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  • Jennifer M Mueller-Phillips
    The Effects of Critical Audit Matter Paragraphs and...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Effects of Critical Audit Matter Paragraphs and Accounting Standard Precision on Auditor Liability
    Practical Implications:

    These results provide new insight into conflicting results in contemporaneous studies that investigate the relationship between CAMS and auditor liability. The results will also be informative to the PCAOB and SEC because they highlight a potential unintended consequence of the proposed audit reporting model and reinforce the importance of the two oversight bodies considering the relationship between their regulatory actions. 

    Citation:

    Gimbar, C., B. Hansen and M. E. Ozlanski. 2016. The Effects of Critical Audit Matter Paragraphs and Accounting Standard Precision on Auditor Liability. The Accounting Review 91 (6): 1629 – 1646.

    Keywords:
    PCAOB, audit reporting, auditor litigation, critical audit matter (CAMs), and accounting standard precision
    Purpose of the Study:

    The PCAOB is currently considering substantial changes to the audit reporting model that would require auditors to disclose critical audit matters (CAMs) in the audit report. CAMs discuss areas of the audit that required a significant amount of professional judgment to evaluate appropriately or that posed the most difficulty in obtaining and evaluating evidence. Although this additional disclosure is expected to increase the information content of the audit report for investors, several interest groups have expressed concerns that CAMs will also increase the audit profession’s liability risks. In addition, the SEC, FASB and IASB have the potential to make sweeping changes to accounting standards in the coming years. These changes have the potential to significantly impact assessments of auditor liability. The purpose of this study is to investigate how jurors’ perceptions of auditor liability are affected by CAMs, accounting standard precision, and the interaction between CAMs and accounting standard precision. 

    Design/Method/ Approach:

    The authors use an experiment in which participants, acting the role of jurors, evaluate auditor liability for an alleged misstatement of financial statements due to inaccurate lease reporting and the subsequent bankruptcy of an audit client.  Following the experiment, the authors use mediation analysis to provide additional evidence regarding participants’ decision making underlying the hypothesized and observed significant association between auditor liability under precise accounting standards and both related and unrelated CAMs. 

    Findings:
    • The authors find that when no CAM is present, the participants have a lower propensity to issue verdicts against the auditor when the client’s accounting conforms to a precise standard than under an imprecise standard with the same accounting treatment.
    • The authors find that under precise standards and an accounting treatment that meets the letter of the law, both related and unrelated CAMs increase auditor liability.
    • The authors observe an interaction between standard precision and CAMs such that CAMs increase auditor liability by a lesser amount under imprecise standards than precise standards.
    • The authors find that, under precise accounting standards, related CAMs increase jurors’ assessments of the auditor’s control over financial reporting, and this increased level of perceived control mediates the relationship between related CAMs and jurors’ assessments of the auditor’s liability.
    • The authors find that unrelated CAMs are significantly associated with a decrease in participants’ evaluation of the audit performed, and this result mediates the relationship between unrelated CAMs and auditor liability under precise standards. 
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Changes in Reporting Formats, Impact of PCAOB
  • Jennifer M Mueller-Phillips
    Fraud Risk Awareness and the Likelihood of Audit Enforcement...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Fraud Risk Awareness and the Likelihood of Audit Enforcement Actions
    Practical Implications:

     This paper sheds light on the implications of a going concern opinion, specifically in the context of litigation against the auditor. While prior research has established that a going concern opinion reduces the likelihood of shareholder litigation in bankruptcy proceedings, this study shows that going concern opinions potentially open up the auditor to increased SEC litigation if the financial statements are found to be fraudulent. The authors suggest this should be taken into consideration when auditors are determining the extent of necessary documentation for fraud risk assessment, especially when the client is likely receiving a going concern opinion.

    Citation:

     Eutsler, J., E.B. Nickell, S.W. Robb. 2016. Fraud Risk Awareness and the Likelihood of Audit Enforcement Action. Accounting Horizons 30 (3): 379-392.

    Purpose of the Study:

     The authors aim to examine whether documented awareness of fraud risk affects the likelihood of SEC enforcement action against the auditor in cases of undetected fraud. They acknowledge that financial distress provides incentive for fraudulent activity, and therefore consider the possibility that a going concern represents information that may affect SEC assessment of the auditor’s fraud risk assessment. This study aims to address concern that regulator investigation of audited fraudulent financials may be biased by economic factors or other information that was unknown at the time of the audit. This concern contradicts prior research, which shows that going concern opinions deter litigation against auditors when the client subsequently goes bankrupt.

    Design/Method/ Approach:

     The authors review Accounting and Auditing Enforcement Releases (AAERs) issued by the SEC for companies alleged to have engaged in fraudulent activity between January 1995 and August 2012. They identify 314 instances of alleged fraud, of which 34 received a going concern opinion and 54 had auditor-involved sanctions.

    Findings:

     The authors find that awareness of fraud risk—specifically noting a going concern issue—exposes the auditor to additional scrutiny of regulators when the financials are subsequently found to be fraudulent. Additionally, this paper points out an interesting contrast in the implications of a going concern opinion. Prior research has shown that auditors are less likely to be sued when a client with a going concern opinion subsequently goes into bankruptcy; however, the results in this paper show that auditors giving a going concern opinion are more likely to be sued when those financial statements are subsequently found to be fraudulent.

    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Going Concern Decisions, Litigation Risk
  • Jennifer M Mueller-Phillips
    Risk Disclosure Preceding Negative Outcomes: The Effects of...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Risk Disclosure Preceding Negative Outcomes: The Effects of Reporting Critical Audit Matters on Judgments of Auditor Liability
    Practical Implications:

    The results of this study are important for both regulators and auditors alike.  Despite auditor concerns that a requirement to disclose CAMs would increase litigation risk, the results of this study indicate that they may actually reduce, or at the very least, have no effect on litigation risk.  This is the case even when the subsequently identified misstatement is not related to the risks documented in the CAM.  Furthermore, standard setters should take comfort in these findings as they weigh the potential benefits of adopting a CAM disclosure requirement because the results indicate that the implementation of CAMS would not increase the risk of litigation to auditors. 

    Citation:

    Brasel, K., M. M. Doxey, J. H. Grenier, and A. Reffett. 2016. Risk Disclosure Preceding Negative Outcomes: The Effect of Reporting Critical Audit Matters on Judgments of Auditor Liability.  The Accounting Review 91 (5): 1345-1362.

    Keywords:
    audit litigation, audit report, negligence, liability, critical audit matters, disclosure
    Purpose of the Study:

    The PCAOB has proposed a change to the standard audit reporting model to include the disclosure of critical audit matters (CAMs).  While there is evidence that investors support additional auditor disclosures like CAMs, many other stakeholders oppose the implementation of a requirement to produce such ex ante risk disclosures.  The opposition, which includes audit firms, academics, and attorneys, assert that this type of requirement would increase litigation against auditors.

    However, CAMs require disclosure of increased risk prior to a subsequently revealed misstatement.  This feature of the proposed disclosure also makes it possible that CAMs may reduce litigation risk because jurors will view the plaintiff as being forewarned of an increased risk.  To the extent that jurors view a misstatement as having been more foreseeable to the plaintiff, this study predicts that jurors will experience less negative affect when considering plaintiff losses because the plaintiff was forewarned.  Below are two objectives the authors address in their study:

    • Examine whether auditors face increased litigation risk when auditors disclose a CAM that is related to a subsequently revealed misstatement.
    • Examine whether auditors face increased litigation risk when auditors disclose a CAM that is unrelated to a subsequently revealed misstatement.
    Design/Method/ Approach:

    The authors conducted an experiment with jury-eligible participants to examine their research questions.  The study included four different disclosure conditions: (1) control – no mention of CAMs, (2) disclosure of a CAM related to the subsequently revealed misstatement, (3) disclosure of a CAM that is unrelated to the misstatement, (4) an explicit statement that the auditors did not identify any CAMs.  Additionally, two different types of misstatements were examined to determine whether the type of misstatement affected the jurors’ propensity to find the auditor negligent: (1) an overstatement of inventory, (2) an understatement of an environmental restoration liability.  Participants read a case study about an audit that failed to detect a material financial statement fraud and then assessed auditor negligence.

    Findings:
    • When auditors failed to detect an overstatement of inventory, participants were less likely to find the auditor negligent when the auditor disclosed a related CAM, relative to both when there was no mention of CAMs and to when the auditor explicitly stated that there were no CAMs.  However, when auditors failed to detect the understatement of the client’s environmental restoration liability, participants were neither more nor less likely to find the auditors negligent when the auditor disclosed a related CAM.  This difference in outcomes was due to participant perceptions that the understatement of the client’s environmental restoration liability was more foreseeable than the inventory misstatement in the control condition thereby reducing the impact of the CAM.
    • Disclosing a CAM that was unrelated to the undetected misstatement did not affect jurors’ auditor liability judgments relative to current reporting standards.  However, disclosure of an unrelated CAM did reduce jurors’ negligence assessments relative to a condition in which the auditor explicitly stated there were no CAMs.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Changes in Reporting Formats, Changes in Reporting Formats, Litigation Risk
  • Jennifer M Mueller-Phillips
    Are Juries More Likely to Second-Guess Auditors Under...
    research summary posted August 31, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.04 Investigations, 15.0 International Matters, 15.02 IFRS Changes – Impacts in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Are Juries More Likely to Second-Guess Auditors Under Imprecise Accounting Standards?
    Practical Implications:

     The results of this study have implications for regulatory agencies and standard-setting bodies. As regulators contemplate whether to mandate IFRS and standard setters determine the level of implementation guidance for new standards, the litigation consequences of standard precision are an important consideration. Further, these results highlight the importance of regulators developing ways for jurors to evaluate audit judgments under imprecise standards, especially in industries and areas without precise industry reporting norms. Prior discussion on this issue has focused on how professional judgment frameworks are necessary to protect auditors and their clients from second guessing. This study suggests that judgments frameworks, if effective, may help protect auditors who make conservative judgments and also help hold auditors accountable for overly aggressive judgments.

    Citation:

     Kadous, K., and M. Mercer. 2016. Are Juries More Likely to Second-Guess Auditors Under Imprecise Accounting Standards? Auditing: A Journal of Practice and Theory 35 (2): 101-117.

    Keywords:
    audit litigation, standard precision, principles versus rules, second-guessing, jury decision making, IFRS
    Purpose of the Study:

    U.S. Generally Accepted Accounting Principles (GAAP) are generally viewed as more precise than International Financial Reporting Standards (IFRS) in that the former tend to contain more detail about implementation and compliance than the latter. Convergence efforts between U.S. GAAP and IFRS are on going, and have led to greater imprecision in U.S. accounting standards in areas such as lease accounting and revenue recognition. These imprecise standards require increased professional judgment by managers and auditors, which has led to concern that the adoption of less precise standards will result in more second-guessing of auditor judgments by juries and thus greater legal liability. This study seeks to address this concern and examines whether juries are more likely to second-guess auditors’ judgments under an imprecise accounting standard compared to a precise accounting standard. 

    Design/Method/ Approach:

    The authors recruited undergraduate students enrolled in introductory accounting courses at a large university as participants for this study. Two administrations were conducted with the students who participated in a simulated case that lasted 45 minutes during their accounting lab session. Participants acted as jurors in an auditor negligence case involving revenue recognition and were given information related to SFAS No. 66 (Real Estate) to help in their evaluation. The authors manipulated the precision of the accounting guidance as either precise or imprecise. The aggressiveness of the client’s reporting choice was manipulated as either aggressive or conservative.  

    Findings:

    The results of this experiment suggest that auditors’ fear about second-guessing by juries under imprecise accounting standards is warranted. Under an imprecise standard, conservative accounting choices are more likely to be called into question and result in negligence verdicts, ex post.

    • When the client’s reporting is conservative, there appears to be more second guessing of auditor judgments under an imprecise standard compared to a precise standard.
    • When the auditor allows aggressive client reporting, there appears to be less second guessing of auditor judgments under an imprecise standard compared to a precise standard.

    These findings indicate that rather than being overly harsh, juries appear to be overly lenient when auditors allow aggressive accounting under an imprecise standard. A lack of precision appears to make it more difficult for juries to identify whether an auditor’s judgment was reasonable or unreasonable. 

    Category:
    Accountants' Reporting, International Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    IFRS Changes – Impacts, Investigations, Litigation Risk
  • Jennifer M Mueller-Phillips
    Audit Report Restrictions in Debt Covenants
    research summary posted August 30, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 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 Report Restrictions in Debt Covenants
    Practical Implications:

     Private debt lenders are more likely to include a covenant that prohibits the borrower from receiving an audit report with going-concern modifications (GCAR) when the borrower has poor creditworthiness and the loan term is long. The auditor choice is more likely to be specified in the loan agreement when a GCAR covenant is included. The borrower with a GCAR covenant experiences both increased audit fees and higher probability of getting a GCAR when financial distress occurs. The results imply the GCAR covenant may complement traditional financial covenants in protecting the lenders but comes with a cost borne by the borrowers. It also shows the lenders’ use of audit reports can influence the auditors’ behavior.

    Citation:

     Menon, K., and D. D. Williams. 2016. Audit Report Restrictions in Debt Covenants. Contemporary Accounting Research 33 (2): 682–717.

    Keywords:
    going concern, auditor choice, debt covenants, audit fees, audit reports
    Purpose of the Study:

    Prior studies on debt contracting mainly focus on financial covenants. This paper extends prior research by investigating why lenders put an audit-related covenant – GCAR covenant – into the loan agreement and the effect of this covenant on auditors. The authors argue a GCAR serves as an effective warning for potential defaults even if common financial covenants are not violated. They expect borrowing firms with low credit quality to have a GCAR covenant. They also expect long-term loans to have a GCAR covenant because the lenders face higher probability that the firm’s financial condition deteriorates before the loan matures. To prevent opinion shopping and for insurance purpose, lenders who impose a GCAR covenant are expected to restrict the borrower’s freedom on auditor selection. From the auditor’s stand point, the authors believe the GCAR covenant increases litigation risk to the auditor and/or require additional audit effort. As a result, audit fees are expected to increase and the borrowers are more likely to receive a GCAR.  

    Design/Method/ Approach:

    The initial sample comes from new private debt placement made by public companies between 2003 and 2009. The final sample consists of 7,749 loan contracts (firm-years) from 3,304 unique companies. The authors obtain debt information from DealScan, financial information from COMPUSTAT and audit-related data from Audit Analytics. The authors first test what factors determine the inclusion of a GCAR covenant and then examine the effect of this covenant on audit-related issues.  

    Findings:
    • Private debt lenders are more likely to impose a GCAR covenant in the loan contract when the credit quality of the borrower is poor and/or the debt’s maturity is long. Additional analyses show the GCAR covenant can capture events or situations lead to potential defaults even if traditional covenants are not violated.

     

    • If the loan contract contains a GCAR covenant, it is more likely that the lenders will require the borrower to engage a specific auditor. The auditors accepted by the lenders are usually the Big 4 auditors or at least national auditors. The auditor choice reflects the view that reputable auditors are stricter in going-concern assessment and have deep pockets to settle litigations.

     

    • Auditors charge higher audit fees on and are more likely to issue a GCAR to clients who have loan contracts contain a GCAR covenant, holding the degree of financial distress constant. The results are consistent with the argument that the GCAR covenant increases auditors’ perception on litigation risk and the demand on audit effort. 
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    There’s No Place Like Home: The Influence of Home-State G...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    There’s No Place Like Home: The Influence of Home-State Going-Concern Reporting Rates on Going-Concern Opinion Propensity and Accuracy
    Practical Implications:

    The findings of this study indicate that increased home-state GC rates lead to lower GC reporting accuracy for non-Big 4 auditors. This lower GC reporting accuracy imposes economic costs on the client and the auditor, which suggests that prior GC rates may be weighted too heavily in the minds of auditors.

    Citation:

    Blay, A.D., J.R. Moon, and J.S. Paterson. 2016. There’s No Place Like Home: The Influence of Home-State Going-Concern Reporting Rates on Going-Concern Opinion Propensity and Accuracy. Auditing: A Journal of Practice and Theory 35 (2): 23-51. 

    Keywords:
    auditor reporting, going-concern opinion, audit quality, Type I error, and Type II error
    Purpose of the Study:

    For a financially distressed client, the auditor’s decision to modify the audit report related to continue as a going-concern (GC) is generally considered the first public signal of imminent financial failure based on relatively private information; furthermore, a modified audit opinion is the auditor’s only means of informing outsiders of the organization’s financial condition. Consequently, two characteristics emerge regrading going-concern opinions. The first is that GC opinions can provide significant information to financial statement users. The second is that an auditor’s willingness to issue a GC opinion can signal both that the auditor is independent and that the audit is of high quality. Considerable research corroborates and relies upon the two characteristics described above. The majority of this research succeeds in identifying client financial characteristics that influence auditors’ going concern reporting decisions; however, there is not very much research that focuses on whether auditors’ circumstances and surroundings influence their propensities to issue modified opinions. This paper looks into whether auditors’ decisions to issue GC opinions are affected by the rate of GC opinions being given in the surrounding area. 

    Design/Method/ Approach:

    Partners and managers from a wide variety of accounting firms are interviewed by the authors to gain initial insight into the potential effects of state-based information. To measure the rate of proximate GC opinions, the authors analyzed 22,862 audit reports of financially distressed clients from 2001-2011. 

    Findings:
    • The authors found through their interviews with partners and managers that non-Big 4 auditors are likely more influenced by prior GC opinions within their state than Big-4 auditors are; ergo, the focus shifted to non-Big 4 firms for all subsequent analyses.
    • The authors find that prior-year first-time GC reporting at the state level is significantly and positively related to current-year first-time GC reporting.
    • The authors’ results show that GC reporting accuracy decreases significantly with increases in the state rate of GC opinions; furthermore, the increased issuance of GC opinions leads to increases in Type I error rates without decreases in Type II error rates.
    • The evidence found by the authors provides strong support that higher proximate GC rates impair GC reporting accuracy measured using Type I errors.
    Category:
    Accountants' Reporting
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    The Relation between Managerial Ability and Audit Fees and...
    research summary posted June 15, 2016 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Relation between Managerial Ability and Audit Fees and Going Concern Opinions
    Practical Implications:

     This research makes two primary contributions. The first is to the literature on audit pricing and going concern opinion by providing empirical evidence that after controlling for firm-level characteristics, managerial characteristics are also associated with audit fees and the propensity of auditors to issue going concern opinions. This evidence is particularly important because there is a paucity of empirical evidence on the relation between managerial characteristics and auditors’ decisions. The second contribution is providing two validation checks on the managerial ability measure developed by Demerjian which is becoming more widely used.

    Citation:

    Krishnan, G.V. and C. Wang. 2015. The Relation between Managerial Ability and Audit Fees and Going Concern. Auditing: A Journal of Practice and Theory 34 (3): 139-160.

    Keywords:
    managerial ability, audit fees, engagement risk, and going concern
    Purpose of the Study:

    Extensive literature exists that examines the determinants of audit pricing and the propensity of auditors to issue going concern opinions; however, much of this literature focuses on firm-level determinants as opposed to if managerial attributes of the client are informative to auditors. This study examines the relation between managerial ability, defined as the ability to transform corporate resources to revenues, and audit fees and the likelihood of issuing a going concern opinion.

    Design/Method/ Approach:

    For the measurement of managerial ability, the managerial ability measure, a recently developed measure, was used. The audit fee sample consists of nearly 31,000 firm-year observations representing more than 5,000 unique firms for the period 2000 through 2011. For the going concern analysis, a sample of financially distressed firms consisting of 11,257 firm-year observations was used.

    Findings:
    • The authors find that their research strongly supports their hypothesis that managerial ability is negatively associated with audit fees after controlling for firm-level characteristics.
    • The authors’ findings are also consistent with the notion that greater managerial ability mitigates the auditor’s engagement risk.
    • The authors’ findings support the notion that when the incoming CEO/CFO is deemed to be more efficient than the outgoing CEO/CFO, audit fees are lower, consistent with lower engagement risk.
    • The authors find that the likelihood of issuing a going concern opinion is negatively related to firm size, cash flows, beta, stock return, and investments, and positively related to leverage, prior-year loss, distress, stock return volatility and audit report lag.
    • The authors’ findings support the hypothesis that after controlling for firm-level characteristics, managerial ability is negatively associated with the likelihood that an auditor will issue a going concern opinion.
    • The findings support the notion that the managerial ability is informative to auditors.
    Category:
    Accountants' Reporting
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Internal Control Opinion Shopping and Audit Market...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Control Opinion Shopping and Audit Market Competition.
    Practical Implications:

    The study results are important to regulators, practitioners, and academics. The findings show that internal controls opinion shopping appears to occur among firms that have clean internal control opinions prior to a restatement. In addition, clients have the incentive to manipulate the audit process, via internal control opinion shopping, due to the increased focus and oversight on internal controls reporting. Finally, auditor dismissals that occur late in the fiscal period are more likely to be associated with internal control opinion shopping.   

    Citation:

    Newton, N. J., J. S. Persellin, D. Wang, and M. S. Wilkins. 2016. Internal Control Opinion Shopping and Audit Market Competition. The Accounting Review 91 (2): 603623.

    Keywords:
    opinion shopping, internal control weaknesses, audit opinion, audit quality, audit market competition
    Purpose of the Study:

    This study evaluates three research questions related to opinion shopping using the internal controls environment. There have been historical concerns with the presence of audit opinion shopping. However, most studies use going concern opinions in assessing audit clients retention and dismissal behavior. This study expands the opinion shopping environment to internal control reporting. Going concern opinions typically have a low base rate of occurrence and have leading indicators (poor growth, bankruptcy indicators, etc.). Internal control opinions do not have similar indicators that give rise to a warning of an adverse internal control opinion. From this background, the authors investigate: 1) whether internal control opinion shopping exist; 2) how audit market competition influences internal control opinion shopping; and 3) does the timing of an auditor dismissal indicate opinion shopping motivations.  

    This study also provides an avenue to evaluate opinion shopping in the period after the passage of the Sarbanes-Oxley Act. In addition, it highlights the unintended consequences of increased audit market competition. Finally, it lends support to recent regulatory concern over the decrease in material weakness assessments that may not be the caused by improved internal control environments.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. Audit opinion and audit client data is from Compustat, Audit Analytics, and the Center for Research in Security Prices (CRSP). The sample period starts in 2005, the year after the implementation of SOX Section 404, and ends in 2011.

    Findings:
    • The authors find that audit clients are successful at internal control opinion shopping. The results show that clients would have received adverse internal control opinions at a higher rate if they made different auditor retention or dismissal choices.
    • When assessing the type of audit firm changes, the results suggest that opinion shopping may be more prevalent for audit clients that do not need the services of a Big 4 auditor.
    • Using three proxies for audit market concentration, the authors find a higher likelihood of opinion shopping in markets with high concentration.
    • The authors also find that auditor dismissals that occur in the third fiscal quarter are more likely to be associated with opinion shopping compared to auditor dismissals occurring prior to the end of the second quarter, especially in competitive markets.
    • The authors performed supplemental analyses to determine the association between internal control opinion shopping and going concern opinion shopping. They find that internal control opinions are less predictable and therefore more valuable than going concern opinions. They did find evidence of going concern opinion shopping in the pre-SOX period but not in the post-SOX period. This gives rise to the possibility that going concern reporting has a reduced role in auditor retention decisions after the introduction of SOX.
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes, Internal Control
    Sub-category:
    Consequences of Adverse 404 Opinions, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    The Auditor's Reporting Model: A Literature Overview and...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Auditor's Reporting Model: A Literature Overview and Research Synthesis.
    Practical Implications:

    Though modest improvements have been made in recent years, confusion still exists as to the content and meaning of the auditor’s report (e.g., users are confused as to the auditor’s responsibilities, the audit process, and the level of assurance provided). The authors suggest that the communicative value of the auditor’s report can be enhanced by including additional disclosures.

    Citation:

    Church, B. K., S. M. Davis, and S. A. McCracken. 2008. The Auditor's Reporting Model: A Literature Overview and Research Synthesis. Accounting Horizons 22 (1): 69-90.

    Keywords:
    auditor’s reporting decision, auditor’s report, accounting standards
    Purpose of the Study:

    This article examines academic research to contribute to the Public Company Accounting Oversight Board’s (PCAOB) project on the auditor’s reporting model. The authors develop a framework to organize a discussion of the literature in light of key questions raised at two Standing Advisory Group (SAG) meetings. They trace the historical development of the auditor’s report and then delve into relevant research that focuses on the auditor’s reporting decision and the content of the auditor’s report.

    This article is important because it provides a state of the art basis to understand the auditor’s reporting model. Such an understanding is necessary to assess the merits of the current model and to establish its shortcomings. Throughout the article, the authors identify areas needing change and areas needing further study.

    Design/Method/ Approach:

    The authors review three lines of research that underlie the auditor’s reporting decision.

    • First, they look at the collection and evaluation of audit evidence, targeting research on factors that directly affect the auditor’s reporting decision.
    • Second, they consider the role of accounting standards in shaping financial statements. The authors look at research on rules- versus principles-based standards and how such standards affect the auditor’s interpretation and application of accounting principles (i.e., GAAP).
    • Third, the authors ponder the role of the auditor in the financial-reporting process. They examine research on auditor-client negotiations, which are integral in the preparation of financial statements, and then look at studies on the auditor’s decision to book or waive misstatements.

    The authors then examine three lines of research on the content of the auditor’s report.  

    • First, they summarize studies that elicit and compare users’ and auditors’ assessments of the report to identify differences that create an expectations gap.
    • Next, they look at research on the market’s reaction to the issuance of the auditor’s report.
    • Finally, the authors evaluate studies on disclosure of additional information in the auditor’s report (e.g., materiality levels) and weigh whether users would benefit from such disclosures.
    Findings:
    • The authors’ review of the extant literature suggests that the audit process is affected by factors that, typically, are assumed to be irrelevant (e.g., the sequence of evidence collection or the specific auditor performing a task).
    • They also find that the nature of accounting standards (principles-based versus rules-based) can influence the audit process, via an effect on auditor-client negotiations.
    • As for the auditor’s report, they conclude that it has symbolic value (i.e., it represents the auditor’s work), but that it provides little communicative value (i.e., it conveys little information).
    Category:
    Accountants' Reporting
    Sub-category:
    Changes in Reporting Formats
  • Jennifer M Mueller-Phillips
    Restatements: Do They Affect Auditor Reputation for Quality.
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 11.0 Audit Quality and Quality Control, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Restatements: Do They Affect Auditor Reputation for Quality.
    Practical Implications:

    This study offers insights into how restatements by one client may impact an auditor’s other clients. The authors find evidence suggesting that when an auditor’s clients restate their financial statements, the auditor’s reputation for audit quality suffers. Non-restating clients experience a small negative market reaction around the restatement date and a higher likelihood of dismissing that auditor. These findings may inform audit firms and their clients about the potential negative consequences of restatements by other clients.

    Citation:

    Irani, A.J., S.L. Tate, and L. Xu. 2015. Restatements: Do They Affect Auditor Reputation for Quality. Accounting Horizons 29 (4): 829-851.

    Keywords:
    financial restatements, audit quality, auditor reputation, auditor dismissal
    Purpose of the Study:

    Signals of low audit quality should harm an audit firm’s reputation for quality in order to make the reputation more accurately reflect the firm’s true audit quality. While prior research has found negative responses from clients and the stock market following strong signals of low audit quality (e.g., SEC disciplinary actions), it is unknown how these stakeholders will react to weaker signals of low audit quality (e.g., restatements). However, the research on industry contagion effects suggests that restatements by one firm in an industry lead to decreased expectations for other firms in the industry, so it would not be surprising if restatements by one firm lead to decreased expectations for other firms that share its auditor. The authors attempt to tie up these loose ends by investigating whether restatements by one firm lead to (1) auditor dismissals by and (2) negative market adjusted returns for other firms that share its auditor(s), especially when restatements are more severe.

    Design/Method/ Approach:

    The authors use data from publicly-traded companies during the 2004-2012 time period. First, they test whether non-restating companies are more likely to dismiss auditors whose other clients filed restatements in the prior year. Second, they test whether non-restating companies experience negative market adjusted returns after one of their auditor’s other clients files a restatement. For both tests, they investigate whether the predicted reputation effect is stronger for more severe restatements.

    Findings:
    • About 4.5% of non-restating companies dismissed their auditor.
    • Non-restating companies more likely to dismiss their auditor had auditors with a higher percent of clients filing restatements and more misstated items in the restatements. The non-restating companies more likely to dismiss their auditor had weaker internal controls, a net loss, higher leverage, and a smaller size.
    • Auditor resignations are not related to the number of clients filing restatements.
    • On average, restating companies (non-restating companies sharing a restating company’s auditor) had a -1.78% (-0.04%) market adjusted return over the 2 day restatement window.
    • Over the 2 day restatement window, the decrease in market value of a non-restating company was higher when there was a stronger decrease in market value for the shared auditor’s restating client, the restatement adversely affected the restating client’s net income, the restatement had more restated items, a larger window existed between the misstatement period and the restatement announcement, the auditor was an industry expert, the auditor was one of the Big 4, the non-restating company had higher cash flow from operations, the non-restating company had lower total accruals, and the non-restating company was bigger.
    Category:
    Accountants' Reporting, Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements