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  • Jennifer M Mueller-Phillips
    Abnormal Audit Fees and Audit Quality: The Importance of...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 11.0 Audit Quality and Quality Control, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management.
    Practical Implications:

    This paper provides new evidence on the fee-quality relationship using the propensity to use income-increasing discretionary accruals to meet or beat analysts' forecasts. The evidence in this paper suggests that abnormal audit fees are positively related to audit quality. This result is consistent with concerns raised by regulators that lower audit fees could reflect a lower level of effort provided by the auditor. This is important, given the trend of declining audit fees in recent years. By finding different results using a more focused sample of firms with the incentive and ability to manage earnings, this study highlights the importance of considering the context when performing tests of earnings management. This information is of interest to regulators, such as the SEC.

    Citation:

    Eshleman, J. D., & P. Guo. 2014. Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management. Auditing: A Journal of Practice & Theory 33 (1): 117-138.

    Keywords:
    audit fees, audit quality, discretionary accruals, meet-or-beat, earnings management
    Purpose of the Study:

    In this study, the authors attempt to shed light on the conflicting evidence by performing a study of the relationship between abnormal audit fees and audit quality using a new research design. Specifically, the authors examine whether clients paying abnormal audit fees are more or less likely to use discretionary accruals to meet or beat the consensus analyst forecast.

    A growing body of accounting literature examines the relationship between audit fees and audit quality. Researchers are interested in this relationship because, ex ante, it is not clear whether receiving higher fee revenue from a client will improve audit quality or harm it. On the one hand, it could be argued that an auditor who receives abnormally high audit fees from a client will lose their independence and allow the managers of the client firm to engage in questionable accounting practices. However, it is also possible that audit fees are a measure of audit effort, i.e., higher fees indicate that the auditor worked more hours, signaling greater effort. To the extent that audit fees are a measure of audit effort, low audit fees could harm audit quality.

    Design/Method/ Approach:

    Audit fee and auditor data are obtained from Audit Analytics, financial statement data are obtained from Compustat, and analyst forecast data are obtained from the I/B/E/S database. The authors perform tests on two samples of 4,476 firm-years and 1,670 firm-year observations spanning 2000 to 2011.

    Findings:

    The authors find that clients paying higher abnormal audit fees are significantly less likely to use discretionary accruals to meet or beat the consensus analyst forecast. If abnormal audit fees are held at their mean, a one-standard-deviation increase in abnormal audit fees decreases the client's likelihood of using discretionary accruals to meet or beat the consensus forecast by approximately 5 percent. This is consistent with higher audit fees being indicative of greater auditor effort and, ultimately, better audit quality. The authors obtain similar results whether they use the audit fee model of Choi et al. (2010), the one proposed by Blankley et al. (2012), or their own audit fee model.

    Category:
    Audit Quality & Quality Control, Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Earnings Management
  • Jennifer M Mueller-Phillips
    Audit Quality and Analyst Forecast Accuracy: The Impact of...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.04 Industry Experience, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Audit Quality and Analyst Forecast Accuracy: The Impact of Forecast Horizon and Other Modeling Choices
    Practical Implications:

    This paper contributes to research examining the determinants and impacts of audit quality by identifying the limitations of aspects of metrics employed in recent research that could have been utilized by practitioners and suggesting useful alternate metrics for investigating the impact of audit quality on the properties of analysts’ forecasts, including the usefulness of audited financial information and the prediction of future performance. 

    Citation:

    Wu, Y. and Wilson, M. 2016. Audit Quality and Analyst Forecast Accuracy: The Impact of Forecast Horizon and Other Modeling Choices. Auditing: A Journal of Practice and Theory 35 (2): 167-185. 

    Keywords:
    audit quality, auditor industry specialization and analyst forecast accuracy
    Purpose of the Study:

    Many studies examine the influence of auditor characteristics on the properties of analyst forecasts of client firms’ earnings. A common argument is that audit quality affects the accuracy of analyst forecasts or closely associated metrics. However, there is considerable divergence in the posited theoretical association between audit quality and forecast accuracy and in the empirical associations reported. The majority of these studies rely exclusively on measures of forecast accuracy based on analysts’ end-of-year forecasts. The authors argue that metrics drawn from these forecasts are noisy indicators of the impact of audit quality because there are convincing reasons why superior audit quality may affect the accuracy of the metrics in either direction. Financial reports of clients of higher quality auditors may be more useful for forecasting future earnings which in turn may increase forecast accuracy; however, higher quality auditors may be more effective in disallowing client attempts to manage earnings. Thus, if an auditor provides superior quality services to their client, then it is conceivable that these competing effects will offset each other, resulting in no net impact on forecast accuracy. As a result, the authors argue that the properties of analysts’ beginning-of-year forecasts provide superior measures of any of the impacts of auditor characteristics because these forecasts are less likely to induce benchmark-beating incentives for earnings manipulation and because audited financial information has a greater relative impact on analysts’ information set at the beginning-of-year than at the end-of-year. 

    Design/Method/ Approach:

    Focusing on measures of audit firm industry specialization common to papers with competing predictions and results, the authors demonstrate the noisiness and sensitivity to model specification of test based on end-of-year forecast accuracy and show that similar tests based on beginning-of-year forecast accuracy generate predicted results that are consistent over a range of modeling approaches. 

    Findings:
    • The authors find that analysts’ beginning-of-year forecasts are a potentially superior proxy for auditors’ impact on the properties of analyst forecasts because the “decision usefulness” impact of an audit is at its strongest soon after those reports are released and is likely to dominate any effect on audit quality on client benchmark-beating behavior.
    • The authors also identify the importance of other modeling choices facing researchers, such as the deflation of forecast errors and controls for the endogenous selection of industry specialist auditors. 
    Category:
    Audit Quality & Quality Control, Corporate Matters
    Sub-category:
    Earnings Management, Industry Expertise – Firm and Individual
  • Jennifer M Mueller-Phillips
    Audit Quality and the Trade-Off between Accretive Stock...
    research summary posted June 21, 2013 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality, 14.0 Corporate Matters, 14.01 Earnings Management, 14.05 Earnings Targets and Management Behavior 
    Title:
    Audit Quality and the Trade-Off between Accretive Stock Repurchases and Accrual-Based Earnings Management
    Practical Implications:

    This study provides evidence that is important to corporate governance decisions. The results suggest that hiring a high quality auditor to constrain accruals earnings management may result in management’s use of real earnings management as a substitute. Real earnings management involves potentially costly deviations from “business as usual.” Consequently, it may be important to consider other corporate governance measures aimed at constraining real earnings management concurrently with the decision to hire a high quality auditor. 

    Citation:

    Burnett, B., B. Cripe, G. Martin, and B. McAllister. 2012. Audit Quality and the Trade-Off between Accretive Stock Repurchases and Accrual-Based Earnings Management. The Accounting Review 87 (6): 1861-1884.

    Keywords:
    Real earnings management; stock repurchases; audit quality; audit industry specialization
    Purpose of the Study:

    When managers decide to manipulate earnings they must make a choice about how they will achieve their goal. The two broad methods for manipulating earnings are the manipulation of accounting choices and estimates (i.e. accrual earnings management) and the manipulation of real business practices (i.e. real earnings management). The authors of this study argue that either method could be considered questionable because the intent of earnings management is to mislead investors or influence accounting-based contractual arrangements. The choice between the two methods is of interest because governance activities that are taken to constrain one type of earnings management behavior may result in another.

    This study investigates whether audit quality affects management’s choice between accrual earnings management and accretive stock repurchases when firms manage earnings per share (EPS) to meet or beat analysts’ forecasts. The use of accretive stock repurchases to manage EPS is a type of real earnings management that involves the firm repurchasing shares in order to boost EPS figures. The authors believe that, because this form of real earnings management can be done quickly and with little disclosure, it is a good comparison to accrual management in this scenario. The authors make and test the following hypotheses (stated in null form):

    H1: High audit quality is unrelated to the use of accretive stock repurchases to meet or beat consensus analysts’ forecasts.

    H2: High audit quality is unrelated to the trade-off between the use of accretive stock repurchases and accrual-based earnings management to meet or beat consensus analysts’ forecasts.

    Design/Method/ Approach:

    The authors use data on publicly-traded companies that meet or beat analysts’ earnings forecasts but would have missed these forecasts if they had not managed their earnings. Using this subset of firms, the authors compare companies that hired an industry specialist auditor to those that had a non-specialist auditor. The sample period includes data from years 1989-2009.

    Findings:

    The authors document (1) a positive and significant relationship between having a high quality auditor and employing accretive stock repurchases in order to meet or beat EPS estimates, and (2) a negative and significant relationship between having a high quality auditor and employing accrual-based earnings management in order to meet or beat EPS estimates. The authors claim that these results suggest the use of accruals-based earnings management is constrained by high quality auditors and, as a result, when managers are faced with a high quality audit they employ accretive stock repurchases instead of accrual-based earnings management to meet or beat analysts’ EPS forecasts.

    Category:
    Audit Quality & Quality Control, Corporate Matters
    Sub-category:
    Earnings Management, Earnings Targets & Management Behavior
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  • Jennifer M Mueller-Phillips
    Capital Structure, Earnings Management, and Sarbanes-Oxley:...
    research summary posted November 17, 2014 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Capital Structure, Earnings Management, and Sarbanes-Oxley: Evidence from Canadian and U.S. Firms
    Practical Implications:

    This study is important because an increase in a firm’s debt level also increases the probability that the firm goes bankrupt.  Thus, it behooves managers and auditors to understand the way that SOX and earnings management impact the percentage of one component of debt (here, long-term debt) in a firm.

    The result contained in the first bullet of the “Findings” section suggests that, even though SOX spurs managers to report more accurate financials, which tend to lower the cost of equity financing, managers still find it cheaper to use debt.  The result in the second bullet of the “Findings” section suggests that managers anticipate a higher cost of debt after SOX and acquire debt while it is relatively cheap.  This result is consistent with research papers that find that market participants rationally expect Congress to pass legislation (e.g., SOX) that protect investors and improves firm behavior in the aftermath of financial or accounting scandals.  Thus, managers rationally expect long-term debt to be more expensive after SOX and, accordingly, take on more of it before SOX. 

    The result contained in the third bullet of the “Findings” section suggests that SOX requires managers who reported less transparent financial statements before SOX to report more transparent financials after SOX.  Since the more transparent financials are likely to be more volatile than and weaker than earlier financials, many managers will not be able to issue bonds to fund projects.  Thus, if those managers wish to take on projects, they will need to finance those projects by issuing equity, leading to lower long-term debt ratios.  Oppositely, SOX’s disclosure requirements will prompt managers who reported transparent earnings before SOX to continue to do so after SOX.  Thus, lenders will reward those managers by allowing them to take on additional long-term debt to finance the projects that the managers wish to undertake.

    For more information on this study, please contact Kelly E. Carter.

    Citation:

    Carter, K. 2013. Capital structure, earnings management, and Sarbanes-Oxley:  Evidence from Canadian and U.S. firms. Accounting Horizons 27 (2): 301-318.

    Keywords:
    Capital structure; earnings management; debt ratio; Sarbanes-Oxley.
    Purpose of the Study:

    The effect of the Sarbanes-Oxley Act (SOX) on earnings quality has been documented in the academic literature.  However, SOX’s effect on other aspects of firms is not known.  The purpose of this study is to document the effect of SOX and earnings quality on the capital structure of firms.  I measure earnings quality via accrual-based earnings management.  I measure capital structure via the ratio of long-term debt to assets (i.e., the long-term debt ratio).

    Design/Method/ Approach:

    This study uses quarterly data from 2000 to 2004, providing a relatively narrow window within which to investigate the effects of SOX’s announcement on capital structure.  Since SOX applies to firms that are listed on a U.S. exchange, the author segments firms by listing location.  Test firms include U.S. firms that are listed on a U.S. exchange as well as Canadian firms that are cross-listed in the U.S.  Control firms are Canadian firms that are listed in Canada.  The pre- versus post-SOX differences in the long-term debt ratios of test firms are compared to those of control firms.

    Findings:
    • SOX is associated with higher long-term debt ratios, as firms listed in the U.S. raise their long-term debt ratios by two to three percentage points.
    • The increase in long-term debt ratios occurs in the two quarters prior to SOX.
    • Firms that heavily manage earnings prior to SOX use less debt after SOX, while firms that lightly manage earnings prior to SOX use more debt after SOX. 
    Category:
    Corporate Matters
    Sub-category:
    Earnings Management
  • Jennifer M Mueller-Phillips
    CEO and CFO Equity Incentives and the Pricing of Audit...
    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, 14.0 Corporate Matters, 14.01 Earnings Management, 14.07 Executive Compensation 
    Title:
    CEO and CFO Equity Incentives and the Pricing of Audit Services
    Practical Implications:

    Our study highlights the importance of taking into account executive incentive plans in improving the understanding of auditors’ risk assessment and pricing decisions, in support of the current professional audit standards. The findings that auditors respond to CEO and CFO equity incentives differently have significant implications for the corporate governance reforms and the design of optimal corporate executive compensation policies. Following the accounting scandals in the early 2000s, there has been increased regulatory and legislative scrutiny on corporate governance. Especially, regulators have recognized CFOs as the individuals bearing responsibilities for the integrity of financial information. Our paper lends support to the regulatory inclusion of CFOs as accountable individuals, and to concerns that firms should exercise caution in compensating CFOs using equity-based tools.

     

    For more information on this study, please contact Yonghong Jia.

    Citation:

    Billings, B. A., X. Gao, and Y. Jia. 2014. CEO and CFO Equity Incentives and the Pricing of Audit Services. AUDITING: A Journal of Practice & Theory 33 (2): 1-25

    Keywords:
    Audit fees; auditor risk assessment; equity incentive; accounting manipulation
    Purpose of the Study:

    The alleged perverse role of managerial incentives in accounting scandals and the distinctive role of auditors in identifying and intervening in attempted earnings manipulation, highlight the importance of explicitly considering executive incentive plans by auditors in the auditing process. However, there is little systematic evidence on auditors’ responses to the sizable holdings of equity by executives, a phenomenon that is particularly common in US public companies. In this paper, we investigate the association between executive equity incentives and auditors’ risk assessment and consequently audit pricing decisions. We examine auditors’ responses to equity incentives for CEOs and CFOs separately and jointly and inquire whether the responses are different.  

    Design/Method/ Approach:

    We gather information on audit fees, non-audit fees, auditors, internal control information from AuditAnalystics, executive compensation data from ExecuComp, and financial variables from Compustat, for the years 2002 through 2009. We estimate standard audit fee regression models that include variables to capture executive equity incentives and control variables that are identified to be determinants of audit fees by prior studies. 

    Findings:

    Using different measures of executive equity incentives and following standard audit service pricing research designs, we document compelling evidence that auditors adjust the price of their audit services upward in response to CFO equity incentives, suggesting that auditors perceive heightened audit risk associated with CFO equity incentives. We find some evidence that auditors view CEO equity incentives as innocuous or even beneficial in term of audit risk. We further demonstrate that the presence of internal control problems augments the positive relation between CFO equity incentives and audit fees, suggesting particularly elevated risk concerning CFO equity incentives perceived by auditors when internal controls are flawed. 

    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Earnings Management, Executive Compensation
  • Jennifer M Mueller-Phillips
    CEO Equity Incentives and Financial Misreporting: The Role...
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.01 Earnings Management, 14.10 CEO Compensation 
    Title:
    CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise.
    Practical Implications:

    The evidence documents an important role for financial statement verification in the way managers are incentivized. While the economic consequences of auditing have focused on improvements to the information environment and a lower cost of capital, this study broadens the role of auditing in the efficient functioning of firms. The link between auditor expertise and managerial incentives is an important one because CEO incentives have wide implications for managerial risk-taking.

    This study contributes to the CEO contracting-financial misreporting literature by providing an economic rationale for the inconsistent evidence in prior studies. The authors show that detection mechanisms such as auditor expertise mitigate the effect of equity incentives on misreporting by limiting the ability of managers to misreport financial statements.

    Citation:

    Jayaraman, S., & Milbourn, T. 2015. CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise. Accounting Review 90 (1): 321-350. 

    Keywords:
    auditor expertise, equity incentives, misreporting, earning management, CEO compensation
    Purpose of the Study:

    In the aftermath of accounting scandals at the turn of the century, many academics, regulators, and the media have questioned whether managerial compensation contracts are the culprits behind these acts of reporting transgressions. Greater equity incentives allegedly encourage managers to indulge in myopic acts aimed at maintaining stock prices and earnings at artificially high levels in the near term. A large literature in accounting and finance tests whether CEOs with equity-based incentives manipulate their financial statements. While the other studies differ in their research designs, empirical measures, and sample periods, none of them consider the role of detection mechanisms that would limit the ability of managers to successfully carry out any misreporting, assuming that equity incentives do indeed encourage misreporting. The authors posit effective auditing as one such mechanism, and argue that incorporating it in a CEO contracting-financial misreporting framework is likely to shed light on the preceding inconsistent findings. Following the auditing literature, the authors use auditor industry expertise to capture the effectiveness of auditing and examine how it affects the association between CEO equity incentives and financial misreporting.

    Design/Method/ Approach:

    The authors merged four databases: (1) data on lawsuits from1994 to 2004, (2) data on CEO equity incentives from ExecuComp, (3) data on auditor expertise from 2003 to 2007 from Audit Analytics, and (4) data on control variables from Compustat and IRRC. The final sample comprises 7,427 firm-year observations over the period 1994 to 2004, of which 201 firm-years of the sample involve a lawsuit concerning an accounting or other misreporting. These observations involve 87 unique firms.

    Findings:

    Controlling for previously identified determinants of CEO incentives, firms audited by an industry expert grant their CEOs an average of 14 percent more equity incentives than those audited by a non-expert. To further validate the inferences, the authors exploit variation across industries in the extent to which earnings matter for determining the stock price, and find that auditor expertise is positively associated with CEO incentives only in industries where earnings matter for stock price informativeness. Overall, these results are consistent with optimal contracting theories where equity-based incentives are, at least in part, granted by trading off the benefits of effort with the costs of financial misreporting.

    The authors find that AA firms audited by an expert auditor in the post-period experience an average of 17 percent larger increase in CEO incentives as compared to AA firms audited by a non-expert in the post-period. Overall, these time-series tests performed complement the cross-sectional inferences on the important effect of auditor expertise on CEO equity incentives.

    Category:
    Corporate Matters
    Sub-category:
    CEO Compensation, Earnings Management
  • Jennifer M Mueller-Phillips
    Discontinuities and Earnings Management: Evidence from...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 14.0 Corporate Matters, 14.01 Earnings Management, 14.05 Earnings Targets and Management Behavior 
    Title:
    Discontinuities and Earnings Management: Evidence from Restatements Related to Securities Litigation
    Practical Implications:

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

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

    Citation:

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

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

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

    Design/Method/ Approach:

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

    Findings:
    • Earnings management drives the discontinuities in distribution of analyst forecast errors and earnings changes for sample firms.
    • Discontinuity is linked to earnings management.
    • The sensitivity to the scaling variable could indicate that factors other than earnings management contribute to the discontinuity in the sample.
    • Actual instances of earnings management do create sizable discontinuities in firms’ earnings distribution.
       
    Category:
    Corporate Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Earnings Management, Earnings Targets & Management Behavior
  • 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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  • The Auditing Section
    Litigation Risk, Audit Quality, and Audit Fees: Evidence...
    research summary posted May 7, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Litigation Risk, Audit Quality, and Audit Fees: Evidence from Initial Public Offerings
    Practical Implications:

    This study provides a more precise analysis of pre- versus post-IPO accruals levels than previous research and the results are consistent with the effects an increase in litigation exposure should have on auditor incentives. That is, both audit quality and audit fees are higher in a higher-litigation regime.

    Citation:

    Venkataraman, R., J. P. Weber, and M. Willenborg. 2008. Litigation risk, audit quality and audit fees: Evidence from initial public offerings. The Accounting Review 83 (5): 1315-1345

    Keywords:
    Abnormal accruals; audit committees; audit fees; audit quality; auditor litigation; earnings management; initial public offering.
    Purpose of the Study:

    Auditors’ responsibilities and exposure to litigation risk vary depending on applicable federal securities laws. For example, when companies register for their initial public offering (IPO) they file under the Securities Act of 1933. However, after going public, they file under the Securities Exchange Act of 1934. Because litigation risk exposure is higher under the 1933 Act than the 1934 Act,  auditors should provide higher quality and receive higher fees for IPO audits.   In spite of this, prior research suggests that issuers engage in pre-IPO earnings management in an effort to inflate IPO prices. However, the prior literature does not use pre-IPO inancial statements to compute accruals levels, but instead infer pre-IPO accruals levels using financial statements from issuers’ first 10-K.  This paper uses pre-IPO audited  financial statements to compute pre-IPO accruals to investigate whether: 

    • Pre-IPO accrualsare significantly positive or negative, and
    • Pre-IPO accruals are less than post-IPO accruals 

    The authors use differences between litigation liability regimes to investigate whether a higher-litigation regime influences audit quality, as measured by audited accruals, and whether there is any effect of litigation risk on auditor compensation.

    Design/Method/ Approach:

    The authors use publicly available data on companies that went public between January 1, 2000 and December 31, 2002 and compare pre- and post-IPO accruals measures. 

    Findings:
    • The authors find that pre-IPO audited accruals are negative and less than post-IPO audited accruals (i.e. audit quality is higher in the higher litigation risk pre-IPO period)
    • The authors find that auditors earn higher fees for IPO engagements than for post-IPO engagements
    Category:
    Risk & Risk Management - Including Fraud Risk, Corporate Matters
    Sub-category:
    Earnings Management, Litigation Risk, Earnings Management
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  • Jennifer M Mueller-Phillips
    Materiality Judgments and the Resolution of Detected...
    research summary posted October 13, 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, 06.05 Assessing Risk of Material Misstatement, 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees.
    Practical Implications:

    The results of this study shed light on the complex interplay between analyst following, the pressure that managers face to manage earnings, the pressure that auditors face to protect their reputations in the post-SOX environment, and the important role that audit committees can play in settings in which managers may act strategically to achieve desired financial reporting outcomes.

    Citation:

    Keune, M. B., and K. M. Johnstone. 2012. Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees. Accounting Review 87 (5): 1641-1677.

    Keywords:
    audit committees, audit fees, error correction, materiality, stock analysts
    Purpose of the Study:

    Auditors detect and inform client managers and audit committees of misstatements, and these agents must reach agreement about whether managers will correct the misstatements prior to issuing the financial statements. Managers may waive correcting misstatements if auditors and audit committees conclude that the misstatements do not render the financial statements materially incorrect. Yet, the Securities and Exchange Commission (SEC) and others have asked the rhetorical question: If a misstatement is immaterial, then why not correct it? Given the absence of bright-line criteria for assessing materiality, judgments about resolving misstatements may be strategic to achieve desired financial reporting outcomes. Analysis of the role of managers, auditors, and audit committees in misstatement materiality judgments is therefore important because it can aid understanding of observed audit and financial reporting outcomes that can affect users.

    In this study the authors make use of regulation concerning the resolution of detected misstatements contained in Staff Accounting Bulletin No. 108 (SAB 108). The implementation of SAB 108 provides disclosure data on detected misstatements that were previously judged immaterial and were not corrected in the financial statements until the release of the new guidance. The authors use the SAB 108 disclosures to measure both the qualitative and the quantitative materiality of misstatements during the periods in which they remained uncorrected.

    Design/Method/ Approach:

    The data-collection period covers 10-Qs filed from November 15, 2006 to February 28, 2007 and 10-Ks filed from November 15, 2006 to February 15, 2008, and the analyses examine waived misstatements that existed in the financial statements during the period January 1, 2003 to September 30, 2006. To identify these misstatements, the authors read SAB 108 disclosures to find companies that corrected misstatements under SAB 108. 

    Findings:
    • The authors find that managers are generally more likely to waive qualitatively material misstatements as analyst following increases, but this effect is primarily present when audit fees are relatively low.
    • They find auditors are less likely to allow managers to waive quantitatively material misstatements as audit fees increase.
    • The authors also find a negative interaction between audit fees and analyst pressure on the likelihood that auditors will allow managers to waive qualitatively material misstatements.
    • Specifically, auditors’ incentives to protect their reputations weaken the effect of managerial incentives associated with the pressure created by analyst following; auditors are less likely to allow managers to waive qualitatively material misstatements as audit fees increase.
    • The authors find that audit committees with greater financial expertise are less likely to allow managers to waive qualitatively or quantitatively material misstatements than are audit committees with less expertise.
    Category:
    Corporate Matters, Governance, Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Board/Audit Committee Oversight, Earnings Management, Earnings Management, Impact of Fees on Decisions by Auditors & Management

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