:

    This study provides further support for the importance of office-specific characteristics on audit and financial reporting outcomes and provides evidence of the benefit of office-specific industry expertise. The study should be of interest to financial reporters and audit firms interested in reducing audit report lag times and to regulators and investors interested in increasing the timeliness of financial reporting information.

    Citation:

    Whitworth, J. D., and T. A. Lambert. 2014. Office-Level Characteristics of the Big 4 and Audit Report Timeliness. Auditing: A Journal of Practice & Theory 33 (3): 129-152.

    Keywords:
    audit report lag, industry expertise, office-level characteristics, product specialist strategy, timeliness
    Purpose of the Study:

    Timeliness of annual financial reporting information has long been a concern of investors, regulators, financial reporters, and auditors. Recent changes in the audit and financial reporting environment have resulted in longer audit report lags and have increased the importance of identifying factors associated with a timely audit. The authors examine timeliness implications of office specific attributes of the audit firm. Specifically, they examine whether office-specific industry expertise, office size, and the importance of the client to the local office are associated with audit delay (i.e., the time between fiscal year-end and the audit report date). The authors explore the sensitivity of the results to various measures and consider the impact of earnings quality. They examine two types of industry expertise and whether the aforementioned audit firm attributes are associated with a propensity to issue an early earnings announcement.

    Design/Method/ Approach:

    The authors use a regression model to test their hypotheses. They obtain audit delay, audit fees, and other audit-related information from Audit Analytics and financial information from Compustat for the years 20032008. Combining the Audit Analytics and Compustat samples provides a sample of 14,948 firm-year observations after excluding firms not audited by one of the Big 4 auditors.

    Findings:
    • The authors find that office-specific industry expertise is negatively associated with audit delay (for all but the largest quartile of firm offices, suggesting that such expertise allows audit firms and their clients to realize efficiencies within the audit process in the form of reduced post-fiscal-year-end audit time.
    • However, sensitivity analyses suggest that office-specific industry expertise is not significantly associated with audit delay for firms with the lowest accruals quality.
    • Office size and client importance are both positively associated with audit delay.
    • However, the most important clients are associated with a more timely audit.
    • Office-specific industry expertise is positively associated with the propensity to announce earnings substantially early and such expertise garnered via a product-specialist strategy is positively associated with audit delay relative to a low-cost specialist strategy.
    Category:
    Accountants' Reporting, Audit Team Composition, Engagement Management
    Sub-category:
    Budgeting & Audit Time Management, Changes in Reporting Formats, Impact of Office Size, Industry Expertise – Firm and Individual
  • Jennifer M Mueller-Phillips
    Perceptions and Misperceptions Regarding the Unqualified...
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.01 Changes in Reporting Formats, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    Perceptions and Misperceptions Regarding the Unqualified Auditor’s Report by Financial Statement Preparers, Users, and Auditors
    Practical Implications:

    The audit reporting model has been an item on the recent PCAOB agendas.  The findings of this study show there are still large gaps that exist between the intended communication of the audit report as stipulated in auditing standards and the perceptions by users, preparers, and auditors.  This study provides evidence to be used in the current debate about updating the current auditor’s report to provide more meaningful information.

    Citation:

    Gray, G.L., J.L. Turner, P.J. Coram, and T.J. Mock. 2011. Perceptions and misperceptions regarding the unqualified auditor’s report by financial statement preparers, users, and auditors. Accounting Horizons 25 (4): 659-684.

    Keywords:
    auditor’s report; audit expectation gap; auditor disclosures; audit stakeholders; focus groups
    Purpose of the Study:

    This research project was commissioned by the AICPA’s Auditing Standards Board (ASB) and the International Audited and Assurance Standards Board (IAASB) because of concern that financial statement users may not understand “intended communications” contained in the auditor’s report.  The purpose of this study is to identify the perceptions and misperceptions regarding the current unqualified auditor’s report and to identify suggestions to improve the auditor’s reports. 

    Design/Method/ Approach:

    Focus groups were conducted for five different stakeholder groups:

    • CFOs (preparers of financial statements)
    • Bankers (users of financial statements)
    • Financial analysts (users of financial statements)
    • Non-professional investors (users of financial statements)
    • External auditors

    The focus group discussions focused on three research areas:

    • overall perception of the audit report;
    • perception about key concepts already incorporated or that should be incorporated;
    • suggestions and challenges for improving the communication of the report.
    Findings:

    The authors found a lack of consensus among all stakeholders as to what is the intended communication of the auditor’s report. Financial statement users only look at the report to see if the opinion is unqualified and if the auditor is a Big 4 auditor. Further, bankers and analysts consider the report to be boilerplate and do not read the report.  These groups also said no matter how much additional content is added to the report they would still not read the report if the additional content is more boilerplate information. Concepts of level of assurance, reasonable assurance, and high level of assurance are not clear to all stakeholder groups. Most participants believed the PCAOB-based audit report is superior to the ASB-report because of the inclusion of reporting on internal controls.

    Category:
    Standard Setting, Accountants' Reporting
    Sub-category:
    Changes in Reporting Formats
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  • Jennifer M Mueller-Phillips
    Risk Disclosure Preceding Negative Outcomes: The Effects of...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    Risk Disclosure Preceding Negative Outcomes: The Effects of Reporting Critical Audit Matters on Judgments of Auditor Liability
    Practical Implications:

    The results of this study are important for both regulators and auditors alike.  Despite auditor concerns that a requirement to disclose CAMs would increase litigation risk, the results of this study indicate that they may actually reduce, or at the very least, have no effect on litigation risk.  This is the case even when the subsequently identified misstatement is not related to the risks documented in the CAM.  Furthermore, standard setters should take comfort in these findings as they weigh the potential benefits of adopting a CAM disclosure requirement because the results indicate that the implementation of CAMS would not increase the risk of litigation to auditors. 

    Citation:

    Brasel, K., M. M. Doxey, J. H. Grenier, and A. Reffett. 2016. Risk Disclosure Preceding Negative Outcomes: The Effect of Reporting Critical Audit Matters on Judgments of Auditor Liability.  The Accounting Review 91 (5): 1345-1362.

    Keywords:
    audit litigation, audit report, negligence, liability, critical audit matters, disclosure
    Purpose of the Study:

    The PCAOB has proposed a change to the standard audit reporting model to include the disclosure of critical audit matters (CAMs).  While there is evidence that investors support additional auditor disclosures like CAMs, many other stakeholders oppose the implementation of a requirement to produce such ex ante risk disclosures.  The opposition, which includes audit firms, academics, and attorneys, assert that this type of requirement would increase litigation against auditors.

    However, CAMs require disclosure of increased risk prior to a subsequently revealed misstatement.  This feature of the proposed disclosure also makes it possible that CAMs may reduce litigation risk because jurors will view the plaintiff as being forewarned of an increased risk.  To the extent that jurors view a misstatement as having been more foreseeable to the plaintiff, this study predicts that jurors will experience less negative affect when considering plaintiff losses because the plaintiff was forewarned.  Below are two objectives the authors address in their study:

    • Examine whether auditors face increased litigation risk when auditors disclose a CAM that is related to a subsequently revealed misstatement.
    • Examine whether auditors face increased litigation risk when auditors disclose a CAM that is unrelated to a subsequently revealed misstatement.
    Design/Method/ Approach:

    The authors conducted an experiment with jury-eligible participants to examine their research questions.  The study included four different disclosure conditions: (1) control – no mention of CAMs, (2) disclosure of a CAM related to the subsequently revealed misstatement, (3) disclosure of a CAM that is unrelated to the misstatement, (4) an explicit statement that the auditors did not identify any CAMs.  Additionally, two different types of misstatements were examined to determine whether the type of misstatement affected the jurors’ propensity to find the auditor negligent: (1) an overstatement of inventory, (2) an understatement of an environmental restoration liability.  Participants read a case study about an audit that failed to detect a material financial statement fraud and then assessed auditor negligence.

    Findings:
    • When auditors failed to detect an overstatement of inventory, participants were less likely to find the auditor negligent when the auditor disclosed a related CAM, relative to both when there was no mention of CAMs and to when the auditor explicitly stated that there were no CAMs.  However, when auditors failed to detect the understatement of the client’s environmental restoration liability, participants were neither more nor less likely to find the auditors negligent when the auditor disclosed a related CAM.  This difference in outcomes was due to participant perceptions that the understatement of the client’s environmental restoration liability was more foreseeable than the inventory misstatement in the control condition thereby reducing the impact of the CAM.
    • Disclosing a CAM that was unrelated to the undetected misstatement did not affect jurors’ auditor liability judgments relative to current reporting standards.  However, disclosure of an unrelated CAM did reduce jurors’ negligence assessments relative to a condition in which the auditor explicitly stated there were no CAMs.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Changes in Reporting Formats, Changes in Reporting Formats, Litigation Risk
  • Jennifer M Mueller-Phillips
    Rules-Based Accounting Standards and Litigation
    research summary posted September 26, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats, 15.0 International Matters, 15.02 IFRS Changes – Impacts 
    Title:
    Rules-Based Accounting Standards and Litigation
    Practical Implications:

    This study exploits variation in U.S. accounting standards to study the effect of rules-based standards on litigation. It provides evidence of an association between rules-based accounting standards and a lower incidence of securities class action litigation. This evidence informs the debate about switching from a more rules-based U.S. GAAP to a more principles based IFRS.


    For more information on this study, please contact John McInnis.
     

    Citation:

    Donelson, D., J. McInnis, and R. Mergenthaler. 2012. Rules-Based Accounting Standards and Litigation. The Accounting Review 87 (4): 1247-1279.

    Keywords:
    securities litigation, safe harbor, rules-based standards, principals-based standards
    Purpose of the Study:

    There is substantial debate about whether U.S. GAAP is too rules-based and should be scrapped for a more principles-based set of standards such as IFRS. Rules-based standards, which explicitly state bright-line thresholds and have detailed implementation guidance, are often criticized because they are said to shield firms from litigation. Critics argue that when firms do not clearly admit to an error by issuing a restatement they can rely on a “safe harbor” defense provided by rules-based standards. Since detailed standards require little managerial judgment and are objectively implemented prosecutors have difficulty calling managerial discretion into question thus creating a “safe harbor” within the rules. Furthermore, critics claim that even when firms admit to a misstatement by restating their financial statements, the complex nature of rules-based standards allows firms to avoid litigation due to the difficulty in ruling out the potential for unintentional mistakes (i.e. rules based standards provide a “innocent misstatement” defense).
        On the other hand, proponents of rules-based standards argue that they provide plaintiffs a “roadmap” to successful litigation. The specificity of rules-based guidance provides plaintiffs the ability to establish intent in situations where they clearly ignored specific guidance and were forced to restate as a result. This argument is essentially the opposite of the “innocent misstatement” argument.
    This study intends to provide evidence that is pertinent to this debate. The authors attempt to determine whether rules-based standards are associated with the incidence and outcomes of securities class action litigation.
     

    Design/Method/ Approach:


    The authors exploit variation in the extent to which some U.S. GAAP standards are more rules-based and some are more principles-based. They use data on resolved securities class action lawsuits filed from 1996-2005 that allege GAAP violations as well as restatement data from the same time period. They perform three analyses with this data:

    • Using a sample of lawsuits unrelated to restatements the authors test whether plaintiffs tend to allege violations of principles-based standards in order to leverage management’s more subjective implementation.
    • Using a sample of all restating firms, the authors test whether restatements are more likely to lead to litigation if they are related to rules-based statements in order to understand if rules-based standards actually provide a “roadmap” to successful litigation.
    • Using a sample of lawsuits the authors test whether meritorious lawsuit outcomes are associated with alleged violations rules-based standards.
       
    Findings:
    • The authors find that in cases where litigation is not connected to a restatement, plaintiffs allege violations of principles-based standards more often than violations of rules-based standards. This evidence is consistent with rules-based standards providing a “safe harbor” from litigation prompting them to be cited less often in litigation.
    • The authors find that when a restatement occurs, violations of rules-based standards are associated with a lower probability of litigation. This finding does not support the idea that rules-based standards provide a “roadmap” to successful litigation. Instead it is consistent with the “innocent misstatement” argument.
    • The authors find no relationship between rules-based standards and litigation outcomes.


    These findings are indicative of rules-based standards deterring litigation. However, the authors note that the overall effect of a shift to a more principles-based accounting system is difficult to predict due to numerous additional factors that would accompany this type of change.
     

    Category:
    Accountants' Reporting, International Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Changes in Reporting Formats, IFRS Changes – Impacts, Litigation Risk
  • Jennifer M Mueller-Phillips
    The Auditor's Reporting Model: A Literature Overview and...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    The Auditor's Reporting Model: A Literature Overview and Research Synthesis.
    Practical Implications:

    Though modest improvements have been made in recent years, confusion still exists as to the content and meaning of the auditor’s report (e.g., users are confused as to the auditor’s responsibilities, the audit process, and the level of assurance provided). The authors suggest that the communicative value of the auditor’s report can be enhanced by including additional disclosures.

    Citation:

    Church, B. K., S. M. Davis, and S. A. McCracken. 2008. The Auditor's Reporting Model: A Literature Overview and Research Synthesis. Accounting Horizons 22 (1): 69-90.

    Keywords:
    auditor’s reporting decision, auditor’s report, accounting standards
    Purpose of the Study:

    This article examines academic research to contribute to the Public Company Accounting Oversight Board’s (PCAOB) project on the auditor’s reporting model. The authors develop a framework to organize a discussion of the literature in light of key questions raised at two Standing Advisory Group (SAG) meetings. They trace the historical development of the auditor’s report and then delve into relevant research that focuses on the auditor’s reporting decision and the content of the auditor’s report.

    This article is important because it provides a state of the art basis to understand the auditor’s reporting model. Such an understanding is necessary to assess the merits of the current model and to establish its shortcomings. Throughout the article, the authors identify areas needing change and areas needing further study.

    Design/Method/ Approach:

    The authors review three lines of research that underlie the auditor’s reporting decision.

    • First, they look at the collection and evaluation of audit evidence, targeting research on factors that directly affect the auditor’s reporting decision.
    • Second, they consider the role of accounting standards in shaping financial statements. The authors look at research on rules- versus principles-based standards and how such standards affect the auditor’s interpretation and application of accounting principles (i.e., GAAP).
    • Third, the authors ponder the role of the auditor in the financial-reporting process. They examine research on auditor-client negotiations, which are integral in the preparation of financial statements, and then look at studies on the auditor’s decision to book or waive misstatements.

    The authors then examine three lines of research on the content of the auditor’s report.  

    • First, they summarize studies that elicit and compare users’ and auditors’ assessments of the report to identify differences that create an expectations gap.
    • Next, they look at research on the market’s reaction to the issuance of the auditor’s report.
    • Finally, the authors evaluate studies on disclosure of additional information in the auditor’s report (e.g., materiality levels) and weigh whether users would benefit from such disclosures.
    Findings:
    • The authors’ review of the extant literature suggests that the audit process is affected by factors that, typically, are assumed to be irrelevant (e.g., the sequence of evidence collection or the specific auditor performing a task).
    • They also find that the nature of accounting standards (principles-based versus rules-based) can influence the audit process, via an effect on auditor-client negotiations.
    • As for the auditor’s report, they conclude that it has symbolic value (i.e., it represents the auditor’s work), but that it provides little communicative value (i.e., it conveys little information).
    Category:
    Accountants' Reporting
    Sub-category:
    Changes in Reporting Formats
  • Jennifer M Mueller-Phillips
    The Effects of Critical Audit Matter Paragraphs and...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    The Effects of Critical Audit Matter Paragraphs and Accounting Standard Precision on Auditor Liability
    Practical Implications:

    These results provide new insight into conflicting results in contemporaneous studies that investigate the relationship between CAMS and auditor liability. The results will also be informative to the PCAOB and SEC because they highlight a potential unintended consequence of the proposed audit reporting model and reinforce the importance of the two oversight bodies considering the relationship between their regulatory actions. 

    Citation:

    Gimbar, C., B. Hansen and M. E. Ozlanski. 2016. The Effects of Critical Audit Matter Paragraphs and Accounting Standard Precision on Auditor Liability. The Accounting Review 91 (6): 1629 – 1646.

    Keywords:
    PCAOB, audit reporting, auditor litigation, critical audit matter (CAMs), and accounting standard precision
    Purpose of the Study:

    The PCAOB is currently considering substantial changes to the audit reporting model that would require auditors to disclose critical audit matters (CAMs) in the audit report. CAMs discuss areas of the audit that required a significant amount of professional judgment to evaluate appropriately or that posed the most difficulty in obtaining and evaluating evidence. Although this additional disclosure is expected to increase the information content of the audit report for investors, several interest groups have expressed concerns that CAMs will also increase the audit profession’s liability risks. In addition, the SEC, FASB and IASB have the potential to make sweeping changes to accounting standards in the coming years. These changes have the potential to significantly impact assessments of auditor liability. The purpose of this study is to investigate how jurors’ perceptions of auditor liability are affected by CAMs, accounting standard precision, and the interaction between CAMs and accounting standard precision. 

    Design/Method/ Approach:

    The authors use an experiment in which participants, acting the role of jurors, evaluate auditor liability for an alleged misstatement of financial statements due to inaccurate lease reporting and the subsequent bankruptcy of an audit client.  Following the experiment, the authors use mediation analysis to provide additional evidence regarding participants’ decision making underlying the hypothesized and observed significant association between auditor liability under precise accounting standards and both related and unrelated CAMs. 

    Findings:
    • The authors find that when no CAM is present, the participants have a lower propensity to issue verdicts against the auditor when the client’s accounting conforms to a precise standard than under an imprecise standard with the same accounting treatment.
    • The authors find that under precise standards and an accounting treatment that meets the letter of the law, both related and unrelated CAMs increase auditor liability.
    • The authors observe an interaction between standard precision and CAMs such that CAMs increase auditor liability by a lesser amount under imprecise standards than precise standards.
    • The authors find that, under precise accounting standards, related CAMs increase jurors’ assessments of the auditor’s control over financial reporting, and this increased level of perceived control mediates the relationship between related CAMs and jurors’ assessments of the auditor’s liability.
    • The authors find that unrelated CAMs are significantly associated with a decrease in participants’ evaluation of the audit performed, and this result mediates the relationship between unrelated CAMs and auditor liability under precise standards. 
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Changes in Reporting Formats, Impact of PCAOB

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