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  • Jennifer M Mueller-Phillips
    Did the PCAOB’s Restrictions on Auditors’ Tax Services Imp...
    research summary posted September 13, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 04.0 Independence and Ethics, 04.03 Non-Audit Services in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Did the PCAOB’s Restrictions on Auditors’ Tax Services Improve Audit Quality?
    Practical Implications:

     This study serves the purpose of examining the PCAOB’s role as overseer of public company auditing, while separating from previous studies by targeting the PCAOB’s restrictions on auditors’ tax services, which have not been examined in the past. This study also examines whether APTS pose a threat to audit quality but again differentiates itself from previous literature by focusing on only the tax services that the PCAOB chose to ban and by utilizing the difference-in-differences design to address the limitation of the cross-sectional approach utilized by other studies in the past. After reviewing these findings, it is possible that the PCAOB restrictions did not fully accomplish their objective.

    Citation:

     Lennox, C. S. 2016. Did the PCAOB’s Restrictions on Auditors’ Tax Services Improve Audit Quality? The Accounting Review 91 (5): 1493-1512.

    Keywords:
    PCAOB, audit quality, and auditors’ tax services.
    Purpose of the Study:

    In 2005, the Permanent Subcommittee on Investigations of the U.S. Senate reported that audit firms were selling potentially abusive or illegal tax-planning strategies to audit clients and their top executives on a contingent fee basis. This concerned regulators for many reasons; consequently, the PCAOB adopted three new rules to address these potential threats to audit quality. First, Rule 3521 reaffirms the ban on contingent fees that existed under Rule 302 of the American Institute of Certified Public Accountants’ Code of Professional Conduct. Second, Rule 3522 bars audit firms from selling aggressive tax services to audit clients. Finally, Rule 3523 forbids audit firms from selling tax services to executives in a financial reporting role. These three rules became effective from October 31, 2006 onward. The PCAOB stated that the rules were intended to improve audit quality, and, by extension, the quality of financial reporting. The purpose of this study is to test whether the restrictions met this objective.

    Design/Method/ Approach:

    Because audit quality is not directly observable the author focuses on accounting misstatements, both misstatements that are tax-related and other types, and the issuance of going-concern opinions. The author separates companies into groups based upon the reduction of APTS purchases between July 26, 2005 and October 31, 2006. He then compares the differences in misstatements and going-concern opinions between the treatment and control groups and tests whether these differences change after the PCAOB imposed the restrictions on auditors’ tax services. 

    Findings:
    • The author finds that in the period before the restrictions, there is no difference in the incidence of going-concern opinions between the treatment and control companies; however, the treatment companies are more likely than the control companies to have accounting misstatements and tax-related misstatements. This supports the premise of regulators that the treatment companies had lower-quality auditing before the restrictions were introduced. 
    • The author finds no significant changes in misstatements, tax-related misstatements, or going-concern opinions subsequent to the APTS restrictions after using a difference-in-differences research design. In fact, the treatment companies continue to have significantly more accounting misstatements and more tax-related misstatements in the period subsequent to the APTS restrictions.
    • The author finds large and highly significant reductions in APTS fees when the restrictions were introduced. 
    Category:
    Independence & Ethics, Standard Setting
    Sub-category:
    Impact of PCAOB, Non-audit Services
  • Jennifer M Mueller-Phillips
    The Role of Auditors, Non-Auditors, and Internal Tax...
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Role of Auditors, Non-Auditors, and Internal Tax Departments in Corporate Tax Aggressiveness.
    Practical Implications:

    The results of this study are important to policymakers as the PCAOB considers whether tax and audit services should be provided by different firms. The results of this study indicate that auditor-provided tax services may actually decrease the tax aggressiveness of companies, especially those serviced by the Big 4. Based on the representative who signs the tax return, tax aggressiveness is higher for internally prepared and non-auditor externally prepared tax returns than auditor-prepared tax returns. Additionally, accounting professionals may be interested in the findings of this study as it provides insights into how tax compliance changes in the presence of an audit. The authors suggest that signing a tax return with aggressive positions is costly to auditors because of reputation risk and financial reporting restatement risk in the tax accounts. As accounting professionals seek to perform effective audits and accurate tax returns, it may be beneficial to consider how tax compliance decisions could be impacted by the same firm providing both services.

    Citation:

    Klassen K. J., P. Lisowsky, and D. Mescall. 2016. The role of auditors, non-auditors, and internal tax departments in corporate tax aggressiveness. The Accounting Review. 91(1): 179-205.

    Keywords:
    tax preparer, auditor, tax fee, FIN 48, tax aggressiveness
    Purpose of the Study:

    Corporate tax returns may be prepared by management, an external party who does not perform the audit, or the company’s auditor. There is little evidence to suggest how the type of tax preparer impacts corporate tax decisions. In particular, it is unclear how the dual role of auditor-tax preparer may impact tax compliance outcomes. This study seeks to provide insight into how tax preparer type influences corporate tax aggressiveness. Specifically, the authors:

    • Examine the relationship between the tax return preparer type and corporation tax aggressiveness. 
    • Examine whether tax fees as a representation of tax planning supports the findings of prior academic research.
    • Examine the link between tax aggressiveness and tax preparer type for Big 4 firms.
    Design/Method/ Approach:

    The authors were able to obtain confidential data from the Internal Revenue Service (IRS) for 2008 and 2009. The data provided by the IRS Large Business & International Division included tax return preparer identities and FIN 48 disclosures. Financial statement data were obtained from Compustat, and auditor identity, tax fees, and audit fees were obtained from the Audit Analytics database. The authors proxy for tax aggressiveness using the current-year increase in the tax reserve from FIN 48 disclosures on each company’s tax return. They use the tax return preparer identities in combination with the auditor identities to identify the tax return preparer type for their analysis. Based on the availability of the data, the final sample consisted of 1,533 firm-years (804 firms in 2008 and 729 in 2009).

    Findings:
    • The authors find that tax returns that are internally prepared by management claim more aggressive tax positions than auditor-prepared returns. Tax returns that are prepared by a non-auditor external party also claim more aggressive tax positions than auditor-prepared returns.
    • The authors find that less tax aggressiveness occurs for clients when the tax preparer is also the auditor and a Big 4 firm than when the tax preparer and auditor are different Big 4 firms.
    • The authors corroborate prior academic research that suggests tax fees represent the level of tax planning by the audit firm. The authors find that even after considering the tax return preparer type which accounts for tax compliance costs, higher tax fees paid to the auditor are indicative of more tax aggressive behavior.
    Category:
    Independence & Ethics
    Sub-category:
    Non-audit Services
  • Jennifer M Mueller-Phillips
    External Auditor Evaluations of Outsourced Internal...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    External Auditor Evaluations of Outsourced Internal Auditors.
    Practical Implications:

    These results have implications for both audit research and practice as well as policy makers and firms deciding on whether to outsource the internal audit function. From a research perspective, this study is the first to examine how external auditors view various internal audit outsourcing arrangements. Further, the results indicate a potential cost of internal audit outsourcing that has not been previously considered. That is, if outsourced internal auditors provide other services, the cost of the external audit could increase, which potentially interferes with some of the expected cost savings of AS No. 5.

    Citation:

    Brandon, D. M. 2010. External Auditor Evaluations of Outsourced Internal Auditors. Auditing: A Journal of Practice & Theory 29 (2): 159-173. 

    Keywords:
    auditor independence, external auditing, nonaudit services, outsourced internal auditing
    Purpose of the Study:

    In the last several decades many companies began outsourcing the internal audit function (IAF) to public accounting firms. The prevalence of outsourcing is likely to continue given current exchange requirements to establish and maintain an IAF. Further, lack of an IAF could be considered a significant internal control deficiency or even a material weakness. The primary concern over external auditors providing nonaudit services appears to be the potential negative effects of the fees from those services on the external auditor’s objectivity. This concern was so pervasive that part of the Sarbanes-Oxley Act prohibits external auditors from performing certain nonaudit services for external audit clients. The Panel on Audit Effectiveness acknowledges the role of internal audit in maintaining good corporate governance and encourages the cooperation between internal and external auditors. Public accountants can utilize the client-specific expertise possessed by strong internal audit departments to increase external audit efficiency (resulting in cost savings that could be passed on to the auditee) and also provide a higher level of assurance. These benefits are of particular interest given concerns over the cost of complying with Section 404 of the Sarbanes-Oxley Act (SOX).

    This study investigates some implications of an outsourced internal auditor providing nonaudit services.

    Design/Method/ Approach:

    The 89 participants for the study were experienced practicing auditors. Fifty-six participants were obtained via contact partners at the respective firm. The contact partners were asked to distribute the instruments to auditors who typically evaluate internal auditors. The remaining participants were obtained through an in-house training session. 89 auditors participating, approximately 64 percent were CPAs and had an average of 4.7 years of audit experience. The evidence was gathered prior to September 2007.

    Findings:

    Results indicate that certain external auditor judgments and decisions are negatively affected when an outsourced internal auditor also provides consulting services, while other judgments (long touted by proponents of auditor-provided nonaudit services as benefits) are not. Specifically, inconsistent with proponents of auditor-provided nonaudit services, competence perceptions do not appear to be improved by the provision of consulting services. Consistent with arguments of opponents of auditor-provided nonaudit services, external auditor perceptions of internal auditor objectivity appears to be impacted negatively by the provision of consulting services. Further, consistent with previous research, these results appear to be tempered by the staffing of the team providing the consulting services.

    Other results indicate reduced planned reliance on outsourced internal auditors also providing other services. External auditors appear reluctant to rely on outsourced internal auditors providing additional services, regardless of staffing decisions. Results also indicate differences in audit fee adjustments. Specifically, participants would recommend greater audit fee increases when consulting services are provided, again regardless of the outsourcing arrangement.

    Category:
    Governance, Independence & Ethics
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Non-audit Services
  • Jennifer M Mueller-Phillips
    Nonaudit Services and Independence in Appearance: Decision...
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Nonaudit Services and Independence in Appearance: Decision Context Matters.
    Practical Implications:

    An implication of the findings from experiment one is that restricting the auditor’s provision of NAS may lead to fewer lawsuits and, importantly, a reduction in the deadweight costs associated with litigation. But such restrictions mean that companies forgo the potential benefits (e.g., knowledge spillovers) of acquiring NAS from the auditor. Based on the findings from experiment two, participants perceive that the potential benefits of NAS outweigh the potential costs, notably when performing a conventional assessment of asset value. The net benefits are lost when the auditor is prohibited from providing NAS. The authors encourage future study to examine the net effect of restricting the auditor’s provision of NAS on social welfare.

    Citation:

    Church, B. K., and P. Zhang. 2011. Nonaudit Services and Independence in Appearance: Decision Context Matters. Behavioral Research in Accounting 23 (2): 51-67.

    Keywords:
    auditor independence, auditor litigation, decision context, nonaudit services
    Purpose of the Study:

    Following the Enron and WorldCom scandals, the Sarbanes-Oxley Act of 2002 (SOX) prohibited the auditor’s provision of many nonaudit services (NAS). The passage of SOX suggests that regulators and legislators believe that certain NAS impair auditor independence and, in turn, lower financial reporting quality. Archival data, however, provide scant evidence of a relation between NAS and audit quality (independence in fact). Notwithstanding, auditors must still maintain independence in appearance for their reports to be credible.

    The fundamental question is whether users’ perceptions of NAS differ across decision contexts; that is, whether NAS are viewed as detrimental in one context and beneficial in another. By examining the effect of decision context on users’ assessments, the authors seek to identify an important factor that may account for some of the mixed findings documented elsewhere. The authors suggest that decision context influences users’ motives, such that the auditor’s provision of NAS is interpreted opportunistically—in a manner that best suits users’ self-interest. If that is the case, then users’ assessments of independence are malleable, which can be problematic for regulators; the challenge of prescribing rules to ensure independence in appearance becomes quite daunting. Because auditor independence is a cornerstone of auditing, regulators may opt to err on the side of caution and mandate strict rules. Yet, such rules may not be socially optimal.

    Design/Method/ Approach:

    The authors design two experiments to investigate. For experiment one, the authors recruited 27 students from a large university to participate in the experiment. The authors recruited 37 students from a large university to participate in experiment two. All the students were in at least their third year, and all but one were pursuing a program of study in business or economics. The evidence was gathered prior to November 2011.

    Findings:
    • The results of the experiments indicate that users’ perceptions of NAS differ across decision contexts.
    • In the first experiment, participants initially perceive that NAS are associated with auditor faultin the face of a bad outcome (loss in value), NAS are perceived negatively.
    • In the second experiment, participants initially provide a higher assessment of asset value when the auditor supplies NASthat is, the net effect of NAS on asset value is beneficial.
    • In both experiments participants eventually decipher the experimental relationsthat NAS are not associated with auditor fault or asset value.
    • The findings indicate that decision context dramatically alters users’ perceptions of NAS and auditor independence.
    • Undoubtedly accounting scandals, which create significant losses for owners and creditors, can lead users to question auditor independence.
    • The findings suggest that users react in this manner for strategic reasons.
    • In responding to public outcry, regulators may overreact, for political purposes, and enact laws/rules that are excessive, potentially sacrificing social welfare.
    Category:
    Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk, Non-audit Services
  • Jennifer M Mueller-Phillips
    Does Mandated Disclosure Induce a Structural Change in the...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 09.0 Auditor Judgment, 09.06 Adequacy of Disclosure in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does Mandated Disclosure Induce a Structural Change in the Determinants of Nonaudit Service Purchases?
    Practical Implications:

    The authors contribute to the literature in three ways. First, the results provide support for the agency-based demand for publicly available audit quality signals in a powerful test setting. They find SOX supply-side approach of banning certain NAS may have hurt some registrants if those banned NAS services previously served to increase overall audit quality. Second, the evidence provided herein suggests that registrants learned from the market’s negative price protection reaction and, in accordance with agency theory, recalibrated their subsequent year NAS purchases. Finally, the results provide archival, empirical support for the audit committee incentive arguments of Gaynor et al.

    Citation:

    Abbott, L. J., S. Parker, and G. F. Peters. 2011. Does Mandated Disclosure Induce a Structural Change in the Determinants of Nonaudit Service Purchases? Auditing: A Journal of Practice & Theory 30 (2): 51-76.

    Keywords:
    auditor fees, mandatory disclosures, nonaudit services
    Purpose of the Study:

    The impact of nonaudit services (NAS) on perceived audit quality has been the subject of a considerable amount of prior research. This stream of research includes investigations of stock and bond markets’ reactions to NAS disclosure as a proxy for perceived auditor independence. In this study, the authors investigate whether the introduction of mandated NAS disclosures is associated with structural changes in the relations between certain company characteristics and NAS purchases in pre- and post-disclosure settings. The authors accomplish this by comparing NAS purchases made in 2000 (pre-disclosure) with those made by the same set of firms (employing the same auditor) in 2001 (post-disclosure). 

    By examining the impact of mandated NAS disclosure on NAS purchasing behavior, the study seeks to provide evidence on the potential regulatory efficacy of disclosure requirements such as the Securities and Exchange Commission’s (SEC) Auditor Independence Rules of 2000, which mandated audit fee and NAS disclosures. During the rule-making deliberations, the SEC adopted a demand-side approach to regulating NAS purchases. In particular, the SEC sought to let the market decide the optimal level of NAS purchases by imposing a mandatory NAS disclosure regime. However, the subsequent Sarbanes-Oxley Act (SOX) took a supply-side approach to the NAS issue by banning several NAS services. Consequently, the test setting represents a unique window of opportunity since it occurs after the Auditor Independence Rules of 2000, but before the SEC altered the NAS definitions and before SOX.

    Design/Method/ Approach:

    For comparative purposes, the authors utilize the sample previously used in Abbott et al. The original sample consisted of the 310 nonfinancial firms filing proxies with the SEC between February 5, 2001, and March 16, 2001. The final sample used by the authors is a sample of 338 firms available for both 2000 and 2001.

    Findings:
    • The authors find little support for an agency-based model for NAS purchases in a nondisclosure environment.
    • In contrast, the authors document statistically significant structural differences in the relation between the NAS/audit fee ratio and three of the four primary agency conflict variables when switching to a disclosure environment.
    • They also find similar results when they use the same model to predict which firms were more likely to reduce 2001 NAS purchases relative to 2000 NAS purchases.
    • They document that inside ownership and financing activity become statistically significant determinants of NAS purchasing behavior in the disclosure environment.
    • In addition, the positive association between company size and the demand for NAS decreases during the post-disclosure environment, consistent with the larger agency costs of larger firms.
    • They also document a statistically significant increase in the magnitude of the audit committee effectiveness coefficient for the subsequent year NAS purchases.
    • The agency-based model’s R2 increases over 70 percent from the initial year (i.e., nondisclosure environment) to the subsequent year of NAS disclosure (i.e., disclosure environment).
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Adequacy of Disclosure, Non-audit Services
  • Jennifer M Mueller-Phillips
    Auditor Industry Specialization, Service Bundling, and...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 04.0 Independence and Ethics, 04.03 Non-Audit Services, 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Industry Specialization, Service Bundling, and Partner Effects in a Mining-Dominated City.
    Practical Implications:

    The authors contribute by providing some of the first evidence of service bundling in the economics of auditing literature. In doing so, they broaden the notion that strategic pricing occurs around audit switches. This study contributes to prior mixed findings of the existence of industry specialist premiums in the small-client segment, suggesting an additional reason why these mixed findings might occur. Where opportunities to package services are attractive, auditors may strategically price and discount audits with bundling premiums in mind. Where potential for such bundling opportunities is less attractive, it is possible the auditor may instead seek to generate premiums in the audit service.

    Citation:

    Ferguson, A., G. Pündrich, and A. Raftery. 2014. Auditor Industry Specialization, Service Bundling, and Partner Effects in a Mining-Dominated City. Auditing: A Journal of Practice & Theory 33 (3): 153-180.

    Keywords:
    audit fees, industry specialization, mining industry, non-audit services, second-tier firms, service bundling
    Purpose of the Study:

    This study examines auditor industry specialization effects in Perth, a remote mining town in Australia characterized by a large number of small, homogeneous firms. In this study, the authors consider whether an auditor industry specialist may strategically price a bundle of services in the small-client segment. They argue that the small company sector is a good environment to consider the existence of service bundling. The setting is the mining development stage entity (MDSE) market in Perth, the biggest industry and city in Australia by client numbers. This market is characterized by small (high-growth) firms where auditing is arguably of less importance to the client compared to tax advisory, the other primary service provided to them. Further, the firms are relatively homogeneous, an appealing feature of industry studies. Thus, the authors have arguably an attractive setting to observe service bundling by an industry specialist.

    First, the authors examine whether industry specialist auditors earn audit fee premiums in the Perth MDSE segment. To do this, an audit pricing model is developed and includes controls likely to impact on audit fees in a mining industry context. Second, the authors redefine the dependent variable to consider the pricing implications of the bundle of services provided by industry specialists.

    Design/Method/ Approach:

    The authors utilize an OLS regression model to test for audit fee premiums with respect to brand name and industry leadership. A sample of 1,799 firms listed on the ASX as of December 31, 2009 is obtained. Of the 1,799 listed entities nationally, 668 (37.13 percent) are domiciled in Perth, making it the largest city-level market by client numbers in Australia. At the city-level, the market share of non-Big 4 firms is 70.1 percent in Perth.

    Findings:

    The authors find no evidence of auditor industry leadership audit fee premiums accruing to either Big 4 (EY) or non-Big 4 (BDO) leaders. However, when the dependent variable is redefined to include non-audit services (NAS), the industry leader, BDO, obtains a total fee premium. This finding is of added interest given that the industry leader is a second-tier firm, implying that strategic audit pricing, such as service bundling, is not confined to Big 4 auditors. Nor is it confined to merely one location, since bundling premiums are observed at the national level. The authors argue MDSEs have little in the way of financial statement complexity, so they do not value specialist audits, but rather are willing to pay more for NAS. Last, in supplementary analysis, the authors find some evidence of partner-scale effects.

    Category:
    Audit Team Composition, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Industry Expertise – Firm and Individual, Non-audit Services
  • Jennifer M Mueller-Phillips
    The Association between Actuarial Services and Audit...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 05.0 Audit Team Composition, 05.01 Use of Specialists e.g., financial instruments, actuaries, valuation in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Association between Actuarial Services and Audit Quality.
    Practical Implications:

    Involving two service providers, rather than one, conveys potential benefits similar to those argued for joint audits. Auditor independence is enhanced because each firm provides a reciprocal check on the diligence of the other, and the allocation of fees between providers reduces economic bonding between the client and any one firm. Regulators might consider requiring disclosure of the recipient of NAS payments for both the audit firm and other consultants to allow a more complete examination of the influence of NAS on audit quality in other settings.

    Citation:

    Gaver, J. J., and J.S. Paterson. 2014. The Association between Actuarial Services and Audit Quality. Auditing: A Journal of Practice & Theory 33 (1): 139-159.

    Keywords:
    actuaries, auditor independence, insurance industry, knowledge spillover, non-audit services, reserve management
    Purpose of the Study:

    A challenge facing the accounting profession is the creation and maintenance of auditor independence from clients, both in fact and in appearance. The authors examine the association between non-audit services and audit quality among firms in the property-casualty insurance industry. Limiting the sample to insurance firms conveys benefits that provide a more powerful test of the audit quality-NAS relation than has been possible in prior studies. This setting allows the authors to focus on a specific non-audit service that is purchased by almost all firms in the industry. The insurance setting is unique because the non-audit service that the authors examine is purchased by all firms in the sample, and they can identify both the audit and non-audit service provider. This allows the authors to directly address the NAS separation issue while holding NAS quality constant.

    Since 1990, the National Association of Insurance Commissioners (NAIC) has required a "Statement of Actuarial Opinion" regarding the adequacy of the company's loss reserve to be submitted with the insurer's Annual Statement. Although auditing standards and SOX both prohibit the audit firm from determining insurance company policy reserves (the audit client must use its own actuaries or third-party actuaries to provide management with primary actuarial capabilities), it is acceptable for actuaries from the audit firm to review and certify reserves established by the client and to sign the Statement of Actuarial Opinion. The loss reserve is the largest liability on insurer balance sheets, and establishing comfort on reserve levels is a crucial aspect of an insurance company audit.

    Design/Method/ Approach:

    The sample consists of 3,261 insurer-year observations where both audit and actuarial services are provided by a Big N firm. The sample was derived from a property-casualty database of the NAIC during the years 1993 through 2006. In 2,977 cases, the services are obtained from the same Big N firm; in the remaining 284 cases, one Big N firm conducts the audit and a different Big N firm certifies the reserves.

    Findings:

    The authors find that when actuarial work is obtained only from Big N firms (NAS quality is constant), audit quality is higher when separate Big N firms provide audit and actuarial services. The implication is that separating audit and NAS functions between two quality providers is beneficial, compared to allowing one quality firm to provide both services.

    The results indicate that joint provision of services is related to significantly more over-reserving by healthy insurers, compared to the case where audit and actuarial services are obtained from two independent firms. Although over-reserving by financially secure insurance clients does not present the same risk of audit failure as does under-reserving by weak insurers, both findings suggest that reserves are more likely to be biased in the client's favor when multiple services are consolidated in one provider. Specifically, jointly provided audit and actuarial services are associated with a greater tendency for weak insurers to under-reserve and strong insurers to over-reserve.

    Category:
    Audit Team Composition, Independence & Ethics
    Sub-category:
    Non-audit Services, Use of Specialists (e.g. financial instruments – actuaries - valuation)
  • Jennifer M Mueller-Phillips
    Internal Control Quality: The Role of Auditor-Provided Tax...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 13.0 Governance, 13.05 Board/Audit Committee Oversight in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Control Quality: The Role of Auditor-Provided Tax Services.
    Practical Implications:

    The results of this study are important to audit regulators as they make decisions regarding policies, and to corporate governance officials as they make decisions regarding the audit firms they engage to provide tax nonaudit services. The evidence indicates that tax nonaudit services accelerate audit firm awareness of material transactions as these services are associated with a lower likelihood of a material weakness in internal controls. In addition, further evidence supports that this finding is not simply due to impaired auditor independence. Overall, this suggests that tax nonaudit services provided by the audit firm improve internal control quality. As regulators and companies evaluate the consequences of tax nonaudit services, the findings in this paper may impact their conclusions.

    Citation:

    De Simone, L., M.S. Ege, and B. Stomberg. 2015. Internal Control Quality: The Role of Auditor-Provided Tax Services. The Accounting Review. 90(4): 1469-1496.

    Keywords:
    auditor fees, nonaudit services, auditor independence, internal controls, tax, financial reporting quality
    Purpose of the Study:

    Audit regulators and companies’ corporate governance officials are charged with understanding and creating policies for auditor provided nonaudit services. To make informed decisions, it is important for these groups to know the benefits and costs of auditor provided nonaudit services. Previous research has reported a positive association between tax nonaudit services and financial reporting quality and audit quality. This paper investigates the relationship between tax nonaudit services and a specific component of financial reporting quality: internal control quality. Specifically, the authors:

    • Examine the relationship between tax nonaudit services and the probability of a material weakness in internal controls (i.e. internal control quality).
    • Examine whether tax nonaudit services are beneficial to companies experiencing a shock to their internal control environment.
    • Examine how the relationship between tax nonaudit services and internal control quality is affected by audit firm tenure.

    The authors also explain the process through which they propose tax nonaudit services affects non-tax financial reporting quality.

    Design/Method/ Approach:

    The authors collected auditor internal control opinions and data necessary to calculate control variables on publicly-traded companies that are subject to SOX Section 404(b). The information collected on these companies was for years 2004-2012.

    Findings:
    • The authors find that companies that purchase tax nonaudit services are significantly less likely to disclose a material weakness. A one standard-deviation increase in tax nonaudit services is associated with approximately a 13% decrease in the rate of material weaknesses relative to the base rate. Further analysis indicates that impaired auditor independence does not account for this result.
    • The authors find that when companies experience a significant shock to their internal control environment, tax nonaudit services incrementally benefit internal control quality relative to other companies.
    • The authors find that the benefits of tax nonaudit services on internal control quality are greater in the early years of audit firm tenure.
    Category:
    Governance, Independence & Ethics, Internal Control
    Sub-category:
    Board/Audit Committee Oversight, Non-audit Services, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Audit Firm Tenure, Non-Audit Services, and Internal...
    research summary posted September 15, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 04.07 Audit Firm Rotation, 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality.
    Practical Implications:

    In first-year audits, lower audit process quality and higher total audit hours are possible additional costs that should be considered in the ongoing debate on mandatory audit firm rotation. Moreover, study results are consistent with the notion thateven prior to the effective date of the Sarbanes-Oxley Act (SOX)market and related regulatory forces disciplined auditors of public entities to achieve a high level of audit quality when tenure was long or fees from auditor-provided non-audit services were large. In order to serve the public interest, these considerations should be included in assessments of the economic costs and benefits of restrictions on audit firm tenure and non-audit services.

    Furthermore, the results suggest that, in the private-client market, audit process quality declines in the long tenure range and when non-audit fees become large, which may be of interest to standard setters in the private sector (e.g., the Auditing Standards Board and US State Boards of Accountancy).

    Citation:

    Bell, T.B., M. Causholli, and W.R. Knechel. 2015. Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality. Journal of Accounting Research 53(3):461-509.

    Keywords:
    audit quality, audit firm tenure, non-audit services
    Purpose of the Study:

    This study asks whether audit quality declines when audit firm tenure becomes long or when fees from auditor-provided non-audit services become large. The financial crisis of 2008 reignited a long standing debate on the impact of audit firm tenure and auditor-provided non-audit services on audit quality. Prior literature examining effects of audit firm tenure and non-audit services on audit quality have had to use externally observable proxies for audit quality which are, therefore, indirect measures of audit-related outcomes that may not fully reflect the quality of auditors’ execution of the audit process. However, regulators focus on process-related characteristics of audit quality including (1) the extent and appropriateness of evidence supporting the auditor’s opinion and (2) the degree of correspondence between the auditor’s procedures and auditing standards. Therefore there may be a difference between indirect external proxies for audit quality and audit quality proxies actually used by regulators. This study assesses audit quality using direct assessments of attributes of the audit process made by internal reviewers at a large international audit firm in 265 US audits of publicly and privately held clients. Primary analyses are based on two quality measures developed from the review data: 1) the total number of assessed audit deficiencies across 55 separate audit process activities; and 2) a composite assessment of the overall quality of the audit.

    Design/Method/ Approach:

    The data set used in this research was obtained from a large international accounting firm by one of the authors who was employed by the firm at the time the data were collected. The author developed a questionnaire to gather information during the reviews on various audit fee, production, and other engagement characteristics. The data were gathered in October 2003.

    Findings:
    • Audit quality is lowest in first-year audits, improves shortly thereafter, and then declines somewhat as audit firm tenure becomes long. The decline in quality in the long-tenure range is attributable to audits of private clients.
    • In public-client audits, quality increases slowly over the entire tenure range and is not significantly higher than in a first-year audit until the longest period where tenure exceeds 13 years.
    • In contrast, quality in private-client audits improves quickly after the first year but declines with very long tenure to the point where it is indistinguishable from audit quality in the first year.
    • Audit quality is not associated with non-audit fees in the full sample but, as above, the public- and private-client subsamples exhibit different patterns of association. The association of audit quality with non-audit fees is positive in audits of public clients and negative in the audits of private clients.
    • For public clients, the probability of a high-quality audit is 7 percentage points higher for clients purchasing non-audit services than for clients not purchasing these services.
    • For private clients, the probability of a high-quality audit of a private client purchasing non-audit services is 18 percentage points lower than for those not purchasing non-audit services.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Audit Firm Rotation, Audit Firm Rotation, Non-audit Services, Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    Future Nonaudit Service Fees and Audit Quality.
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Future Nonaudit Service Fees and Audit Quality.
    Practical Implications:

    The results indicate that prior to the Sarbanes-Oxley Act, rewards to the auditor in the form of future additional nonaudit service fees from current-year high fee-growth-opportunity clients adversely affects audit quality. This effect is particularly strong among companies with powerful incentives to manage earnings. The findings indicate that regulators should consider the multi-period nature of the client-auditor relationship when contemplating policies that restrict nonaudit services, as well as the overall environment in which audit partners operate. This might include partner compensation arrangements that put pressure on audit partners to focus on increasing revenue at the expense of audit quality.

    Citation:

    Causholli, M., D. J. Chambers, and J. L. Payne. 2014. Future Nonaudit Service Fees and Audit Quality. Contemporary Accounting Research 31 (3): 681-712.

    Keywords:
    auditor independence, revenue, auditor-client relationships, financial management, auditing, non-audit services
    Purpose of the Study:

    Prior to the Sarbanes-Oxley Act of 2002, audit partners experienced economic pressure to grow revenue from the sale of nonaudit services to their audit clients. To an auditor who is highly rewarded for revenue generation and growth, nonaudit services may represent a particularly strengthened economic bond with the client. Prior research shows that, in general, nonaudit service fees received in the current period do not impair audit quality. The authors examine a different setting. Future nonaudit fees present an important source of career advancement and a source of particularly strengthened economic bond with the client. They propose that auditor independence can become impaired, and audit quality compromised, when clients that currently purchase relatively low amounts of nonaudit services, increase their purchases of nonaudit services from the auditor in the subsequent period. They test the prediction in the context of earnings management as a proxy for audit quality, measured by (a) performance-adjusted discretionary accruals and (b) classification shifting of core expenses.

    Design/Method/ Approach:

    The authors obtain the data on the Big-N clients’ audit and nonaudit fees from Audit Analytics, the data on client characteristics from COMPUSTAT, and the data on stock returns from CRSP for fiscal years 2000-2001. The Accruals Model has a sample of 4,078. The Classification-shifting Model has a sample of 3,361.

    Findings:
    • The results show that earnings management is higher for high fee-growth-opportunity clients who increase their future nonaudit services (NAS) purchases from the auditor.
    • Both forms of earnings management are higher for companies with relatively low NAS in the current year that simultaneously increase future NAS purchases from the auditor.
    • The negative effect of future NAS is even more pronounced in companies that have greater incentives to manage earnings such as those that meet or just beat earnings forecasts or those that issue equity and less likely to occur in companies with strong corporate governance.
    • When using the absolute value of discretionary accruals to proxy for earnings management, the authors find that future increases in NAS fees are positively associated with the absolute discretionary accruals for high fee-growth-opportunity clients. This association continues to hold when the authors separate total discretionary accruals into income-increasing and income-decreasing accruals.
    • When using the association between unexpected core earnings and income-decreasing special items as the proxy for classification shifting, the authors find that the association becomes more positive, indicating greater classification shifting for high fee growth opportunity clients who increase future NAS purchases.
    Category:
    Independence & Ethics
    Sub-category:
    Non-audit Services