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  • Jennifer M Mueller-Phillips
    Real Earnings Management: A Threat to Auditor Comfort?
    research summary posted January 12, 2017 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.06 Earnings Management – Detection and Response in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Real Earnings Management: A Threat to Auditor Comfort?
    Practical Implications:

    Given that REM often causes significant auditor discomfort, the authors’ paper provides broader REM and auditor comfort-related questions pertaining to the effects of management’s focus on short-term results, the extent to which REM is a problem that can or needs to be fixed, and the possibility that REM is a gateway to more serious forms of accounting manipulation. 

    Citation:

    Commerford, B. P., D. R. Hermanson, R. W. Houston, and M. F. Peters. 2016. Real Earnings Management: A Threat to Auditor Comfort? Auditing: A Journal of Practice and Theory 35 (4): 39 – 56. 

    Keywords:
    real earnings management, auditor, comfort, rationality, emotions, and body senses
    Purpose of the Study:

    The authors address two overarching questions that have not received very much attention to date. First, “To what extent does real earnings management (REM) affect auditor comfort?” Second, “What strategies do auditors rely on in trying to reach a state of comfort when the client engages in REM?” Auditing standards that relate to REM are vague and limited and, despite evidence showing that REM is becoming increasingly common, little research considers auditors’ perceptions of REM and how they respond to it. The authors wish to fill this void by writing this paper. 

    Design/Method/ Approach:

    The authors conduct in-depth interviews with experienced auditors to examine how auditors respond to an emerging issue in the post-SOX period, the increasing use of real earnings management to achieve financial reporting objectives. 

    Findings:
    • The authors find that auditors are aware of REM and often identify it through formalized audit protocols, including analytical procedures, discussions with management, ad/or their knowledge of the business.
    • The authors find that formal audit procedures play a role in identifying sources of discomfort but also find references to body senses and the use of emotive language related to feelings of discomfort.
    • The authors find that most of the interviewees have concerns about REM, largely because they believe it indicates management’s desire to meet short-term targets, implying poor management tone, which could signal other, less acceptable earnings management methods. 
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Management Integrity
  • Jennifer M Mueller-Phillips
    Fair value accounting, fragile bank balance sheets and...
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.06 Earnings Management – Detection and Response in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Fair value accounting, fragile bank balance sheets and crisis: A model.
    Practical Implications:

    The model offers a simple explanation of why the world, for so long after the height of the global financial crisis, is still mired in slow growth. During a prolonged and excessive boom bank profits and capital were materially increased by unrealized FVA profits. These profits justified the pay-out of liquid assets weakening the financial system. The additional capital further justified more debt financed asset expansion. With the crisis bank management realized that these unrealized capital items were not permanent. Management was able to postpone the recognition of FVA losses by using the flexibility inherent in FVA regulations, but lending was slowed to a point reflective of “safe” capital levels. Lending activity will stay subdued until all of these marked-up items have been worked off banks’ balance sheets.

    Citation:

    de Jager, P. 2014. Fair value accounting, fragile bank balance sheets and crisis: A model. Accounting, Organizations & Society 39 (2): 97-116.

    Keywords:
    fair value accounting, financial crises, financial statements, transmission mechanism, earnings management
    Purpose of the Study:

    The primary objective of this paper is to provide a reasonable alternative perspective on the relationship between fair value accounting (FVA) and the global financial crisis; a perspective that focuses on finding the link before the crisis (during the upswing) and one that reminds accountants that in banking, accounting is more than just a messenger: when bank deposits are created by accounting entries, accounting is money. To this end, a model will be developed in this paper that demonstrates the link between accounting and bank capital regulations and helps to aid understanding of the global financial crisis.

    The nexus of the model to be developed will be the impact of FVA on the regulatory capital of banks. Not all FVA entries impact banks’ regulatory capital. Thus, only FVA entries related to trading instruments or instruments designated at fair value are relevant for the model when values increase. FVA increases in the value of available-for-sale instruments are not covered because those increases would be excluded from regulatory capital. When values decrease, other-than-temporary-impairments of available-for-sale instruments become relevant as these are posted through profit and loss.

    Design/Method/ Approach:

     The author uses analytical modeling to conclude on the questions of interest.

    Findings:

    The model demonstrates the expansionary impulse generated when FVA increases bank regulatory capital. It can be argued that the same expansionary impulse will result from other accounting entries that also increase regulatory capital. FVA’s impact differs in two important aspects. First, FVA impacts regulatory capital much faster and more materially than other accounting entries that need time to impact retained earnings. It is the speed of the feedback process that matters. The second way in which the capital increase from FVA differs from increases caused by other accounting entries is that these alternatives will not result in the replacement of liquid assets in bank capital with riskier FVA gains; FVA profits do not provide liquidity that can fund dividends and remuneration payments.

    Another characteristic of the model is that it is incomplete. Banks do not just lend money due to the interaction between FVA and their capital ratios. The real economy has a need for credit before the supply of credit is considered. In the same way it is not argued in this paper that FVA is the primary or sole reason behind the cyclicality of financial capitalism.

    Category:
    Auditing Procedures - Nature - Timing and Extent
    Sub-category:
    Earnings Management – Detection and Response
  • Jennifer M Mueller-Phillips
    Monitoring by Auditors: The Case of Public Housing...
    research summary posted December 1, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.06 Earnings Management – Detection and Response in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Monitoring by Auditors: The Case of Public Housing Authorities
    Practical Implications:

    While prior research has investigated audit effects in for profit industries, this study investigates audit effects at nonprofit organizations. Nonprofits in general and PHAs in particular are largely served by smaller auditors frequently classified in prior research as lower quality. Further, nonprofits in general represent low litigation risks for the auditors and the threat of litigation and associated economic loss is generally considered one motive for an audit firm to perform a high quality audit. The evidence suggests that audits matter in the nonprofit industry. So even in a setting where research would suggest there would be low audit quality, when the auditor is smaller and the risk of litigation is low, auditors make significant adjustments to pre-audited data and help to constrain management bias toward meeting pre-established financial thresholds.

    For more information on this study, please contact Barbara Grein.

    Citation:

    Grein, B. M., and S. L. Tate. 2011. Monitoring by Auditors: The Case of Public Housing Authorities. The Accounting Review 86 (4):1289-1319.

    Keywords:
    auditor monitoring; audit adjustments; earnings management; management incentives; public housing authorities; nonprofit organizations; auditing procedures; risk
    Purpose of the Study:

    Audits are widely believed to be a means of improving financial reporting and mitigating management bias, although determining the actual effect of an audit is exceptionally difficult. In most cases, only the final results – audited financial statements and the audit report – are available. The authors take advantage of the unique setting of Public Housing Authorities (PHAs) where both pre-audit and post-audit data at the general ledger level are available. The study investigates

    • the number, dollar amount, and direction of audit adjustments to common financial statement line items and to financial ratios that were integral in the monitoring system established by the Department of Housing and Urban Development (HUD), PHA overseer;
    • whether audits result in significant adjustments to pre-audited data, both in terms of numbers of engagements with adjustments and the dollar amount of adjustments;
    • whether auditors’ adjustments act to reduce potential management bias when PHAs have greater incentives to meet financial targets that were part of the HUD monitoring system; and
    • whether auditors constrain overstatement bias differently than understatement bias.
    Design/Method/ Approach:

    The pre- and post-audit general ledger level data for nonprofit public housing authorities used in this study was obtained from HUD under the Freedom of Information Act. The study uses data from September 2001 through December 2007 as this was the period during which HUD enforced this specific monitoring system, Public Housing Assessment System.

    Findings:
    • The authors find that for key accounts and ratios (e.g., total expenses, tenant revenue, current ratio) the percentage of observations with audit adjustments ranges from a low of 15% to a high of 69%.
    • Further the study finds that audits result in material (economically significant) adjustments in PHA audit engagements.
    • Overall, audit adjustments are consistent with auditors attempting to reduce management bias in the financial statements.
    • In addition, the authors find that auditors appear to attend more to potential overstatements of quality scores than understatements.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Earnings Management
  • Jennifer M Mueller-Phillips
    Was Dodd-Frank Justified in Exempting Small Firms from...
    research summary posted November 26, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.08 Impact of SEC Rules Changes/SarbOx, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.05 Evaluating Accruals/Detection of Abnormal Accruals, 08.06 Earnings Management – Detection and Response, 14.0 Corporate Matters, 14.01 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance?
    Practical Implications:

    Our study evaluates a provision of Dodd-Frank which provided permanent exemption from Section 404b compliance to non-accelerated filers. Our results show that these small firms did not improve their reporting quality to the same extent as large firms implying that the Dodd-Frank exemption will probably serve to keep the reporting quality of the exempted firms at lower than achievable levels.

    We also note that as part of the Dodd-Frank legislation, the SEC was given a mandate to investigate raising the Section 404b exemption requirements from $75 million to $250 million in market capitalization (Dodd Frank 2010). While the SEC eventually decided to leave the exemption criterion at $75 million, this matter is still considered to be an open topic (SEC 2011). Our study informs this ongoing debate.

    For more information on this study, please contact

    Anthony D. Holder, PhD, CPA

    Assistant Professor, Department of Accounting - MS 103

    University of Toledo

    Toledo, OH 43606-3390

    Email: Anthony.Holder@utoledo.edu

    Web:    http://homepages.utoledo.edu/aholder4/

    Phone: 1.419.530.2560

    Fax: 1.419.530.2873 

    Citation:

    Holder, A., K. Karim, and A. Robin. 2013. Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance? Accounting Horizons 27 (1): 1-22.

    Keywords:
    Sarbanes-Oxley; Dodd-Frank; earnings management; exempt filers
    Purpose of the Study:

    A major component of the Sarbanes-Oxley Act of 2002 (SOX) is Section 404b, which requires auditor certification of internal controls. However, not all firms were required to comply with this section. Fearing that compliance costs may be prohibitive, SOX allowed a temporary exemption to small firms called non-accelerated filers (typically those firms with market capitalizations under $75 million). Later, the Dodd-Frank Act of 2010 made this exemption permanent.

    Needless to say, both 404b itself and the small-firm exemption, remain controversial. At the heart of the issue, as with any regulation, is the cost-benefit tradeoff. In this particular instance, what are the potential benefits small firms would have obtained had they been subject to SOX Section 404b? By focusing just on the costs of compliance, we may be overlooking these benefits. We consider these foregone benefits an opportunity cost.

    The purpose of our study is to estimate this opportunity cost. We estimate the benefits lost by small firms, because they were not subject to SOX Section 404b.

    Design/Method/ Approach:

    Our sample contains listed firms (subject to SOX), divided into the large (accelerated) and small (non-accelerated) categories. Our data span the SOX period and are from 1995-2009. We measure reporting gains using two standard approaches, one measuring the extent of earnings management and the other measuring accrual quality.

    The reporting benefits foregone by small-firms can be understood by comparing the following two quantities:

    • Post-SOX reporting gains achieved by large firms (accelerated filers).
    • Post-SOX reporting gains achieved by small firms (non-accelerated filers). If these gains (or losses) are smaller than those achieved by large firms, we know there is an opportunity cost.
    Findings:

    We detect a significant deterioration in reporting quality for non-accelerated filers but not for accelerated filers. The result is invariant to whether we compare non-accelerated filers with all accelerated filers or only with small accelerated filers.  Our findings suggest a significant opportunity cost for the exemption. Although the consideration of the cost of Section 404b compliance is outside the scope of our study, our result concerning the opportunity cost suggests that it may have been premature to grant permanent exemption to the non-accelerated filers. This result is especially important, considering contemporaneous discussions to grant Section 404b exemption to even larger firms (up to a market capitalization of $500 million).

    Category:
    Auditing Procedures - Nature - Timing and Extent, Corporate Matters, Independence & Ethics, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Earnings Management, Evaluating Accruals/Detection of Abnormal Accruals, Impact of 404 on Fees and Financial Reporting Quality, Impact of SEC Rules Changes/SarBox
  • Jennifer M Mueller-Phillips
    Auditors’ Consideration of Material Income-Increasing v...
    research summary posted April 28, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.06 Earnings Management – Detection and Response, 11.0 Audit Quality and Quality Control, 11.09 Evaluation of Evidence in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditors’ Consideration of Material Income-Increasing versus Material Income-Decreasing Items during the Audit Process
    Practical Implications:

    The results of this study suggest that auditors spend a greater effort on analyzing income-increasing items compared to income-decreasing items. They also suggest that auditors compensate for greater risk associated with income-increasing items by requiring greater verification of such items. Because of the limitations placed on the results of this study due to the specific context of the experiment, future research should try and examine such differences in auditors’ decision-making processes.

    For more information on this study, please contact Naman K. Desai.
     

    Citation:

    Desai, N. K., and G. J. Gerard. 2013. Auditors’ Consideration of Material Income-Increasing versus Material Income-Decreasing Items during the Audit Process. Auditing 32 (2).

    Keywords:
    accruals; auditing; conservatism; memory; risk
    Purpose of the Study:

    The purpose of this study is to examine whether auditors’ consideration of material items, as evidenced by recognition memories, is influenced by the direction of material items. During the gathering of audit evidence, auditors come across evidence in support of material items that affect earnings in a positive or negative manner. Because earnings can be managed upward or downward depending on management’s objectives and incentives, auditors should be sensitive to both material increasing and deceasing items. Prior research indicates that auditors face greater litigation risk for non-detection of fraudulent income-increasing items compared to income-decreasing items. Therefore, the expectation is that auditors will spend greater cognitive effort evaluating material income-increasing items, resulting in superior memories for such items.

    Design/Method/ Approach:

    The experimental design is a 2 x 2 mixed design with data collected using a signal detection theory paradigm. The participants were randomly assigned to treatments. A total of 60 experienced auditors (all CPAs) participated in the experiment. The participants had an average of 9.83 years of auditing experience. The minimum experience was two years and the maximum was 19 years. The experiment was conducted on site during firm training sessions. 

    Findings:
    • Auditors’ memories for income-increasing items are significantly greater than that for income-decreasing items when auditors are not asked to form expectations about the future effects of the items.
    • This difference above is not observed when auditors are asked to form expectations about future effects of each item.
    • Auditors are less likely to refer back to the work papers to verify the accuracy of income-decreasing items compared to income-increasing items.
       
    Category:
    Audit Quality & Quality Control, Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Earnings Management, Evaluation of Evidence