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  • Jennifer M Mueller-Phillips
    The Association Between Audit Partner Rotation and Audit...
    research summary posted August 31, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 05.0 Audit Team Composition, 05.03 Partner Rotation in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Association Between Audit Partner Rotation and Audit Fees: Empirical Evidence from the Australian Market
    Practical Implications:

     The results of the study have important implications for regulators, auditors, and companies. In recent years, audit partner rotation has increased due to mandatory rotation legislation in Australia and has led to increased monetary and social costs. This study identifies the extent to which auditors pass on these costs and the relative bargaining power between an audit firm and a client, which varies across different segments of the market. This study also makes several contributions to existing literature. Specifically, this study informs the debate on the costs and benefits of audit partner rotation by focusing on the financial costs of partner rotation in the form of increased audit fees. Further, this study extends prior research that examines the impact of mandatory and voluntary partner rotation and the association between audit fees and partner rotation in different market segments. In addition, this study informs policy makers and regulators on whether and in which context the costs of audit partner rotation are passed on to clients as increased audit fees.

    Citation:

     Stewart, J., P. Kent and J. Routledge. 2016. The Association Between Audit Partner Rotation and Audit Fees: Empirical Evidence from the Australian Market. Auditing, A Journal of Practice and Theory 35 (2): 181-197.

    Keywords:
    Audit partner rotation, audit fees, voluntary partner rotation, mandatory partner rotation, audit markets
    Purpose of the Study:

     Audit partner rotation has become an accepted practice in many jurisdictions as a means of enhancing audit independence. Both regulators and professional bodies believe that greater auditor independence should lead to improved audit quality and hence improved financial reporting quality. A number of studies have examined the benefits of partner rotation in terms of its impact on audit quality, but these studies have produced mixed results and the benefits of the practice have been questioned. Given the concern that audit partner rotation may not improve audit quality, it is appropriate to consider the impact of partner rotation on audit costs and whether any increased costs are passed on to the client. This study seeks to examine the direct relation between audit fees and partner rotation using data from Australia where mandatory partner rotation after 5 years was introduced in 2006.

    Design/Method/ Approach:

     The authors used a sample of publicly traded companies selected from those listed on the Australian Securities Exchange (ASX) in 2007 for this study. Details of audit partner rotation and financial and nonfinancial data were then collected from Morningstar DatAnalysis, Connect 4 Annual Reports Collection, or company annual reports for the years 2007-2010. The authors used this information to evaluate the relation between audit partner rotation and audit fees in the year of rotation and the two years post rotation. The impact of audit partner rotation was examined as either mandatory or voluntary. The data was also examined based on stratification into three groups: large global clients, mid-level clients, and small local clients.

    Findings:

    The results indicate that audit fees are higher in the year of partner rotation and the higher fees persist in the first year post rotation and, to a lesser extent, in the second year post rotation. Further, the results indicate the following:

    • Higher audit fees are associated with both mandatory and voluntary rotations in the year of rotation and with voluntary rotation in the first year post rotation.
    • Stratification of the sample shows that mandatory and voluntary rotations are associated with higher audit fees for the large global segment but only voluntary rotation is associated with higher audit fees for the small local segment. No association between audit fees and rotation was found for the mid-level market segment. 
    Category:
    Audit Team Composition, Standard Setting
    Sub-category:
    Audit Partner Rotation, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Spillover of SOX on Earnings Quality in Non-U.S....
    research summary posted March 22, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 14.0 Corporate Matters, 14.01 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Spillover of SOX on Earnings Quality in Non-U.S. Jurisdictions.
    Practical Implications:

    The costs and benefits of SOX have been researched by numerous authors, however the benefits outside of the United States have generally been limited to those of firms that are listed on U.S. exchanges. The authors observe improvements in earnings quality for subsidiaries of U.S. firms which file financial reports in Belgium, suggesting that there is a spillover effect of SOX compliance outside of domestic firms. The authors caveat that they cannot determine if the results are driven by improved internal controls or improved audit quality of the parent company, but they show improvement in foreign-filing earnings in spite of these financial reports being generated outside of the U.S. reporting process.

    Citation:

    Dutillieux, W., J.R. Francis, M. Willekens. 2016. The Spillover of SOX on Earnings Quality in Non-U.S. Jurisdictions. Accounting Horizons 30 (1): 23-39.

    Keywords:
    Earnings quality, U.S. foreign subsidiaries, Sarbanes-Oxley
    Purpose of the Study:

    The authors use Belgian subsidiaries of Belgian companies and U.S. companies around the implementation of SOX to determine if SOX compliance effects performance outside of the United States. While other research has looked at the effect of SOX on foreign firms trading on U.S. exchanges, this study looks into the quality of financial reporting of foreign subsidiaries in their own country, which would be a second-order effect of SOX compliance.

    Design/Method/ Approach:

    The analyses in this paper utilize a sample of Belgian subsidiaries owned by U.S.-based and Belgian-based firms from 1999 to 2005, excluding 2002 (the year of implementation) for a clean separation of pre- and post-SOX windows. The sample of over 2,000 subsidiaries is used to observe the change of earnings quality measures from pre-SOX to post-SOX, and how that changes differs between U.S.-owned subsidiaries and Belgian-owned subsidiaries.

    Findings:

    The authors look at earnings quality for subsidiaries which file financial reports outside of the U.S. which are still obligated to comply with SOX regulations. They find that SOX has a spillover effect on these firms specifically in that they report higher quality earnings relative to a control group of subsidiaries from the same country which do not have to comply with SOX. The U.S.-owned subsidiaries report smaller abnormal accruals and recognize losses more timely, whereas the Belgian-owned subsidiaries had no improvement or even a decline in some instances.

    Category:
    Corporate Matters, Standard Setting
    Sub-category:
    Earnings Management, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Effect of Auditing Standard No. 5 on Audit Report Lags.
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 01.04 Impact of 404, 01.05 Impact of SOX, 01.06 Impact of PCAOB, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Effect of Auditing Standard No. 5 on Audit Report Lags.
    Practical Implications:

    The findings support the regulators’ contention that the new top-down, risk-based approach under AS5 makes the audit process timelier and efficient by decreasing audit report lags and facilitating firms’ efforts to meet the reporting deadline set by the SEC, especially when the firms have an effective internal control system. However, the firms with material internal control problems that persist either at the company level or at the accounts/transaction level continue to experience larger reporting lags in the post-AS5 years compared with the clean SOX 404 firms. The results are generally consistent with auditors focusing more on critical risk areas associated with ineffective internal controls and applying principle-oriented top-down, risk-based audit procedures to minimize risk, which requires increased audit efforts and longer audit time to accomplish their work properly.

    Citation:

    Mitra, S., H. Song, and J. S. Yang. 2015. The Effect of Auditing Standard No. 5 on Audit Report Lags. Accounting Horizons 29 (3): 507-527.

    Keywords:
    AS5, audit report lags, PCAOB, SOX 404
    Purpose of the Study:

    This study investigates whether the Public Company Accounting Oversight Board’s (PCAOB) Auditing Standard No. 5 (AS5), which was introduced in June 2007, makes the audit process timelier in an extended post-AS5 period from 2007 to 2011 relative to a pre-AS5 period of 20062007. For this, the authors focus on evaluating the AS5 effect on audit report lags (ARL) both for the firms with material internal control weaknesses (ICW) and the firms with a clean SOX 404 opinion (non-ICW). ARL, a proxy for audit effort, has long been an important topic of academic research because ARL is considered critical in influencing timely judgment and decision making by financial statement users.

    First, the authors investigate the impact of the change from AS2 to AS5 on audit report lags over an extended period from 2006 to 2011. Second, they compare the effect of AS5 on report lags separately for the large accelerated filers and accelerated filers given significant differences in the 10-K filing deadlines for these two types of filers. Third, they examine the impact of AS5 on audit report lags for firms with internal control weaknesses (ICW) with separate analyses for firms with company-level control weaknesses and for firms with account-specific control weaknesses.

    Design/Method/ Approach:

    The analyses are conducted for the period from 2006 to 2011, which covers the AS2 period of 20062007 and the AS5 period of 20072011. The sample comprises 2,062 AS2 observations (divided between 1,877 non-ICW and 185 ICW observations) and 9,200 AS5 observations (divided between 8,870 non-ICW and 330 ICW observations). The authors use Compustat Annual and Business Segment files to gather information.

    Findings:
    • Audit report lags in the AS5 years were significantly lower than those in the AS2 years; the report lags decline, on an average, by 1.85 days.
    • ICW firms, in general, have larger report lags than the clean SOX 404 firms, but AS5 does not have an incremental effect on the report lags for the ICW firms, indicating the report lags decline only for the firms with a clean SOX 404 opinion.
    • Separate analyses for the ICW firms with company-level and account-specific material weaknesses show that audit report lags for those firms do not significantly change between the AS2 and AS5 periods and continue to be higher compared with those for the clean SOX 404 firms.
    • Additional tests using a constant sample of firms demonstrate a learning curve effect of AS5 in reducing report lags in the post-AS5 period both for the full sample and for the firms with a clean SOX 404 opinion.
    • The report lags significantly decline in both the early and late AS5 periods for both the large accelerated filers and accelerated filers and for the full constant sample.
    • Overall, the results show that the new top-down, risk-based approach under AS5 makes the audit process more efficient and timelier by decreasing audit report lags.
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Changes in Audit Standards, Consequences of Adverse 404 Opinions, Impact of 404, Impact of PCAOB, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Cost of Compliance to Sarbanes-Oxley: An Examination of...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Cost of Compliance to Sarbanes-Oxley: An Examination of the Real Estate Investment Industry.
    Practical Implications:

    The results suggest that viewing the impact of SOX as occurring only once, ignoring either the costs due to the independence requirements or the later impact of Section 404 internal control provisions, and failure to control adequately for business complexity, may have resulted in the prior studies underestimating the effect of SOX on audit and audit related fees.

    Citation:

    Shaw, W. H., and W. D. Terando. 2014. The Cost of Compliance to Sarbanes-Oxley: An Examination of the Real Estate Investment Industry. Auditing: A Journal of Practice & Theory 33 (1): 177-186.

    Keywords:
    audit pricing, Sarbanes-Oxley
    Purpose of the Study:

    The purpose of this paper is to document the extent to which Sarbanes-Oxley (SOX) impacted the costs of audits. The authors conduct a within-industry test of the effect of the SOX enactment on audit pricing in one industry, real estate investment firms (REITs). This industry was selected because of its simple business and industry structure. To retain their favorable tax structure, REITs are required to operate only domestically and in only one business segment, remain 70 percent invested in domestic real estate or real estate mortgages, and pay out 90 percent of earnings each year to investors. As a result, all REITs are classified within one four-digit SIC code. This transparent business structure eliminates the need for the inclusion of complexity variables for foreign operations and business segments. The lack of business complexity in the REIT industry would suggest that the primary determination of audit fees within the industry would be firm size. The lower inherent risk of the REIT industry is supported by the fact that level of audit fees paid by the average REIT prior to Sarbanes-Oxley was equal to that paid by an industrial firm one-seventh its size. 

    Design/Method/ Approach:

    The authors obtained a list of all publicly traded REITs from the National Association of Real Estate Investment Trusts, and from Compustat total assets, long-term debt, and cash from operations for the years 2001-2005. They compiled a final sample of 130 firms with complete data from 2001 through 2015.  Nineteen of the 112 firms were listed on the American Stock Exchange, four on NASDAQ and 89 on the New York Stock Exchange.

    Findings:
    • The authors find support for their concern that dummy variables in prior studies do not adequately capture business complexities.
    • The authors show that the REIT industry actually incurred an 88 percent increase in audit and audit-related fees during the SOX implementation period after controlling for other audit and client characteristics, as compared to 74 percent in the Ghosh and Pawlewicz (2009) study.
    • They also show that ignoring intra-industry variations in audit pricing would have led to a conclusion that the increase due to SOX for REITs was 97 percent.
    • The authors find that by assuming that the increase in audit fees due to SOX occurred only in 2002, and not also in 2004 when the internal control provisions became effective, understates the estimation of the effects of SOX on audit pricing.
    • The authors find that the enactment of Titles 200 and 300, which was meant to enhance auditor independence, resulted in a 52 percent increase in audit fees for REITs, while Section 404, which required internal control testing, led to a 145 percent increase.
    Category:
    Client Acceptance and Continuance, Standard Setting
    Sub-category:
    Audit Fee Decisions, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Impact of PCAOB AS5 and the Economic Recession on Client...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 01.06 Impact of PCAOB, 06.0 Risk and Risk Management, Including Fraud Risk in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Impact of PCAOB AS5 and the Economic Recession on Client Portfolio Characteristics of the Big 4 Audit Firms.
    Practical Implications:

    These findings should be of interest to regulators (e.g., ACAP and Department of Treasury) that have focused efforts on assessing the sustainability of the audit profession. However, the results can be viewed as good news in terms of the overall risk level of the Big 4 client portfolio, but possibly as bad news if regulators believe the Big 4 firms are the most qualified to provide audit services to riskier clients and should not use market forces as an excuse to shed or avoid these riskiest clients.

    Citation:

    Schroeder, J. H., and C. E. Hogan. 2013. The Impact of PCAOB AS5 and the Economic Recession on Client Portfolio Characteristics of the Big 4 Audit Firms. Auditing: A Journal of Practice & Theory 32 (4): 95-127.

    Keywords:
    audit risk, auditor portfolio, economic recession, PCAOB Auditing Standard No. 5 (AS5), Sarbanes-Oxley Act
    Purpose of the Study:

    The accounting scandals of the early 2000s, and the resulting loss of investor confidence in the U.S. capital markets, led to significant changes in the U.S. audit market. These changes include a decrease in the number of large international audit firms from five to four with the demise of Andersen, an increase in regulatory scrutiny with the passage of the Sarbanes-Oxley Act of 2002 (SOX) and the establishment of the Public Company Accounting Oversight Board (PCAOB), as well as an increase in the demand for assurance services associated with SOX Section 404.

    The authors examine the impact of PCAOB Auditing Standard No. 5 (AS5) and the economic recession on risk characteristics and degree of auditor/client misalignment in the publicly traded client portfolios of Big 4 firms. AS5 and the economic recession both likely resulted in an increase in audit firm personnel capacity as well as a decline in current and future revenue prospects, leading to concerns that the Big 4 firms may pursue clients that present greater risk to the portfolio.

    Design/Method/ Approach:

    Using Audit Analytics and Compustat the authors compile a sample for 20,736 firm-year observations. The pre-AS5/recession period is from 2002 through November 14, 2007 and the post-AS5/recession period is from November 15, 2007 through 2009. 

    Findings:
    • During the post-AS5/economic recession period the authors continue to see a net loss of clients to the non-Big 4 level; however, at a lower rate than documented during the pre-AS5/recession period.
    • When comparing the overall Big 4 portfolio characteristics, the authors find that the public client portfolio in 2009 presents greater financial risk, but lower audit risk and auditor business risk relative to 2006 (last year of the pre-AS5 period).
    • The net increase in financial risk is attributable to the impact of the economic recession on continuing clients.
    • The net decrease in audit and auditor business risks is also attributable to clients that remain in the portfolio over this period, as post-AS5/recession increases in audit risk and auditor business risk for new clients is offset by reductions due to departing clients.
    • The overall portfolio has a lower percentage of misaligned” clients in 2009 relative to 2006.
    • The findings suggest the Big 4 firms have continued to balance their portfolios with risk in mind, and continue to reduce the percentage of misaligned clients, consistent with portfolio trends of Big 4 firms documented in earlier post-Enron/SOX studies.
    Category:
    Risk & Risk Management - Including Fraud Risk, Standard Setting
    Sub-category:
    Impact of PCAOB, Impact of SOX
  • Jennifer M Mueller-Phillips
    Insider Trading, Litigation Concerns, and Auditor...
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Insider Trading, Litigation Concerns, and Auditor Going-Concern Opinions.
    Practical Implications:

    The study offers two primary contributions. First, it provides insight into the incentive effect of corporate insider trading on auditor behavior. The study helps to fill this gap by providing evidence on the relationship between managers’ incentives and auditors’ opinions. Second, this study adds to the literature on insider trading. The evidence extends this literature by showing that insiders’ incentives to sell and their desire to avoid litigation can influence auditors’ reports.

    Citation:

    Chen, C., X. Martin, and X. Wang. 2013. Insider Trading, Litigation Concerns, and Auditor Going-Concern Opinions. Accounting Review 88 (2): 365-393.

    Keywords:
    going-concern opinion, insider tracking, litigation risk, SOX
    Purpose of the Study:

    The authors investigate whether managers’ litigation concerns about insider selling affect the likelihood of firms receiving going-concern opinions. Prior studies show that managers face the risk of trade-related litigation around news events. To reduce their risk exposure, managers have at least two options. First, they can abstain from trading before notable events.  Alternatively, when managers do choose to trade, they can attempt to alter the information flow in the post-trading period to avoid price swings and escape regulators’ scrutiny. The authors focus on this option with respect to the association between managers’ insider sales and auditors’ going-concern modifications.

    At least two reasons motivate the focus on insider selling. First, the information content of the two types of auditor opinion is asymmetric. First-time going-concern opinions induce significantly negative market reactions, while clean opinions do not generate positive market reactions. Insiders are therefore less concerned about buying and the subsequent receipt of a clean opinion. Second, Roulstone (2008) argues that bad-news disclosures are more likely to trigger investor lawsuits that allege inadequate disclosure by management. Such lawsuits usually use pre-disclosure insider selling to indicate management’s foreknowledge of bad news. Thus, in contrast to insider purchases ahead of good news, insider sales ahead of bad news carry a significant legal risk.

    Design/Method/ Approach:

    The authors obtain insider trading data from Thomson Reuter. They obtain information about audit opinions and audit fees from Audit Analytics for the period 2000 through 2007. They then match the audit opinion data with the Compustat industrial annual file, the Center for Research in Security Prices (CRSP) database, and the Insider Trading database. The final sample retains 12,329 firm years, consisting of 801 observations with first-time going-concern opinions and 11,528 observations with clean opinions.

    Findings:
    • The authors find evidence that a higher level of insider selling is associated with a lower likelihood of receiving a first-time going-concern report.
    • For a one standard deviation increase in insider selling, the probability of receiving going-concern reports decreases by 1.39 percent.
    • The negative relation between insider selling and the probability of receiving a going-concern opinion is stronger for firms that are more economically important to their auditors but weaker for firms whose auditors have greater concerns about litigation exposure and reputation loss and for firms with more independent audit committees.
    • Auditors who issue clean opinions for clients with higher levels of insider selling have a lower frequency of dismissals in the subsequent year.
    • These results are consistent with the notion that management influences auditors’ opinions but are inconsistent with the notion that insiders reduce their selling in anticipation of going-concern reports.
    • The negative relation between insider selling and the likelihood of receiving a going-concern opinion holds for the pre- and post-SOX periods but is significantly weaker in the post-SOX period.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk, Standard Setting
    Sub-category:
    Going Concern Decisions, Going Concern Decisions, Impact of SOX, Litigation Risk
  • Jennifer M Mueller-Phillips
    Audit committee stock options and financial reporting...
    research summary posted July 30, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.04 Board/Audit Committee Compensation in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Audit committee stock options and financial reporting quality after the Sarbanes-Oxley Act of 2002.
    Practical Implications:

    This study contributes to existing literature by re-examining the relationship between audit committee compensation and financial reporting quality. The findings indicate the continuance of a negative relationship between audit committee members’ stock-option compensation and financial reporting quality in the post-SOX era. These results are relevant to regulators, compensation committees, and auditors because they imply that shifting audit committee director compensation away from stock options has the potential to improve financial reporting quality.

    Citation:

    Campbell, J. L., J. Hansen, C. A. Simon, and J. L. Smith. 2015. Audit Committee Stock Options and Financial Reporting Quality after the Sarbanes-Oxley Act of 2002. AUDITING: A Journal of Practice & Theory 34 (2):91-120.

    Keywords:
    audit committee quality, financial reporting oversight, financial reporting quality, independence
    Purpose of the Study:

    The Sarbanes-Oxley Act (SOX) was passed by Congress in 2002 in order to improve the accuracy and reliability of corporate disclosures. The introduction of SOX resulted in a substantial increase in audit committee members’ required level of independence and responsibility. In defining independence, however, regulators did not restrict companies from providing equity incentives for audit committee members. Pre-SOX research has shown stock option incentives to be associated with lower financial reporting quality. This study aims to re-examine the association between audit committee equity-based incentives and financial reporting quality (as proxied by a company’s propensity to meet or beat its consensus analyst forecast) in the post-SOX environment.

    Design/Method/ Approach:

    After removing problematic data, the sample collected for the study consisted of audit committee members’ equity holdings and compensation data for a sample of 2,172 company-year observations from 2006 to 2008. This information was then used in conjunction with a series of probit models in order to examine whether audit committee member’ equity incentives are associated with the likelihood of meeting or beating the analyst forecast. In order to mitigate the effect of outliers, the top and bottom 1% of the selection was winsorized.

    Findings:

    Findings were consistent with stock-option incentives being associated with lower financial reporting quality. Specifically, it was found that:

    • 58.8 percent of the average audit committee members’ pay is in the form of stock options and grants.
    • The likelihood of meeting or beating analyst expectations is positively associated with audit committee members’ stock-option compensation and holdings.
    • There is no association for non-equity compensation and holdings, and meeting or beating analyst expectations.
    • A company whose audit committee holds the mean value of exercisable options (i.e., about $200,000 in exercisable options) is associated with a 10.0 percent increase in the likelihood of meeting or beating its consensus analyst forecast.
    • A high-growth opportunity company whose audit committee holds the mean value of exercisable options is associated with a 17.8 percent increase in the likelihood of meeting or beating its consensus analyst forecast.
    Category:
    Governance, Independence & Ethics
    Sub-category:
    Board/Audit Committee Compensation, Impact of SEC Rules Changes/SarBox
  • Jennifer M Mueller-Phillips
    Internal Control Material Weaknesses and CFO Compensation.
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 14.0 Corporate Matters, 14.07 Executive Compensation in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Control Material Weaknesses and CFO Compensation.
    Practical Implications:

    The results emphasize the importance of the composition of the compensation committee. Specifically, results suggest that boards should consider appointing financial experts to serve not only on the audit committee but also on the compensation committee, as it would improve the oversight of the CFO. The results reveal that CFOs are held accountable not only for their managerial duties as reflected in firm financial performance, but also for their fiduciary duties associated with accurate financial reporting and high-quality internal controls.

    Citation:

    Hoitash, R., Hoitash, U., & Johnstone, K. M. 2012. Internal Control Material Weaknesses and CFO Compensation. Contemporary Accounting Research 29 (3): 768-803.

    Keywords:
    executive compensation, CFO compensation, material weakness, internal controls
    Purpose of the Study:

    The purpose of this paper is to help fill the void in the literature by examining the association between internal control material weakness (ICMW) disclosures and CFO compensation. Under the Sarbanes-Oxley Act of 2002 chief executive officers (CEOs) and chief financial officers (CFOs) are required to establish, maintain, and evaluate internal control effectiveness and to report on this evaluation in both quarterly and annual financial statements. CFOs play a leading role in the oversight of internal control compliance, and research shows that in the post-SOX period CFOs are being held more accountable for their actions. As a result, CFO compensation outcomes are likely to depend in part on reported internal control quality.

    In recent years there has been a trend toward including nonfinancial performance measures in compensation decisions, particularly given the fact that internal control information has become readily available with the implementation of SOX. Therefore, the tests will detect an association between internal control quality and CFO compensation outcomes only if boards and compensation committees incorporate this new nonfinancial performance measure into their compensation decisions.

    Design/Method/ Approach:

    The authors obtain compensation data from ExecuComp, firm characteristic data from COMPUSTAT, and internal control quality data from Audit Analytics. A final sample of 604 firms from the fiscal year 2005 was developed. The authors conduct ordinary least squares regressions in which they use as the dependent variable the change in various components of CFO compensation: total compensation, bonus, equity, and salary. 

    Findings:
    • The basic finding is that the change in CFO total compensation, bonus compensation, and equity compensation, but not base salary, are each negatively associated with ICMW disclosures.
    • These results are economically significant. ICMW disclosures are associated on average with a 14.9 percent decrease in CFO bonus (as a percentage of salary) compared to the prior year.
    • Although the CEO is also responsible for certifying internal control reports, robustness tests reveal no significant association between ICMW disclosures and changes in any of the CEO compensation measures.
    • Account specific ICMWs (as opposed to general, company-wide ICMWs) drive the effects on CFO compensation, which highlights the importance of CFO-specific job responsibilities in relation to compensation outcomes.
    • Results also reveal that CFOs at firms with stronger corporate governance experience larger bonus compensation decreases upon an ICMW disclosure compared to CFOs at ICMW-disclosing firms with weaker corporate governance.
    • CFOs in firms with greater cost of misreporting experience larger declines in bonus compensation and total compensation compared to CFOs in firms with lower costs of misreporting.
    Category:
    Corporate Matters, Internal Control, Standard Setting
    Sub-category:
    Executive Compensation, Impact of SOX, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Home Country Investor Protection, Ownership Structure and...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Home Country Investor Protection, Ownership Structure and Cross-Listed Firms’ Compliance with SOX-Mandated Internal Control Disclosures.
    Practical Implications:

    The results carry important implications for regulators, investors, and researchers. The findings suggest both firm-level corporate governance and home country investor protection still matter in explaining the disclosure behavior of cross-listed firms. Hence, it may be warranted for U.S. securities regulators to devote more resources to monitoring the financial disclosure quality of CONTROL_WEDGE firms from weak investor protection countries. The results suggest that U.S. investors should pay closer attention to the financial disclosure quality of cross-listed firms, especially CONTROL_WEDGE firms from weak investor protection countries. This is important because the recent accounting frauds involving cross-listed firms suggest that U.S. investors might not have paid sufficient attention to the disclosure quality, and as a result suffered significant economic losses after the revelation of the accounting frauds.

    Citation:

    Gong, G., Ke, B., & Yu, Y. 2013. Home Country Investor Protection, Ownership Structure and Cross-Listed Firms' Compliance with SOX-Mandated Internal Control Deficiency Disclosures. Contemporary Accounting Research 30 (4): 1490-1523. 

    Keywords:
    investor protection, Sarbanes-Oxley, internal controls
    Purpose of the Study:

    The objective of this study is to assess the effects of home country investor protection and ownership structure on the Sarbanes-Oxley Act (SOX)mandated internal control deficiency (ICD) disclosures by foreign firms that are listed on the U.S. stock exchanges (hereafter referred to as cross-listed firms). In this study, the authors focus on SOX-mandated internal control disclosure provisions, because internal control systems play a crucial role in ensuring the reliability of financial reporting. It is widely recognized that material internal control weaknesses give management the flexibility to manipulate financial reporting to conceal their expropriation activities. In addition, the SOX-mandated internal control disclosure provisions are regarded as the most costly and controversial provisions of SOX. Therefore, it is important to analyze cross-listed firms’ compliance with SOX-mandated ICD disclosure requirements.

    The authors focus on the ICD disclosures during the Section 302 reporting regime and examine whether cross-listed firms whose management is the controlling shareholder of the firm and holds greater voting rights than cash flow rights (denoted as CONTROL_WEDGE firms) have a higher likelihood of misreporting ICDs than other cross-listed firms, especially for cross-listed firms domiciled in weak investor protection countries where managers’ ICD misreporting faces fewer constraints.

    Design/Method/ Approach:

    The sample is restricted to cross-listed firms that are listed on the three major U.S. stock exchanges as of the end of 2002. The sample includes both American Depository Receipts (ADRs) and foreign firms directly listed on the U.S. stock. Using COMPUSTAT, SEC filings, CRSP, and Audit Analytics, the authors created a sample of 355 unique cross-listed firms, of which 41 firms disclosed at least one material weakness during the Section 302 reporting regime.

    Findings:

    For cross-listed firms domiciled in weak investor protection countries, the authors find the following results: 

    • CONTROL_WEDGE firms have a higher likelihood of ICD misreporting than other firms during the Section 302 reporting regime. In addition, the likelihood of ICD misreporting is negatively associated with earnings quality during the Section 302 reporting regime.
    • The likelihood of ICD misreporting is positively associated with the likelihood of voluntary deregistration from the SEC prior to the Section 404 effective date.
    • For cross-listed firms that chose not to deregister, the likelihood of ICD misreporting is positively associated with the likelihood of reporting previously undisclosed ICDs during the Section 404 reporting regime.

    The authors do not find similar results for cross-listed firms domiciled in strong investor protection countries. Overall, the results are consistent with the hypothesis that management of CONTROL_WEDGE firms domiciled in weak investor protection countries is reluctant to disclose ICDs in order to protect its private control benefits. In addition, the results suggest that Section 404 is effective in weeding out cross-listed firms whose management has an incentive to hide ICDs or forcing cross-listed firms to truthfully reveal their ICDs.

     

    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Interactive Effects of Internal Control Audits and...
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Interactive Effects of Internal Control Audits and Manager Legal Liability on Managers' Internal Controls Decisions, Investor Confidence, and Market Prices.
    Practical Implications:

    The results demonstrate a demand for IC audits such that, even in the presence of increased manager liability, the IC audit incrementally motivates managers to spend on improving IC and to provide more consistent and accurate ICFR disclosures. Unlike managers, investors react as though manager liability and IC audits are substitutes. This finding has implications for policymakers as it demonstrates the need to consider the possible differing effects of regulation on managers and investors. Moreover, with respect to regulatory actions to simultaneously implement both manager liability and an IC audit, the results suggest that both mechanisms may not be necessary to improve investors’ confidence and in turn market prices.

    Citation:

    Wu, Y., & Tuttle, B. 2014. The Interactive Effects of Internal Control Audits and Manager Legal Liability on Managers' Internal Controls Decisions, Investor Confidence, and Market Prices. Contemporary Accounting Research 31 (2): 444-468.

    Keywords:
    internal controls, internal auditing, investor confidence, Sarbanes-Oxley
    Purpose of the Study:

    This study investigates the effects of the audit of internal controls (IC audit) and manager liability for the company’s internal controls on investor confidence and market prices. This research is motivated by the substantial debate regarding the incremental effectiveness of IC audits and manager liability on investor confidence in financial disclosures. This debate came to the forefront with the Sarbanes-Oxley Act of 2002 (SOX) when the U.S. Congress simultaneously implemented both regulatory mechanisms. Section 302 requires that CEOs and CFOs personally attest, under penalty of perjury, that effective internal controls over financial reporting (ICFR) have been established, maintained, and evaluated on a timely basis. Section 404 requires that the auditors of publicly-traded companies provide assurance on the effectiveness of ICFR. However, direct empirical evidence remains limited regarding the individual versus joint effectiveness of these two regulatory mechanisms in (1) motivating managers to spend on improving ICFR and to provide more accurate ICFR disclosures and (2) improving investor confidence and market prices.

    Design/Method/ Approach:

    Seventy-six MBA students from a major public university participated in this study. The 76 participants resulted in a total of 19 sessions with four participants assigned to each. The experiment is programmed and conducted using ZTree software. Each session takes approximately 90 minutes and includes three practice rounds followed by 21 experimental rounds. The number of rounds is not known by participants. The evidence was collected prior to the summer of 2014.

    Findings:
    • Results suggest that the effects of manager liability and an IC audit are additive with respect to IC spending, with the IC audit having a stronger effect than manager liability.
    • Even after controlling for managers’ IC spending, results also demonstrate that IC audits improve the accuracy of managers’ ICFR disclosures.
    • Similar improvement is not associated with increased manager liability. In the presence of the IC audit, managers’ IC spending strategies are more constant over time and enable managers to provide accurate information more consistently regarding the effectiveness of ICFR.
    • Managers will spend more to improve ICFR when either liability or IC audits are present and that even in the presence of manager liability the IC audit incrementally increases managers IC spending.
    • The results demonstrate that investor confidence and stock price are no greater when both regulatory mechanisms are present than when only one is present.
    • Supplemental analyses suggest that manager reputation for accurate ICFR disclosures explains, at least in part, why investors perceive manager liability and IC audit to be substitutes.
    • The results suggest that when managers accrue a reputation for accurate ICFR disclosures, both regulatory mechanisms may not be necessary to improve investor confidence in managers’ earnings reports.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX