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  • Jennifer M Mueller-Phillips
    Are Auditors Professionally Skeptical? Evidence from...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Are Auditors Professionally Skeptical? Evidence from Auditors’ Going-Concern Opinions and Management Earnings Forecasts.
    Practical Implications:

    The decision process concerning a firm’s going-concern status is a crucial component of the overall audit. The authors provide new empirical evidence showing how auditors use potentially biased management forecasts in their going-concern decision process. Auditor professional skepticism is an important concept in audit practice as evidenced by its prominence throughout auditing standards. The authors show that auditors do not significantly overweight management forecasts on average, and even underweight management forecasts they perceive as being suspicious, indicating that auditors exercise professional skepticism when using management earnings forecasts. Thus, this paper is informative to regulators who are mainly concerned about auditors relying too heavily on what their clients tell them and failing to sufficiently test or challenge the forecasts, views, or representations of management.

    Citation:

    Feng, M., & Li, C. 2014. Are Auditors Professionally Skeptical? Evidence from Auditors' Going-Concern Opinions and Management Earnings Forecasts. Journal Of Accounting Research 52 (5): 1061-1085.

    Keywords:
    going-concern, management forecast, professional skepticism
    Purpose of the Study:

    This paper investigates whether auditors exercise professional skepticism about management earnings forecasts when assessing a client firm’s going-concern status. Professional skepticism is “an attitude that includes a questioning mind and a critical assessment of audit evidence”. Regulators have long been concerned that auditors rely too much on what their clients tell them rather than applying professional skepticism. For example, a lack of professional skepticism is one primary cause of SEC actions against audit firms.

    This paper sheds light on auditor professional skepticism due to the joint effect of three important factors.

    • Prospective financial information provided by managers is an important input to auditors when they evaluate the client’s going-concern status. Among this information, management earnings forecasts are particularly important because, if a financially distressed firm is expected to continue generating losses, the losses are likely to drain the firm’s limited cash resources and increase the firm’s likelihood of going bankrupt.
    • Financially distressed firms tend to issue optimistically biased forecasts. Because the firms to which auditors consider issuing a going-concern opinion are generally financially distressed, professional skepticism could be especially important in this setting.
    • Auditors could obtain management earnings forecasts through private communication with managers and/or public earnings forecasts.
    Design/Method/ Approach:

    The authors obtain data from financially distressed firms that have auditor reports available on Audit Analytics and are covered by the Compustat and First Call database for fiscal years 2000 through 2010. This results in final sample of 1,054 firm-year observations with 39 observations receiving going-concern opinions, and 33 filing for bankruptcy in the 12 months subsequent to the auditor opinion issuance date.

    Findings:

    The authors find that, when management earnings forecasts are higher, the firms are less likely to receive going-concern opinions and to subsequently go bankrupt. Moreover, the coefficient on management forecasts in the going-concern model is not significantly different from the coefficient in the bankruptcy model. Hence, there is no significant evidence showing that auditors, on average, overweight management earnings forecasts and thus fail to apply professional skepticism when evaluating the firms’ going-concern status.

    The authors find that auditors’ going concern decisions are not associated with management earnings forecasts with lower perceived credibility, but significantly and negatively associated with the other management earnings forecasts. In contrast, the likelihood of bankruptcy is significantly related to management earnings forecasts, regardless of auditor-perceived credibility. More importantly, the weight that auditors assign to management forecasts with low perceived credibility is significantly lower than the weight implied in the bankruptcy model. In other words, auditors’ underweight management earnings forecasts that are issued by managers who previously missed their own forecasts and management forecasts that predict high earnings increases or high earnings.

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Are PCAOB-Identified Audit Deficiencies Associated with a...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Are PCAOB-Identified Audit Deficiencies Associated with a Change in Reporting Decisions of Triennially Inspected Audit Firms?
    Practical Implications:

    Our findings seem to support statements made by the PCAOB regarding the usefulness of the inspection process in changing audit firm behavior.

    The change in GC reporting decisions that we find suggests either (1) an increased conservatism following a PCAOB inspection, of the audit firm on important reporting issues, and/or (2) an increased level of competence brought to the reporting decision.

    It is important to note that we find no change in the accuracy of the GC opinions, as measured by the future bankruptcy (or not) for clients that received a GC opinion.

    For more information on this study, please contact Jayanthi Krishnan.

    Citation:

    Gramling, A.A., J. Krishnan and Y. Zhang. 2011. Are PCAOB-Identified Audit Deficiencies Associated with a Change in Reporting Decisions of Triennially Inspected Audit Firms? Auditing: A Journal of Practice and Theory 30 (3): 59-79.

    Keywords:
    PCAOB inspection reports; going-concern; audit deficiencies.
    Purpose of the Study:

    At a broad level, we are obtaining evidence on whether the PCAOB inspection process is associated with changes in auditor behavior. More specifically, we examine whether PCAOB-identified audit deficiencies are associated with a change in triennially inspected audit firms’ going concern (GC) reporting decisions for their financially distressed clients. 

    Design/Method/ Approach:

    We obtained PCAOB inspection reports, dated between 01/01/2005 and 12/31/2007, from the PCAOB website. These reports covered PCAOB inspections of audits completed by the audit firms during 2004-2007. For the audit firms included in the sample, we read the inspection reports to identify those that indicated audit deficiencies. Data on GC opinions were obtained from Audit Analytics. The final sample on which we base our results consists of 202 audit firms and 1,648 client-year observations. The sample clients are distributed across a wide spectrum of industries, with over 50 two-digit SIC industries represented.

    Findings:
    • Firms with PCAOB-identified audit deficiencies were more likely to issue GC opinions for financially distressed clients subsequent to their PCAOB inspection than prior to their inspections.
    • While there was a change in behavior, the change does not suggest an improvement in reducing Type I errors (i.e., issuing a GC opinion to clients that subsequently remain viable) or Type II errors (i.e., failure to issue a GC opinion to a client that subsequently declares bankruptcy). Additional analysis indicates no systematic change in Type I and Type II errors following the issuance of a PCAOB report.
    • We find limited evidence of a change in the likelihood of issuing a GC opinion for audit firms that had no PCAOB-identified audit deficiencies. This finding suggests that the inspection reports without identified audit deficiencies have some, but limited, impact on changing audit firm behavior.
    Category:
    Auditor Judgment, Standard Setting
    Sub-category:
    Going Concern Decisions, Going Concern Decisions, Impact of PCAOB
  • Jennifer M Mueller-Phillips
    Audit Reporting for Going-Concern Uncertainty: A Research...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Audit Reporting for Going-Concern Uncertainty: A Research Synthesis
    Practical Implications:

    This study provides a summary of the literature examining the auditor’s GCO decisions. Determinants of GCOs include client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), auditor factors (e.g. audit firm size), auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and environmental factors (e.g. changes in regulations, auditing standards and audit market structure). Important findings are that auditors will change the likelihood of issuing GCOs in response to changes in the environment (whether due to changes in regulation or changes in the economy) and that the majority of companies that receive GCOs do not subsequently file for bankruptcy.

    For more information on this study, please contact Elizabeth Carson.

    Citation:

    Carson, E., N. L. Fargher, M. A. Geiger, C. S. Lennox, K. Raghunandan, and M. Willekens. 2013. Audit reporting for going-concern uncertainty: A research synthesis. Auditing: A Journal of Practice & Theory 32 (Supp): 353-384.

    Keywords:
    going-concern; audit reporting; bankruptcy
    Purpose of the Study:

    The global financial crisis in 2007 has resulted in an increased incidence of company failures. This led to renewed interest from regulators, standard setters and investors in the auditor’s assessment and reporting on a company’s ability to continue as a going concern. In order to facilitate the understanding of the role and effectiveness of independent audit, this study conducts a comprehensive review to synthesize and discuss the extant academic literature on auditors’ decisions to issue a modified opinion based on going concern uncertainty (hereafter, GCO).

    Design/Method/ Approach:

    This study synthesizes major findings from audit research since the 1970s. Most of the research reviewed is archival; however, a few studies using experimental designs are also cited. A framework is developed to structure the categorization of the extant GCO literature. Three main themes are identified: (1) Determinants of GCOs, (2) Accuracy of GCOs, and (3) Consequences of GCOs. This study also provides a discussion on issues related to research methodology and identifies areas for further research.

    Findings:

    Under the category of “Determinant of GCOs”, the synthesis shows that:

    • Auditors are more likely to issue GCOs after December 2001, which is in response to the accounting and auditing scandals in early 2000s (e.g. collapse of Enron). Also, smaller companies more likely to receive GCOs.
    • In the ten-year period between 2000 and 2010, 60.10% of bankruptcy filings are preceded by GCOs.
    • Determinants of GCOs include: (1) client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), (2) auditor factors (e.g. audit firm size), (3) auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and (4) environmental factors (e.g. changes in regulations, auditing standards and audit market structure).

    Under the category of “Accuracy of GCOs”, the synthesis shows that:

    • Since the adoption of SAS No.59, 40-50% of bankruptcy firms did not receive a prior GCO.
    • 80-90% of companies receiving a GCO do not file for bankruptcy in the subsequent year.

    Under the category of “Consequences of GCOs”, the synthesis shows that:

    • Issuance of GCOs is associated with negative excess returns, and the reaction is more negative when problems with obtaining financing are cited.
    • In the U.S., the issuance of GCO can be a “self-fulfilling prophecy” and cause the financial demise of company that would have survived if it had not received a GCO.

    With regards to issues in research methods, this study cautions the use of small samples in analysis and the interpretation of interaction variables in the statistical models. The study also finds general limitations in extant research due to the varying sample selection criteria for identifying financial stressed firms and the exclusion of private companies from samples examined.

    This study suggests further research could (1) examine the relations between auditor independence and GCO decisions, (2) investigate auditor’s GCO decisions and the related issues for financial institutions, non-profit organisations and government entities, (3) replicate research on GCO accuracy in different time periods with different samples, (4) examine the information usefulness of GCOs to a wide set of market participants, and (5) properly distinguish between the roles of management, audit committee and auditor in the disclosure and discussion of going-concern. 

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Auditor Differentiation, Mitigating Management Actions, and...
    research summary posted October 10, 2013 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Differentiation, Mitigating Management Actions, and Audit-Reporting Accuracy for Distressed Firms
    Practical Implications:

    SAS No. 59 requires auditors to evaluate the adequacy and feasibility of management’s plans to mitigate financial distress.  The results of this study show that industry specialization improves auditors’ ability to more accurately evaluate management’s initiatives and the likelihood of going-concern issues.  Though BRA methodology was not shown to improve reporting accuracy, the implementation of the methodology was limited to only two firms at the time of the study.     This study suggests the importance of auditor specialization in improving reporting accuracy which can impact the approach audit clients take in obtaining an auditor. 

    For more information on this study, please contact Liesbeth Bruynseels.
     

    Citation:

    Bruynseels, L., W.R. Knechel, and M. Willekens. 2011. Auditor differentiation, mitigating management actions, and audit-reporting accuracy for distressed firms. Auditing: A Journal of Practice & Theory 30 (1): 1-20.

    Keywords:
    audit reporting, going-concern, management plans, audit methodology, auditor industry specialization
    Purpose of the Study:

    Since auditors are required to evaluate the adequacy of management plans to mitigate financial distress, when bankruptcies occur that were not preceded by a going-concern report, the audit report is perceived to lack quality.   This study investigates whether enhanced industry knowledge (auditor specialization) or an increased focus on business risk auditing methodologies improves audit-reporting accuracy.  These are the two areas of focus because:

    • Prior research has shown that industry specialization produces higher audit quality.
    • A new audit approach defined as “business risk auditing” (BRA) forces an auditor to determine whether the client’s strategic objectives are being met and to assess the likelihood of going-concern issues.  BRA is embedded in international auditing standards (ISA 315) and proposed standards by the PCAOB to require the auditor to assess a client’s business environment and risks in the audit.  Recent studies have shown that BRA can lead to more efficient and effective audits.

    Recent research has also indicated that information obtained about the client’s strategic plans to mitigate financial distress can have a significant impact on the likelihood that an auditor will issue a going-concern report.  Therefore, this paper examines the impact of auditor specialization and auditor risk methodology on audit-reporting accuracy in the setting of financially distressed firms in which managers take initiatives to reduce this distress.

    Design/Method/ Approach:
    • The data consists of U.S. public companies from manufacturing industries that declared bankruptcy between 1999-2002.
    • Auditor specialization is measured based on audit firm market share within a particular industry.
    • Two of the Big 5 firms in the study implemented the BRA methodology. Therefore, only audits conducted by these two firms are considered to have employed BRA methodology.
    • The authors also report if a company in the sample had a significant strategic or operating initiative reported in its 10-Ks as a sign of management’s actions to mitigate financial distress.
       
    Findings:
    • For companies that subsequently declared bankruptcy:
      • Specialist auditors were more likely than non-specialists to issue a going-concern opinion even when management had undertaken strategic turnaround initiatives.
      • Audit firms that used a BRA methodology were less likely to issue a going-concern opinion if the client had undertaken operating initiatives to mitigate financial distress.
      • All auditors, irrespective of type, were less likely to issue a going-concern opinion when the client had plans to raise cash in the short-term.

    Contrary to the authors’ expectations, the reporting accuracy of BRA auditors is reduced when a client implements short term operating initiatives to reduce financial distress.  Specialist auditors correctly interpret the information contained in management’s strategic long-term initiatives and more accurately signal the potential for a future bankruptcy by issuing a going-concern report. 

    Category:
    Audit Quality & Quality Control, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Industry Experience
  • Jennifer M Mueller-Phillips
    Auditor Fees and Auditor Independence: Evidence from Going...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Fees and Auditor Independence: Evidence from Going Concern Reporting Decisions
    Practical Implications:

    The finding of this study suggest that concerns over the relation between auditor fees and the possible impairment of auditor independence, as reflected in going concern modification decisions, are supported in the more recent years for highly distressed clients. The relationship between auditor fees and impairment of auditor independence with respect to auditor decision-making has long been a concern of many regulators in the accounting industry. This research may inform both audit firms and standard setters with respect to specific types of engagements and the judgments or behaviors most likely to be affected.

    For more information on this study, please contact Allen D. Blay.
     

    Citation:

    Blay, A. D., and M. A. Geiger. 2013. Auditor Fees and Auditor Independence: Evidence from Going Concern Reporting Decisions. Contemporary Accounting Research 30 (2).

    Keywords:
    auditor fees; auditor independence; going concern; regression analysis
    Purpose of the Study:

    The possible adverse effect of auditors providing services to clients who pay them directly has historically been a concern of the public accounting profession. Without independence there is no need for external auditors attesting to the purported accuracy and completeness of company financial statements. The association between fees received by audit firms directly from clients and the possible impairment of auditor independence, particularly with respect to going concern decisions, continues to be of considerable interest to regulators and others. This study assesses the potential impairment of auditor independence in the context of going concern reporting.

    Design/Method/ Approach:

    The authors derive their findings examining the association between both current and future audit service and nonaudit service fees received by U.S. auditors and the type of opinion rendered to a financially distressed client. To achieve their sample, the authors used the Audit Analytics database and first identified firms that received a going concern modified (GCM) audit opinion in the years 2004-2006. They also identified firms that had both negative income and cash flows from operations in the same year but did not receive a GCM opinion. Finally, the authors tested their hypotheses by using a research model to determine the probability of issuing a GCM audit opinion to a financially distressed client. 

    Findings:

    A negative correlation exists between future fees paid to auditors and auditor going concern opinion decisions.
    Higher levels of current nonaudit service fees paid to auditors reduces the frequency of going concern opinion modifications in the more recent 2004-2006 time period when using a more stringent control sample of financially distressed firms.
    Findings related to going concern decisions and nonaudit service fees in the United States are sensitive to both the time period examined and the selection of appropriate control samples of distressed non-GCM firms.
    A negative association exists between current nonaudit service fees and total subsequent fees paid to auditors.
     

    Category:
    Auditor Judgment, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Going Concern Decisions, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Auditor Tenure and Going Concern Opinions for Bankrupt...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Tenure and Going Concern Opinions for Bankrupt Clients: Additional Evidence
    Practical Implications:

    This study should be of particular interest because the findings represent evidence concerning the relationship between auditor tenure and audit failures. The tenure effect, which is pronounced in the early years, is particularly important to the non-Big 4 sample because approximately 75 percent of non-Big 4 clients in the author’s sample have auditor tenures of four years or less. This short tenure, coupled with association between tenure and Type II errors suggest the adverse impact of short tenure is concentrated in the non-Big 4 sample. With this in mind, the findings of this paper may help to inform the continuing debate regarding the possible adverse effects of long auditor tenure. 

    Citation:

    Read, W.J., and A. Yezegel. 2016. Auditor Tenure and Going Concern Opinions for Bankrupt Clients: Additional Evidence. Auditing: A Journal of Practice and Theory 35 (1): 163-179.

    Keywords:
    going concern opinions, Type II errors, and auditor tenure
    Purpose of the Study:

    Regulators and lawmakers in the U.S. periodically express concerns about a possible association between auditor tenure length and audit failure. The authors define audit failure as a bankrupt company not receiving a going concern modified audit opinion prior to bankruptcy, a Type II reporting error.  Geiger and Raghunandan began investigating this relationship in the early 2000’s; however, the authors of this study hope to extend this investigation in the three following ways:

    • Studies have shown that audit reporting companies in financial distress changed following the enactment of the Sarbanes-Oxley Act of 2002 and related legislature and media scrutiny of the auditing profession; ergo, a closer examination of more recent data would be a worthwhile measure.
    • The previous study did not examine differences between Big 4 and non-Big 4 audit firms, and studies show that there are significant differences between Big 4 and non-Big 4 auditors, including going concern decisions.
    • The previous study assumed and tested for a linear relationship between auditor tenure and audit reporting failures; however, more recent data leads the authors to allow the association between auditor tenure and audit quality to be nonlinear. 
    Design/Method/ Approach:

    The authors examine prior audit reports for a sample of 401 U.S. publicly held companies that filed for bankruptcy during the period 2002-2008. A quadratic model was used to control for potential nonlinearity in the relationship between audit tenure and audit reporting.

    Findings:
    • The authors did not find evidence of a significant relation between auditor tenure and going concern opinions issued by Big 4 firms to their subsequently bankrupt clients.
    • The authors did find evidence indicating a higher likelihood of Type II errors for non-Big 4 auditors in the early years of an audit; however, this relation weakens and after approximately year four of the engagement, the authors begin to observe no statistical association between tenure length and Type II errors for non-Big 4 auditors, either.
    • The authors’ results from the endogeneity analysis are consistent with their primary conclusions that non-Big 4 audit firms are more likely to make Type II reporting errors compared to Big 4 firms during the initial years of an audit engagement.
    • The authors find that long auditor tenure, of itself, is not associated with Type II reporting errors. 
    Category:
    Auditor Judgment
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Business Strategy and Auditor Reporting
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 09.04 Going Concern Decisions, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Business Strategy and Auditor Reporting
    Practical Implications:

    This study is informative for stakeholders when they are analyzing financial statements. It provides support that a going concern opinion for a prospector firm may not be as alarming as it appears. It also reveals that many influences are at play when auditors are determining which audit opinion is most appropriate for the situation.

    Citation:

    Chen, Yu, J. D. Eshleman, and J. S. Soileau. 2017. Business Strategy and Auditor Reporting. Auditing, A Journal of Practice and Theory 36 (21): 63-86.

    Keywords:
    business strategy; auditors; going concern; material weakness
    Purpose of the Study:

    This study examines the effects that a firm’s business strategy, whether prospector or defender, has on an auditor’s decision in areas requiring significant professional judgment. Specifically, the authors investigate areas involving material weakness and going concern opinions. Prospector business strategies focus on innovation and invest heavily in marketing and research and development. Alternatively, defender business strategies place a strong emphasis on cost efficiency and instead invest heavily in automated production and distribution processes. It is important to note the focus in the study is on business-level strategy, not corporate strategy. Business level-strategy is the way a firm competes within an industry, not what industries it competes in.

    Design/Method/ Approach:

    All firms in the study were placed into 3 categories: prospectors, analyzers, and defenders. The authors used 6 characteristics to measure strategy in order to categorize the firms. The final sample size was 4,332 firms from 2000-2013. Financial information was obtained about the firms from databases such as Compustat, Audit Analytics, and CRSP.

    Findings:

    The authors find that a firm’s decision to adopt a prospector versus defender strategy significantly increases the likelihood of an auditor issuing an unfavorable opinion.

     

    The authors find the reasoning behind this to be comprised of the following:

    • Prospector business strategies are rooted within innovation and therefore likely to take risks. Often times this leads to past performances being more volatile which reduces the auditor’s ability to accurately predict future outcomes. This results in auditors choosing the most conservative choice, a going of concern opinion.
    • Collectively, prospector strategy characteristics such as decentralized control, frequent product changes, and high executive turnover all lead to a higher probability of material weakness.

     

    Overall, auditors are more prone to Type II errors regarding the issuant of going concern opinions to prospector firms. The evidence suggests that auditors are less successful in predicting bankruptcy for these firms and the going concern opinion is not always warranted. 

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • Jennifer M Mueller-Phillips
    Did SOX Influence the Association between Fee Dependence and...
    research summary posted February 20, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Did SOX Influence the Association between Fee Dependence and Auditors’ Propensity to Issue Going-Concern Opinions?
    Practical Implications:

    This research note presents evidence that the question of whether new standards or regulations have achieved the objective of altering the behavior of their intended target cannot be adequately assessed shortly after they have come into effect, as the implementation often requires a steep learning curve and is frequently accompanied by intense public debates and media scrutiny. From the policy standpoint, it suggests that the concern expressed by the U.S, Treasury Department officials about auditors’ applying an overly strict approach in their audits to counter elevated liability after SOX may not be warranted.

    For more information on this study, please contact Wenjun Zhang.

    Citation:

    Kao, J. L., Y. Li., and W. Zhang. 2014. Did SOX influence the association between fee dependence and auditors’ propensity to issue going-concern opinions? Auditing: A Journal of Practice and Theory 33 (2): 165-185

    Keywords:
    Fee dependence, going-concern opinion, auditor independence, SOX
    Purpose of the Study:

    Li (2009) shows that the association between fee dependence (FEEDEP) and auditors’ likelihood to issue qualified going-concern audit opinions (GCO) changes from insignificant in 2001 to positive in 2003. Since then, several studies have quoted Li’s (2009) findings as evidence that SOX has led auditors to behave more conservatively with respect to going-concern reporting.

    This research note extends Li’s (2009) post-SOX sample period from 2003 to 2011 and demonstrates that her findings for 2003 do not hold over a much longer post-SOX period, implying that SOX has had little effect on auditors’ behavior with respect to going-concern reporting for their large financially distressed clients. These results call into question whether the positive FEEDEP-GCO association identified by Li (2009) indeed represents new audit practice in the post-SOX era.

    This research note is motivated by Feldmann and Read (2010), who showed that the incidence of qualified going-concern opinions issued to subsequently bankrupt companies reverted back to the pre-Enron level by 2006-2007 after a brief increase in 2002-2003, suggesting that the year right after the passage of SOX was not typical. Thus, by focusing on 2003, researchers merely capture a transitory reaction by the audit profession to intense public scrutiny following SOX.

     

    Reference: Li, C. 2009. Does client importance affect auditor independence at the office level? Empirical evidence from going-concern opinions. Contemporary Accounting Research 26 (1): 201-230.

    Design/Method/ Approach:

    The authors run ten annual regressions (2001; 2003-2011) of auditors’ propensity to issue qualified going-concern opinions to financially distressed audit clients (GCO) on a fee dependence measure (FEEDEP). Comparing the association between GCO and FEEDEP before versus after the passage of SOX, the authors draw inferences about whether the more conservative going-concern reporting documented by Li (2009) indeed represents a long-term equilibrium behavior in the post-SOX audit market. 

    Findings:
    • The authors find no association between auditors’ propensity to issue qualified going-concern opinions to financially distressed audit clients and the fee dependence measure over an extended post-SOX period (i.e., 2003-2011), implying that SOX has had no observable lasting effect on auditor conservatism with respect to going-concern reporting.
    • The authors find that while auditors were equally cautious in issuing qualified going-concern opinions to clients that eventually failed, both before and after SOX, they have made more Type I misclassifications in 2003 by issuing qualified going-concern opinions to clients that remained solvent within two years of financial statement dates. 
    Category:
    Auditor Judgment, Independence & Ethics, Standard Setting
    Sub-category:
    Going Concern Decisions, Impact of Fees on Decisions by Auditors & Management, Impact of SOX
  • Jennifer M Mueller-Phillips
    How Do Auditors Behave During Periods of Market Euphoria?...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism, 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    How Do Auditors Behave During Periods of Market Euphoria? The Case of Internet IPOs
    Practical Implications:

    Due to the potential for future market bubbles, the findings of this study may be of interest to audit regulators and standard setters. These finding suggest mixed conclusions regarding the Big 5’s behavior during periods of market euphoria. The presence of going concern opinions varies inversely with variables that represent client viability and auditor self-interest. Evidence that points to a decrease in the predictive value of Big 5 opinions signed during the Internet IPO bubble may also have consequences for investors.
     
    For more information on this study, please contact Andrew J. Leone.
     

    Citation:

    Leone, A. J., S. Rice, J. P. Weber, and M. Willenborg. 2013. How Do Auditors Behave During Periods of Market Euphoria? The Case of Internet IPOs. Contemporary Accounting Research 30 (1).

    Keywords:
    auditors’ opinions; going concerns; initial public offerings; online information services
    Purpose of the Study:

    The study of periods of market euphoria is a long-standing topic of interest to economists. Theorists specify conditions under which market participants and institutions cause bubbles to form. This study looks at how auditors behave during these periods of euphoric market conditions, specifically around the time of the wave of Internet companies’ IPOs in the late 1990s and early 2000s. The goal was to discover how audit decisions change with fluctuations in the external marketplace. The authors address whether auditors are maintaining their responsibility to act in the public’s best interest during these unique market conditions, and how going concern decisions of these Internet IPO companies might vary based on these conditions.

    Design/Method/ Approach:

    The authors obtained a sample of 756 Internet IPO filings from 1996 to 2000 using an online database, as well as a sample of non- Internet IPO registrants. Using descriptive statistics, the authors tested these samples for determinants that could lead auditors to shift their going concern decision criteria during euphoric market conditions.

    Findings:
    • The presence of going concern opinions varies with variables that proxy for both economic reasons and for less independence and skepticism by the Big 5.
    • Some evidence points to associations between costs to investors and a decrease in Big 5 going concern opinions during the bubble.
    • Big 5 firms were not a major cause of the Internet IPO bubble, but large audit firms did little to slow it from inflating.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Auditor Judgment, Client Acceptance and Continuance
    Sub-category:
    Auditors’ Professional Skepticism, Business Risk Assessment (e.g. industry - IPO - complexity), Going Concern Decisions
  • The Auditing Section
    Independence Threats, Litigation Risk, and the Auditor’s D...
    research summary posted May 4, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Independence Threats, Litigation Risk, and the Auditor’s Decision Process
    Practical Implications:

    This study is important for audit firms and audit regulators, as it provides a more complete picture of how threats to auditor independence and litigation risk affect auditor performance. Rather than just focusing on the auditor’s final decision, this study demonstrates that the above incentives affect auditors through their evaluation of information during the decision process. Therefore, firms and regulators may be interested in research that specifically addresses processing biases. This research advocates using decision aids, such as artificial neural networks, to attenuate processing bias. Accountability-inducing controls, like those promoted by audit documentation standards, are unlikely to achieve this goal. Further, reviews conducted by individuals within the same firm are less likely to detect process bias. Review by independent parties, such as an audit committee, would likely be more effective.

    Citation:

    Blay, A.D. 2005. Independence Threats, Litigation Risk, and the Auditor’s Decision Process. Contemporary Accounting Research 22 (4): 759-789.

    Keywords:
    Auditor independence, auditor reporting, decision process, going concern, motivated reasoning
    Purpose of the Study:

    The preservation of auditor independence is a concern of audit regulators. The Sarbanes-Oxley Act of 2002 attempts to minimize the economic bond between the auditor and the client, but cannot completely eliminate it. Litigation risk is often proposed as a safeguard to mitigate independence threats. Prior studies about auditor independence focus solely on auditors’ final reporting choices, but this paper addresses auditors’ judgment and decision-making process as well. Particularly, this paper investigates whether independence threats (high versus low) and litigation risk (high versus low) influence auditors’ evaluation of information and their subsequent reporting choices. 

    The author expects that when high threats to auditor independence are present, auditors will be more supportive of the client-preferred position (unqualified opinion) both during the decision process and in the final reporting decision.  However, when high litigation risk is present, the author expects auditors will be less supportive of the client-preferred position. 

    These expectations are derived from the psychology literature on directional goals and motivated reasoning. Directional goals arise when an individual is dependent on a particular decision outcome. Though accurate judgment should be the auditor’s ultimate goal, the literature on motivated reasoning suggests that, as long as the conclusion is justifiable, individuals will evaluate information consistent with a desired conclusion. Thus, economic incentives associated with independence threats and litigation risk are likely to affect not just the auditor’s final decision, but also his/her evaluation of information during the decision process.

    Design/Method/ Approach:

    The research evidence was collected in the early-2000s (pre-SOX). Audit managers from three Big-4 firms participated in the experiment.  Participants completed a simulated task involving a hypothetical manufacturing client where they assessed the initial likelihood of going-concern, searched for informational cues, and reassessed the likelihood of going-concern. As informational cues were obtained, auditors also assessed whether the cues provided positive or negative support for the client’s going concern.

    Findings:
    • The author finds that auditors facing greater threats to independence will be more supportive of an unqualified opinion (client-preferred) when:
      • Assessing initial information,
      • Evaluating additional information cues,
      • Making a final report choice.  
    • The author finds that auditors facing higher litigation risk will be less supportive of an unqualified opinion (client-preferred) only when:
      • Evaluating additional information cues,
      • Making a final reporting choice  
    • The author finds that both threats to independence and litigation risk affect final report choice completely through their influence on the auditor’s evaluation of additional information cues. Thus, it appears that independence threats and litigation risk lead to information processing bias, as opposed to an up-front choice bias. 
    • The author finds that when both threats to independence and litigation risk are high, auditors gather additional information cues and spend more time evaluating evidence.  Further, there is no significant difference in final reporting choice when independence threats and litigation risk are low, supporting regulators’ claim that litigation risk offsets independence threats.
    Category:
    Independence & Ethics, Auditor Judgment, Accountants' Reporting
    Sub-category:
    Impact of Fees on Decisions by Auditors & Managmeent, Going Concern Decisions, Going Concern Decisions
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