The results of this study suggest a course of action for enhancing professional skepticism, so they are important for audit firms specializing in privately held clients, which is an institutional setting where auditors may find it more difficult to maintain their objectivity. The authors suggest that audit firms can use their internal messaging to help individual auditors decrease the harmful effects of client identification. Specifically, audit firms can encourage auditors to (1) take the perspective of financial statement users (e.g., shareholders), (2) view themselves and clients as members of a group assigned the goal of providing accurate financial statements to shareholders, and/or (3) identify more strongly with the audit firm or the audit profession. Furthermore, the authors suggest that audit firms increase client commitment by encouraging auditors to be more attentive and available to clients (e.g., catching up with clients periodically and spending more time at the client site) and encouraging clients to feel free to reach out to auditors.
Herda, D. N. and J. J. Lavelle. 2015. Client Identification and Client Commitment in a Privately Held Client Setting: Unique Constructs with Opposite Effects on Auditor Objectivity. Accounting Horizons 29 (3): 577-601.
Prior accounting scandals raised concerns that auditors’ relationships with their clients lower auditor independence, which in turn lowers professional skepticism, and ultimately decreases audit quality. Accounting research attempting to shed light on the social processes related to such concerns suggest that client identification can decrease auditor. However, the authors argue that client identification (i.e., “the extent to which an auditor’s self-concept and self-definition are derived from perceived oneness with the client”) differs from client commitment (i.e., “a responsibility for and a dedication to the client, but the auditor and client remain separate psychological entities”). The purpose of this study is to discover if (1) client identification and client commitment are two different ideas, (2) client identification detracts from auditor objectivity, and (3) client commitment enhances auditor objectivity.
The authors collected their evidence via research questionnaires emailed to auditors, ranging from staff auditors to partners, at a large regional public accounting firm during the summer of 2013. Survey participants were asked questions about client identification and client commitment, and then were asked to perform a case that dealt with auditors’ behavior in an audit conflict situation.
These results suggest that audit firms specializing in privately held clients may enhance audit quality by decreasing auditors’ client identification and increasing auditors’ client commitment.
PCAOB Chairman James Doty recently announced plans to convene a task force on audits of fair value measurements, as well as plans to change the auditor’s report to provide more useful, relevant, and timely information to users of public company financial statements. The authors hope their commentary is helpful to standard-setters’ deliberations, and the authors believe it should be useful to auditing scholars, both as a supplemental reading in auditing courses and a source of ideas to help guide future research designs on auditor and user judgment and decision making for high uncertainty FVA estimates.
Bell, T. B., and J. B. Griffin. 2012. Commentary on Auditing High-Uncertainty Fair Value Estimates. Auditing: A Journal of Practice & Theory 31 (1): 147-155.
Debate over the relevance and reliability of fair value accounting (FVA) dates back at least seven decades, as evidenced by excerpts presented above from MacNeal’s 1939 “accounting classic,” Truth in Accounting. In recent years, accounting and auditing standard-setters in the U.S. and abroad have issued a number of authoritative pronouncements that, collectively, indicate institutional embracement of FVA. However, today’s business transactions, terms of contractual arrangements, and structures of financial instruments and other assets and liabilities are more varied and complex. Against this backdrop, continuing controversy over the usefulness and verifiability of high-uncertainty fair value estimates centers primarily on estimates and associated disclosures pertaining to assets and liabilities that are not traded in active markets, i.e., estimates involving the use of Level 2 and Level 3 inputs in the FASB’s fair value hierarchy in Fair Value Measurement.
This commentary addresses challenges faced by standard-setters, preparers, users, and auditors pertaining to high-uncertainty fair value estimates. The authors briefly describe the financial reporting environment and the difficulty of obtaining reasonable assurance for fair value estimates with high levels of inherent measurement uncertainty. They then discuss some characteristics of an effective accountability framework for fair value accounting.
This article is a commentary.
The authors discuss interdependencies between FVA disclosures and auditing attributes, within the context of an accountability framework for FVA, and propose a combination of changes to these institutional features whose joint effects should (1) improve transparency to users of the inherent (i.e., irreducible) level of measurement uncertainty in high-uncertainty FVA estimates and disclosures, (2) enhance the value to users of the audit of such estimates and disclosures, and (3) help standard-setters improve the clarity of related auditing standards.
The authors propose additional disclosures on management’s estimation processes, assumptions, and historical estimation accuracy that they believe provide the best avenues for improving the verifiability of decision-useful information on inherent measurement uncertainty. Also, the authors suggest a modified audit report conveying that only negative assurance has been obtained for high-uncertainty FVA estimates, reasons why, and an overview of the procedures performed by the auditor, which should provide a more faithful representation of the true nature and extent of assurance provided to users.
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.
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.
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.
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.
These findings provide important insight into investors’ current perceptions of auditor independence, particularly in the absence of relative or comparative information, and suggests that it might be useful for regulators, when contemplating additional disclosure requirements, to allocate some attention to disclosures that have the potential to enhance investor perceptions of auditor independence. The findings of this study contribute to the forum of debate concerning the current state of audit-related disclosures and their value for investors.
Beck, A. K., R. M. Fuller, L. Muriel, and C. D. Reid. 2013. Audit Fees and Investor Perceptions of Audit Characteristics. Behavioral Research in Accounting 25 (2): 71-95.
Very little information is provided to the investor about the audits performed or the nature of the relationship between the auditor and client. It is difficult for investors and other external constituents to observe important qualitative aspects of an audit engagement such as the experience level, technical competence, conscientiousness, or objectivity of audit personnel.
The objectives of this research are two-fold. First, the authors investigate whether the provision of additional referent information about audit fees (percentile rank data relative to other firms in the industry that establish a comparative benchmark) alters user perceptions of audit characteristics. This enables them to determine what investors perceive, based on audit fees, about the audit characteristics, and whether their perceptions coincide with the audit fee–audit characteristic relationships identified in previous archival research. Second, the authors contrast the perceptions of investors who are merely supplied with the total dollar amount of the audit fees with the perceptions of investors who are told that a company’s audit fee is approximately average in comparison to the audit fees of other companies within the same industry. Making this latter comparison offers insights as to how investors perceive audit and company characteristics when lacking additional information, consistent with the current state of audit fee disclosures.
One hundred and fourteen accounting students were recruited to participate in the experiment. These students were enrolled in an undergraduate auditing course. The instrument was administered in two different semesters, but in the same course. The participants were randomly assigned to groups, and an initial ANOVA verified that there were no differences between the four groups in terms of age, gender, or investing experience. Participants were incented to participate via bonus points in the course. The evidence was gathered prior to January 2013.
The results of the study suggest that investors do develop perceptions about a company and its audit based on audit fees, as the authors find that providing supplemental audit fee disclosures indicating the relative magnitude of a company’s audit fees significantly influences investor perceptions of auditor independence, auditor effort, and audit quality. Specifically, the authors present evidence that when fees are presented to investors as low, average, or high (as compared to industry averages), investors commensurately perceive audit quality and auditor effort as being low, average, or high, respectively. When not provided with any additional information concerning the audit fee (similar to the present state of disclosures), investors assess audit quality and auditor effort as being average. However, they find that while investors perceive auditor independence as low, average, and high when fees are presented as high, average, or low, respectively, investors not provided with any relative fee information assess auditor independence as low.
This study makes several important contributions. This study extends and complements prior research by looking at an additional characteristic of narrative disclosures not accounted for in prior research: language categories. In examining language categories, the authors contribute to the voluntary disclosure literature by: (1) introducing the LCM as a framework for classifying and organizing the language in accounting narratives; (2) validating that the LCM is indeed descriptive of the language included in accounting narratives; and (3) demonstrating that how prior events are construed in a narrative (using different predicate forms) has a predictable effect on investor judgments and decisions. This study is the first to take a meta-semantic approach to the content of accounting narratives and to apply the LCM in an accounting context.
Riley, T. J., Semin, G. R., & Yen, A. C. 2014. Patterns of Language Use in Accounting Narratives and Their Impact on Investment-Related Judgments and Decisions. Behavioral Research In Accounting 26 (1): 59-84.
Recent research has examined the role of accounting narratives on investors’ judgments and decisions. This study extends this line of inquiry by examining the effects of language categories on investors’ judgments and decisions—the notion that narratives written with different predicates (verbs versus adjectives/nouns) will have a differential effect on investors. In examining the effects of language categories, the research focus shifts away from semantic manipulations and word choice (e.g., choosing words to convey either an optimistic or pessimistic tone), which can alter a narrative’s overt meaning. Instead, the language category differences examined in the current study can manifest themselves even as a narrative’s overt meaning is held constant, with the use of parallel/similar words in different language categories, or with the use of variations of the same root word (e.g., ‘‘demonstrating our ability to broaden and diversify’’—verbs, versus ‘‘demonstrating our breadth and diversity’’—nouns). Understanding the effects of this more subtle, as yet unexplored, source of variation in accounting narratives is the objective of this study.
The authors use a language classification system, the Linguistic Category Model (LCM), to identify linguistic categories that vary on the dimension of abstractness/ concreteness. The sample in this test includes the narrative sections of 553 quarterly earnings press releases of fifty-one randomly selected S&P 500 publicly traded companies, between the years 2002 and 2004. The sample includes only companies whose earnings press releases are available on Lexis-Nexis and published by PR Newswire or BusinessWire. The experiment manipulated linguistic construal and valence resulting in a 2 x 2 between-subjects design to investigate the effect of language categories (contained in an earnings press release) on nonprofessional investors’ investment judgments and decisions. Seventy-nine graduate business students from several major Northeastern universities who had completed their core courses served as participants for this study. Sixty-seven were accounting majors, two were finance majors, and ten were M.B.A. students.
The first part of this study introduces a psycholinguistic model used in social psychology, the Linguistic Category Model, and proposes it as an organizing framework for the content of accounting narratives. The analysis of the earnings press releases shows that positive information is more likely to be written in a concrete construal than negative information, validating the model’s use in this new context.
The second part manipulates orthogonally the construal and valence of the narrative section of an earnings press release and finds that investors are influenced by these construal-related differences. Specifically, investors reading a concretely written negative (positive) narrative are least (most) likely to find value in the firm as an investment, with the judgments of those with abstractly written narratives of either valence in between.
The analysis of earnings press releases show a distinct pattern, where the language in press releases is more concrete (abstract) when the associated financial information is positive (negative). These results validate the use of the LCM in this new context.
The authors find that the informative disclosure of non-GAAP earnings information enables investors to better understand firms’ future operating performance relative to opaque disclosures. Further, the results suggest that the most pervasive motive behind the disclosure of non-GAAP earnings information is to inform, although an economically significant proportion of firms appear to be opportunistic in that they only disclose non-GAAP earnings information when it increases investors’ perceptions of core operating earnings. The study should be useful to investors, financial analysts, regulators, and researchers for assessing the non-GAAP disclosure motives of management and the effect of these motives on market participants.
Curtis, A. B., McVay, S. E., & Whipple, B. C. 2014. The Disclosure of Non-GAAP Earnings Information in the Presence of Transitory Gains. Accounting Review 89 (3): 933-958.
Managers regularly highlight the transitory components of GAAP earnings in their earnings announcements, and frequently disclose non-GAAP earnings excluding these transitory components. The motivation for managers to disclose non-GAAP earnings, however, is heavily debated. On one hand, managers claim that they disclose non-GAAP earnings to aid investors in assessing the firm’s core operating performance. On the other hand, regulators express concerns that some managers may be motivated to inflate perceptions of core operating performance, which could mislead investors. Essentially, this ongoing debate centers on whether managers disclose non-GAAP earnings to inform or mislead. Non-GAAP earnings are generally more predictive of future operating earnings, but they can also be overstated to meet strategic earnings benchmarks on a non-GAAP basis. Because most transitory items are income-decreasing, both motives predict the same disclosure choice. Because both motives impact managers’ non-GAAP disclosure, it is difficult to determine which motivation is more pervasive or to provide evidence that a particular disclosure is unambiguously informative or opportunistic.
The authors examine the disclosure of non-GAAP earnings information in quarters containing transitory gains to investigate whether the primary motivation for these managers to disclose non-GAAP earnings is to inform or mislead.
The authors examine a sample of 1,920 firm-quarters with transitory gains in the form of net income-increasing special items of at least one penny per share from 2004 to 2009. They require sample firms to have (1) CRSP coverage, (2) a non-missing earnings announcement date on Compustat, (3) a non-missing 10-Q/K filing date on EDGAR, (4) at least two days between the earnings announcement and filing dates, and (5) data available for each of the variables, including one-year-ahead earnings.
Managers motivated to inform stakeholders about sustainable earnings will disclose non-GAAP earnings information excluding the gain, whereas managers motivated to report higher earnings will obscure the transitory nature of the gain by focusing on GAAP earnings.
This study claims that, “our understanding of firms' R&D disclosure decisions is limited, and therefore the study’s results provides new insights about these decisions by showing that firms adjust their narrative R&D disclosures in response to changes in current earnings performance.
Furthermore, this study’s findings, “increase our understanding of firms' narrative disclosure decisions, an important disclosure channel used to convey contextual information about a firm's activities beyond financial statement numbers.”
“These findings suggest that narrative disclosures should not be generalized as a whole and emphasize for future research the importance of considering disclosure type in the formation of hypotheses and empirical tests.”
Kenneth J. Merkley (2014) Narrative Disclosure and Earnings Performance: Evidence from R&D Disclosures. The Accounting Review: March 2014, Vol. 89, No. 2, pp. 725-757
In its introduction, this study calls on a particular passage to elucidate its central purpose:
“Narrative disclosure provides a channel for managers to convey contextual information about their firms to market participants. This type of disclosure can bridge the gap between a firm's financial statement numbers and its underlying business fundamentals. For narrative disclosure to perform this function, managers must be willing to modify their disclosures based on their firms' changing financial performance and investors' changing information needs.”
Thus, “this study examines whether managers adjust their narrative disclosures based on current earnings performance and whether such disclosures are informative to market participants.”
This study includes firm-year observations from 1996 to 2007 and requires that data be available from the Compustat, CRSP, and SEC EDGAR databases. It was required that all observations have at least $1 million in assets and report non-zero R&D expense. This study’s sample includes 22,482 firm-year observations.
This study was conducted through measuring narrative R&D disclosure quantity by using a computerized content analysis of 10-K filings
Broadly speaking, this study finds that managers adjust R&D disclosures based on earnings performance to provide relevant information rather than to obfuscate performance.