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  • Jennifer M Mueller-Phillips
    Professionalism and Performance Incentives in Accounting...
    research summary posted July 24, 2017 by Jennifer M Mueller-Phillips, tagged 11.13 Partner incentive schemes in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Professionalism and Performance Incentives in Accounting Firms
    Practical Implications:

    The authors of the study state that it will be vital for accounting firms to ensure that partner incentive schemes align incentives with values of the accounting profession.  This issue gains greater importance as mid-tier firms adopt such performance-based profit sharing models in their attempts to stay competitive with Big 4 firms because the new incentives they face represent a risk to their culture and values.  Although the current models appear to measure and weigh both commercial success and professional values, these models represent a significant change from the past when mid-tier firms used lock-step approaches that incentivized partners to follow professional values.  These findings are of interest to accounting firms and regulators as they consider the impact of partner incentive schemes on audit quality.

    Citation:

    Coram, P. J., and M. J. Robinson. 2017. Professionalism and Performance Incentives in Accounting Firms. Accounting Horizons 30 (4): 103-123.

    Keywords:
    accounting firms; profit sharing; performance incentives
    Purpose of the Study:

    In recent years, accounting regulators across the globe (United States, European Union, and United Kingdom) have pushed for greater transparency from accounting firms.  In the required “Transparency Reports,” firms conceptually discuss partner compensation.  This study examines the actual profit-sharing frameworks in place at accounting firms of various sizes in order to understand partner remuneration in the Big 4 and mid-tier accounting firms in Australia.  Particularly, this study addresses the relationship of firm performance to partner remuneration and the commercialism/professionalism trade-off inherent in accounting firms.  This study aims to increase our understanding of the two-decade change in how accounting firms design their partner remuneration framework.  While traditional profit-sharing schemes consisted of equal shares of profit made to partners, accounting firms are currently utilizing partner performance information in determining profit splits.  This trend has given rise to criticism that suggests accounting firms are becoming too commercial—perhaps failing to accomplish their mission in the public’s best interest.

    Design/Method/ Approach:

    The study interviews nine partners of Big 4 and mid-tier firms in Australia.  The mean time spent as a partner was 17.6 years—ranging from 5 years of experience to 27 years.  Six partners interviewed had audit experience or were practicing auditors; the remaining three served in “Financial Advisory” or “Private Clients” capacities.  Each interview occupied one hour, took place at the respective firm of the interviewee across eight firms, in a one-month period in 2012.  Due care was exercised for interviewers to not express opinions that may bias responses given by partners.    

    Findings:
    • Each Big 4 firm has adopted the means to set individual performance expectations and reward performance that exceeds expectations. 
    • Mid-tier firms have, also, adopted elements of performance-based methods to calculate partner profit shares.  However, mid-tier firms continue to embody traditional, lock-step approaches.   
    • A few partners expressed concerns regarding performance-based remuneration—particularly due to firm’s inadequate ability to track each partner’s contributions.
    • When compared to previous literature (2013 and 1998) regarding partner remuneration, results from this study showed an increase in the variation of partner compensation.  The increase corresponds to the stronger influence performance plays in partner compensation.
    • All Big 4 firms utilize the same types of measures to evaluate partner performance.  Partner reviews consist of two steps: ranking (no profit units distributed) and scrutinizing.
    • Big 4 firms appear to be using a balanced scorecard approach, and mid-tier firms have adopted the balanced scorecard to evaluate partner performance.  This model captures partners’ financial and nonfinancial contributions to the firm.
    • Accounting firms are increasingly aware of the “erosion” of professionalism for commercialism.  Firms are counteracting the erosion by introducing metrics on values, quality, and staff development.  However, the study illustrates that performance measures are not equally weighted.  Often, weighting is dependent on the firm’s goals, current economic climate, and partner’s role in the firm.
    • Mid-tier firms—aspiring to grow—are reengineering their remuneration frameworks to take on performance-based elements, with hopes of attracting new talent. 
    • Consistent with previous research, this study finds that accountants working in mid-tier firms identify more strongly with core professional values than their Big 4 counterparts.
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Partner incentive schemes
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  • Jennifer M Mueller-Phillips
    Auditor Choice and Audit Fees in Family Firms:Evidence from...
    research summary posted July 20, 2017 by Jennifer M Mueller-Phillips, tagged 04.02 Impact of Fees on Decisions by Auditors & Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Choice and Audit Fees in Family Firms:Evidence from the S&P 1500
    Practical Implications:

    This study provides policy-makers and practitioners with critical insight into differences in auditor selection criteria between family and non-family firms and differences in the severity of their agency conflicts between shareholders and managers and also between family owners and minority shareholders.

    Our empirical evidence also sheds light on how family firms view and value the external audit and whether they are selecting auditors on price or quality, or some combination of these factors. In addition, given the current downward trend in audit revenues as a percentage of total revenues, our findings could lead accounting firms to re-examine how they market audit services to family firms.

    Citation:

    Ho, J.L., and F.Kang. 2013.Auditor Choice and Audit Fees in Family Firms: Evidence from the S&P 1500.Auditing: A Journal of Practice and Theory32(4): 71-93

    Keywords:
    Auditor choice; audit fees; family firms; agency problems
    Purpose of the Study:

    The authors study auditor choice and audit fees in family firms, which have a special ownership structure and different types of agency problems. Family firms are both prevalent and important in the U.S. About one-third of the S&P 500 are family-controlled companies in which the founding families on average own 11 percent of the cash flow rights and 18 percent of the voting rights.

    The unique class of family shareholders may influence firms’ auditor choice in two competing ways. On one hand, compared to non-family firms, family owners can more directly and closely monitor managers and therefore have less severe agency conflicts with managers. This may result in a lower demand for high-quality auditors. On the other hand, due to the agency problems between family owners and minority shareholders, family firms may have incentives to hire high-quality auditors as a signal of credible financial reporting in exchange for better contracting terms (e.g., lower cost of capital). Similarly, the different types of agency problems in family firms may also affect the level of audit fees. Family owners’ active monitoring reduces the inherent risk of material misstatements in financial reporting and results in a lower demand for audit effort, and therefore audit fees. However, the severe agency problems between family owners and minority shareholders suggest that family firms may incur higher audit fees due to higher audit risk and greater audit effort. Therefore, the effect of family firm characteristics on auditor choice and audit fees warrants empirical investigation.

    Design/Method/ Approach:

    The empirical analysis is performed on firms listed on the S&P 1500 index from 2000 through 2008. We define family firms as those in which founders or their family members (by either blood or marriage) are key executives, directors, or block holders and update the classification every year. We hand collected the ownership of the founding family and test our hypotheses on family firms’ auditor choice and audit fees using regressions.

    Findings:
    • The authors find that, on average, family firms are less likely to appoint top-tier accounting firms and incur lower audit fees than non-family firms.
    • The authors observe that the tendency not to hire top-tier accounting firms and to pay lower audit fees is more significant for firms in which family owners are the largest shareholders.
    • The authors find that, compared to family firms without dual-class shares, family firms with dual-class shares tend to mitigate their more severe agency problems between family owners and minority shareholders by hiring top-tier accounting firms to signal their earnings quality and they incur higher audit fees.
    • The authors also find that active family control (i.e., family members as CEOs or on the board) is associated with a lower tendency to hire top-tier accounting firms and lower audit fees.
    Category:
    Independence & Ethics
    Sub-category:
    Impact of Fees on Decisions by Auditors & Management
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  • Jennifer M Mueller-Phillips
    U.S. Audit Partner Rotations
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 05.03 Partner Rotation in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    U.S. Audit Partner Rotations
    Practical Implications:

    This study helps to inform about the effects of audit partner rotations. The evidence suggests that partner rotation does add a fresh look at U.S. audit engagements. The results can also be applied to the U.S. debate over audit firm rotation. It demonstrates that firm rotation is not the only way to add a fresh look to audit engagements and that the current system of audit partner rotation already has a measurable effect.

    Citation:

    Laurion, Henry, A. Lawrence, and J. Ryans. 2017. “U.S. Audit Partner Rotations”. The Accounting Review. 92.3 (2017): 209. 

    Keywords:
    U.S. audit partner rotations; fresh look; restatements; valuation allowances and reserves; write-downs; special items
    Purpose of the Study:

    Currently, the SEC requires that lead partners rotate off an audit engagement after five years and then sit out another five years before returning to the audit engagement. The audit partner rotation requirement was put into place to add renewed professional skepticism and a fresh insight into the audit. Previous studies in the United States generally indicate that partner rotation decreases audit quality due to a loss of client-specific knowledge and expertise. This paper adds to the discussion by examining the incidence of restatements, write-downs, and special items, as well as changes in valuation allowances and reserves surrounding partner rotation.

     

    Design/Method/ Approach:

    The authors identified audit partner rotations by using SEC comment letter correspondences for issuers who have received comment letter reviews in two consecutive years that copy different audit partners for each of those years. The information was gathered using the Audit Analytics Comment Letter database and comprised of 205 U.S. partner rotations at 189 SEC public companies from 2006 to 2014. A difference-in-differences model was used to compare the before and after results against a non-rotating firm control group. 

    Findings:

    The authors find the following:

    • There is no change in the frequency of misstatements after a partner rotation.
    • However, restatement discoveries and restatement announcements display relative increases of 5.9% and 5.1% respectively after there is a new lead partner. This suggests that the audit partner rotation requirement does in fact increase audit quality.
    • Additionally, there is some evidence of decreases in positive special items.
    Category:
    Audit Quality & Quality Control, Audit Team Composition, Independence & Ethics
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  • Jennifer M Mueller-Phillips
    Auditor Changes and the Cost of Bank Debt
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Changes and the Cost of Bank Debt
    Practical Implications:

    Currently, bank loans account for more than half of the total debt financing in the United States. The results from this study indicate that there is an increase in loan costs for companies within the following year of an auditor change. This is a factor companies should consider when applying for loans after a switch. 

    Citation:

    Francis, Bill B., D. M. Hunter, D. M. Robinson, Michael N. Robinson, and X. Yuan. 2017. “Auditor Changes and the Cost of Bank Debt”. The Accounting Review. 92.3 (2017): 155.

    Keywords:
    auditor change; information risk; financial reporting quality; information signaling; loan contracting; cost of bank debt; loan spreads; private credit market
    Purpose of the Study:

    Companies change auditors for various reasons, however due to the costs associated with switching, it is often an indication of potential problems between the auditor and company. This study examines the effects that an auditor change has on bank loan contracting. Specifically, whether companies that switch auditors incur increased costs and more stringent nonprice terms on loans. The authors address two potential reasons of why an auditor change would lead to information risk, and subsequently higher costs on loans. The first is if creditors perceive that the auditor change is opportunistic, such as management trying to find a more compliant auditor. The second information risk is related to the new auditor’s lack of client-specific knowledge. Both of these risks would cause for audit quality to decrease and, therefore loan costs would increase. The authors also consider the type of switch and its effect on loan costs. The three types examined are from (Non)Big 4 to (Non)Big 4, Big 4 to Non-Big 4, and Non-Big 4 to Big 4.

    Design/Method/ Approach:

    The sample includes 312 pairs of auditor change companies and non-audit change companies from 1998-2014. The audit change information was gathered using Audit Analytics and the bank loan data was from DealScan. Additionally, the authors excluded all audit switches due to the collapse of Arthur Andersen in 2002. The authors utilize a difference-in-differences (DID) research design comparing loan spreads between auditor change companies (before and after switch) and non-audit change companies.

    Findings:

    Overall, the authors find that when companies initiate a loan within a year of changing auditors there is a 22% increase in loan costs.           

    Specifically, the authors find the following:

    • There is no significant difference in the incremental loan spread between the three types of auditor switches. This evidence suggests creditors place a stronger emphasis on the two information risks instead of the potential differences between Big 4 and Non-Big 4 audit quality.
    • There is still a substantial increase in information risk following the change regardless of whether the company initiates the auditor switch (dismissal) or the auditor resigns
    • There is a 13.65% increase in the probability that banks add collateral requirements following an auditor change. The upfront and annual fees also increase by an average of about 53% and 25% respectively.
    Category:
    Auditor Selection and Auditor Changes
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  • Jennifer M Mueller-Phillips
    Finding Needles in a Haystack: Using Data Analaytics to...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 06.02 Fraud Risk Models, 08.09 Impact of Technology on Audit Procedures in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Finding Needles in a Haystack: Using Data Analaytics to Improve Fraud Predication
    Practical Implications:

    Data analytics can be used to create fraud prediction models that help auditors improve audit planning decisions. It can also be used to help regulators identify firms for potential fraud investigation. In particular, the SEC is investing resources to develop better fraud risk models and the results of this study could be useful. 

    Citation:

    Perols, Johan L., R. M. Bowen, C. Zimmermann, and B. Samba. 2017. “Finding Needles in a Haystack: Using Data Analytics to Improve Fraud Prediction”. The Accounting Review. 92.2 (2017): 221.

    Keywords:
    fraud; financial statement fraud; data analytics; predictive analytics; data rarity; data imbalance
    Purpose of the Study:

    Financial statement fraud causes organizations to lose an estimated 1.6% of annual revenue. This study examines 3 different methods that use data analytics in an attempt to predict fraud. The methods are as follows:

    • The first method, Multi-Subset Observation Undersampling (OU), addresses the imbalance between the low number of fraud observations relative to the number of non-fraud observations by creating multiple subsets of the original dataset that each contain all fraud observations and different random subsamples of non-fraud observations.
    • The second method, Multi-subset Variable Understampling (VU), addresses the imbalance between the low number of fraud observations relative to the number of explanatory variables identified in the fraud prediction literature by creating multiple subsets of randomly selected explanatory variables.
    • The third method, VU partitioned by type of fraud (PVU), is a variation of the second method that addresses issues associated with treating all fraud cases as homogenous events.
    Design/Method/ Approach:

    The sample contains data from 51 fraud firms. The authors identified fraud firms from SEC investigations that were reported in AAERS from 1998-2005. The objectives of the experiments were to determine how to best implement OU and VU and then to subsequently evaluate their performance against benchmarks. 

    Findings:

    The authors find the following:

    • When the Multi-Subset Observation Undersampling (OU) is used with 12 subsamples it improves fraud prediction by lowering the expected cost of misclassification by more than 10% relative to the best performing benchmark.
    • The Multi-Subset Variable Undersampling (VU) was found to improve fraud prediction in select situations. However, it does not do so reliably.
    • The Multi-Subsets Variable Undersampling by partitioning variables into subsets (PVU) was able to improve fraud prediction and reduce the expected cost of miscalculation by 9.6% relative to the best performing VU benchmark.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Models, Impact of Technology on Audit Procedures Confirmation – Process and Evaluation of Responses
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  • Jennifer M Mueller-Phillips
    Investor Reaction to the Prospect of Mandatory Audit Firm...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 01.06 Impact of PCAOB, 04.07 Audit Firm Rotation in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Investor Reaction to the Prospect of Mandatory Audit Firm Rotation
    Practical Implications:

    The implementation of a mandatory audit firm rotation in the United States would have large implications within the accounting industry. This study provides the PCAOB and other regulators with relevant information regarding the potential policy. The evidence indicates that the majority of investors would have a negative reaction to a mandatory audit firm rotation. It is possible the investors believe the potential benefits of rotation are outweighed by the costs, direct and indirect.

    Citation:

    Reid, Lauren C., and J. V. Carcello. 2017. “Investor Reaction to the Prospect of Mandatory Audit Firm Rotation”. The Accounting Review. 92.1 (2017): 183.

    Keywords:
    mandatory audit firm rotation; event study; PCAOB; investor perception
    Purpose of the Study:

    In recent years the PCAOB has considered implementing a mandatory audit firm rotation in order to better align auditors’ interests with investors’ interests. This study examines investor reactions to a mandatory audit firm rotation in the United States. It is important to understand investor reactions because the implementation of such a policy would be enacted for their benefit. Due to the fact that it is still a potential policy, it is difficult to determine how investors will react if the PCAOB moves forward. Broadly, the authors test the overall stock market reaction. However, the primary focus is on whether certain markets react differently based on a company’s auditor characteristics. The characteristics considered were industry specialization, audit firm tenure, Big 4/non-Big 4, and audit quality.

    Design/Method/ Approach:

    The sample contains 3,688 companies and represents over 75% of the entire market capitalization of U.S. companies. The authors obtained U.S. company returns through CRSP and the prices for the MSCI World Index excluding the U.S. through DataStream. The auditor tenure and fee data were collected through Compustat and Audit Analytics. The authors determined 10 main dates to observe investors’ reactions and how that affected the markets for the following 3 days. 

    Findings:

    Overall, the authors find a significant negative market reaction to events that increased the likelihood of rotation.

    Specifically, the authors find the following:

    • Companies that were audited by Big 4 firms were significantly more likely to have a negative reaction on dates that increased the likelihood of rotation.
    • Similarly, companies that were audited by an industry-expert were significantly more likely to have a negative reaction on dates that increased the likelihood of rotation.
    • Companies with a lower-audit quality experienced a negative market reaction on dates that decreased the likelihood of rotation.
    Category:
    Independence & Ethics, Standard Setting
    Sub-category:
    Audit Firm Rotation, Impact of PCAOB
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  • Jennifer M Mueller-Phillips
    Malleable Standards of Care Required by Jurors When...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 06.09 Litigation Risk, 11.07 Attempts to Measure Audit Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Malleable Standards of Care Required by Jurors When Assessing Auditor Negligence
    Practical Implications:

    This study is relevant for practitioners, investors, and regulators. It demonstrates to firms that the effectiveness of high audit quality as a defense in litigation may be decreased depending on the timing of jurors’ assessment of SOC. One way to try and lower the probability of jurors’ assessing SOC after receiving audit knowledge is to warn the jury about the potential affects. Simply changing the jurors’ instructions has been found to mitigate the outcome effects.

    Citation:

    Maksymove, Eldar M., and M. W. Nelson. 2017. “Malleable Standards of Care Required by Jurors When Assessing Auditor Negligence”. The Accounting Review. 92.1 (2017): 165.

    Keywords:
    auditor liability; jury; audit quality; mediation; anchoring; sample size; audit adjustment
    Purpose of the Study:

    In court cases against auditors due to audit failure, often times the main defense used is that there was a high audit quality. This is true if the audit was performed at a level similar to what prudent auditors would have done in the same circumstances, also known as standard of prudent care (SOC). This study examines whether jurors’ definition of SOC is malleable based on the timing of the SOC assessment in accordance with the jurors’ exposure to the audit quality of the case. Specifically, whether or not the juror learns of audit quality first and then assesses SOC, or vice versa. 

    Design/Method/ Approach:

    The research project contains four experiments. The first experiment is a simulation where 125 participants, found using Amazon’s Mechanical Turk (AMT), are asked to assume the role of jurors who are considering a case of alleged auditor negligence. The level of audit quality and the timing of jurors’ SOC assessments are manipulated. In the subsequent three experiments 60-63 of the previous participants were asked to determine SOC based on the level of audit quality being manipulated and a change in some of the background information.

    Findings:

    Overall, the authors find that the timing of the SOC assessment in accordance with the jurors’ exposure to the audit quality of the case does in fact change the outcome of the SOC assessment. Therefore, the results indicate the jurors SOC assessments are malleable.

    The authors find the following:

    • In situations where SOC is determined prior to jurors learning about the audit quality of the case, the verdict better discriminates between high and low-quality auditors. This is due to the fact that the audit quality of the case cannot affect the jurors’ decision of what SOC should be.
    • On the other hand, when SOC is assessed after jurors learn about the audit quality of the case, it can cause SOC assessments to vary. This leads to inconsistent rulings of whether or not the auditor was negligent.
    • The reasoning behind the second situation is as follows. The jurors’ knowledge of higher audit quality in the case directly lowers the negligence judgment. However, when doing the SOC assessment after learning about the higher audit quality, the jurors raise SOC. This then increases the negligence judgment. The authors refer to this effect as competitive mediation. 
    Category:
    Audit Quality & Quality Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Attempts to Measure Audit Quality, Litigation Risk
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  • Jennifer M Mueller-Phillips
    The Contagion Effect of Low-Quality Audits at the Level of...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 03.01 Auditor Qualifications, 11.07 Attempts to Measure Audit Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Contagion Effect of Low-Quality Audits at the Level of Individual Auditors
    Practical Implications:

    This study highlights the importance of individual auditor identification in audit reports. The results are also useful for financial information users, regulators, and policymakers to help them understand the impact of an auditor’s characteristics on an audit. The results are especially helpful for firms trying to understand the reasons behind audit failures and subsequently, to mitigate audit failures in the future.

    Citation:

    Li Baolei Qi Gaoliang Tian, Liuchuang, and G. Zhang. 2017. “The Contagion Effect of Low-Quality Audits at the Level of Individual Auditors”. The Accounting Review 92.1 (2017): 137.

    Keywords:
    contagion effect; individual auditors; audit failures; audit quality; auditors’ personal characteristics
    Purpose of the Study:

    This study examines whether there is a relation between audit failure by an individual auditor and the quality of other audits performed by this individual, and if the audit failure creates a rippling effect onto the rest of the office’s audit quality. In China, unlike most other countries, the identity and personal profile of signing auditors are disclosed in the public domain. This allows for the authors to determine the role of an individual auditor in an audit failure. The authors also consider whether or not qualitative characteristics (experience, gender, education) of an auditor can decrease the contagion effect of audit failure within an office location.

    Design/Method/ Approach:

    The sample consists of 11,706 audit decisions and 3,357 of which were audited by failed auditors from 1999-2011. The China Securities Markets and Accounting Research (CSMAR) database was used to find financial information and information about the financial restatement reports were found on the China Information website. The qualitative characteristics of auditors used were age, gender, education level, major, CCP membership, and experience. This data was gathered from the CICPA website.

    Findings:

    The authors find the following:

    • Auditors who experience audit failure are more likely to have further failures in the subsequent four years. Additionally these auditors are more likely to have higher levels of abnormal accruals in other audits as well, indicating an overall lower audit quality. This combination suggests that there is a contagion effect between individual audit failure and future audit quality.
    • Offices that experience audit failures and offices that do not have no significant differences in failed audits in subsequent years or audit quality. This suggests that contagion does not seem to occur across different auditors in the same office.
    • The contagion effect can be decreased based on certain qualitative characteristics of the auditor. Specifically, it is decreased for female auditors, auditors holding a master’s degree, and auditors with more auditing experience.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Attempts to Measure Audit Quality, Auditor Qualifications (e.g. size - industry expertise)
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  • Jennifer M Mueller-Phillips
    Debt Covenant Violations, Firm Financial Distress, and...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 02.01 Audit Fee Decisions, 02.06 Resignation Decisions, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Debt Covenant Violations, Firm Financial Distress, and Auditor Actions
    Practical Implications:

    The findings from this study impact firms with debt covenant requirements. Violations from debt covenants occur frequently and are often due to tight restrictions rather than signs of financial distress. These types of violations often lead to renegotations or waivers instead of immediate repayment. However, this study shows that auditors will still have negative reactions regardless of whether or not the violation is due to financial difficulty. It is important for firms to not only consider the financial and lending consequences of a violation, but the auditing consequences as well.

    Citation:

    Bhaskar, Lori Shefchik, G. V. Krishnan, and W. Yu.2017. “Debt Covenant Violations, Firm Financial Distress, and Auditor Actions”. Contemporary Accounting Research 34.1 (2017): 186.

    Purpose of the Study:

    This study investigates auditor actions resulting from debt covenant violations for firms. The violations increase business risk and subsequently cause the auditor to respond negatively. The audit actions examined in this paper are:

    • Adjustments in the audit plan causing higher audit fees.
    • The issuance of a going concern opinion.
    • The resignation of the auditor.

    The authors also consider the financial health of the firms before the violation was given. It is hypothesized that auditors are more likely to have a negative reaction to firms that are already financially distressed.

    Design/Method/ Approach:

    The sample includes 4,267 violations occurring from 2000 to 2008. All of the firms were U.S. nonfinancial public companies. The authors gathered the information from databases such as Compustat and Audit Analytics. The analysis was performed by estimating models of the auditor actions based on different client characteristics.

    Findings:

    The authors find the following:

    • Firms with debt covenant violations have significantly higher audit fees.
    • Firms have an increased likelihood of receiving a going-concern opinion after a violation. This is increased even more for firms that are not financially distressed. The authors attribute this to the fact that auditors tend to act more strongly because the information was inconsistent with prior beliefs.
    • Debt covenant violations lead to an increased likelihood of auditor resignation.
    • There is a positive association between the Big 4 auditors and all three auditor actions listed above.
    Category:
    Accountants' Reporting, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Going Concern Decisions, Resignation Decisions
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  • Jennifer M Mueller-Phillips
    Auditor Quality and Debt Covenants
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 14.0 Corporate Matters in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Quality and Debt Covenants
    Practical Implications:

    This paper contains important applications for borrowing firms wanting to have more favorable loan contract terms. By hiring a high-quality auditor this decreases risks for the creditors and therefore oftentimes reduces the stringency of debt covenants. Subsequently, the borrowing firm will violate the debt covenants less.

    Citation:

    Robin, Ashok, Q. Wu, and H. Zhang. 2017. “Auditor Quality and Debt Covenants”. Contemporary Accounting Research 34.1 (2017): 154.

    Purpose of the Study:

    Debt covenants are in place to help mitigate information asymmetry and agency problems between lender and borrower. This study examines whether high-quality auditors decrease the lenders’ demand for strict covenants (contracting effect), therefore reducing the likelihood of covenant violations (violation reduction effect). The assumption is that the information provided by a high-quality auditor would lower information asymmetry and agency problems, and consequently there would be no reason for strict debt covenants. 

    Design/Method/ Approach:

    There was a sample of 35,181 observations from 1996-2007. Compustat was used to gather annual covenant-violation data and Deal Scan was used to gather U.S. loan facility information.  The authors used an ordinary least squared (OLS) regression model in the analysis.

    Findings:

    Overall, the authors find high-quality audits are in fact related with fewer and looser covenants in debt contracts.

    Specifically, the authors find the following:

    • As auditor quality increases the probability of financial covenant violations decrease. The probability is 1.45% lower for firms audited by industry experts and about 4.98% lower for firms audited by the Big 4.
    • High-quality auditors play a role in mitigating the adverse effect of covenant violations on corporate borrowing costs.
    Category:
    Audit Quality & Quality Control, Corporate Matters
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