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  • Jennifer M Mueller-Phillips
    Abnormal Audit Fees and Restatements
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Abnormal Audit Fees and Restatements
    Practical Implications:

    The conclusion that audit fees are associated with the risk of audit failure may impact auditors as they face pressure to reduce audit fees. Auditors should consider this risk based on the client’s position as well as trying to minimize risk related to audit fee reductions. Similarly, client’s audit committee should consider the trade-off between current fees and the risk of restatement. With the changes that SOX introduced, regulators should review how changes in audit fees affects the quality of financial statements over time.

     

     

    For more information on this study, please contact Dr. David Hurtt.

    Citation:

    Alan I. Blankley, David N. Hurtt, and Jason E. MacGregor. 2012. Abnormal Audit Fees and Restatements. Auditing: A Journal of Practice & Theory: 31 (1): 79-96.

    Keywords:
    Restatements, audit fees, audit quality
    Purpose of the Study:

    Overall, this paper investigates whether there is a relationship between audit fees and subsequent financial statement restatements. The authors investigated whether audit firms charged more for audit services prior to a restatement compared to non-restatement clients. Past research finds that this relationship has a positive correlation. However, the authors revisited this relationship for the post-SOX period based on multiple factors:

     

    • The relationship of audit fees to future restatements is unclear since high fees may increase restatement probability due to independence issues, while low fees may increase the probability of future restatement because they potentially reflect lower levels of service or effort.
    • SOX affects the auditor-client relationship through changes such as partner rotation and prohibiting some non-audit services provided to audit clients. Research revealed a shift in firms increasing pricing for risk.
    • With the recent economic downturn, companies trying to decrease audit fees could be focusing on cutting cost instead of focusing on the quality of the financial statements.
    • Past research was inconclusive on the relationship between future restatements and audit fees because of the time frame studied as well as the omission of an internal control strength variable.

     

    Finding a clear relationship between audit fees and future restatements could have implications in how auditors, audit committees, and regulators view audit fees in a post-SOX business environment. As a result, the study could impact fee negotiations from the standpoint of audit quality.

    Design/Method/ Approach:

    Audit fee and restatement data was collected from Audit Analytics for the 2002 through 2009 period. The authors used two statistical models to study the association audit fees may have with future restatements. First, using an audit fee model based on prior research, the authors derived the abnormal or unusual audit fee after controlling for audit risk, client complexity, internal control strength and other influences on fees. In the second model, the authors tested a robust logistic regression model where the variable of interest was the abnormal audit fee derived from the first model. 

    Findings:
    • The authors find that abnormal audit fees are negatively associated with the probability of future financial statement restatements.
    • When audit fees are noticeably high, the likelihood of restatement is low. When audit fees are noticeably low, the likelihood of restatement is high.
    • When audit fees are abnormally low, there may be pressure for auditors to maintain the profitability of the engagement by minimizing hours to complete the audit.
    • This relationship is robust when the model included or excluded a variety of internal control and restatement variables.
    Category:
    Accountants' Reporting, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Restatements
  • Jennifer M Mueller-Phillips
    Accelerated filing deadlines, internal controls, and...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.07 Impact of SEC Actions, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Accelerated filing deadlines, internal controls, and financial statement quality: The case of originating misstatements.
    Practical Implications:

    Given the significant amount of concern regarding the reliability of financial statement reporting under new filing deadlines (movement from 90 days to 75 days in 2003 and then to 60 days in 2006), the authors provide evidence which shows the concern was valid but only temporarily. The authors use originated misstatements to indicate the beginning of a misstatement, showing that accelerated filers experienced higher likelihood of misstatements after the first acceleration, however large accelerated filers did not experience such a change in response to the second acceleration. Additionally, implementation of SOX appears to have increased reliability with fewer originated misstatements upon implementation.

    Citation:

    Boland, C. M., S. N. Bronson, C. E. Hogan. 2015. Accelerated filing deadlines, internal controls, and financial statement quality: The case of originating misstatements. Accounting Horizons 29 (3) 297-331.

    Keywords:
    Accelerated filing, financial statement restatements, Sarbanes-Oxley Act, filing lags, internal controls
    Purpose of the Study:

    The authors investigate whether Government regulationspecifically through changes in filing deadlines and implementation of the Sarbanes Oxley Act (SOX)influence the origination of financial statement misstatements. They specifically focus on the origination of misstatements to determine if firms sacrificed relevance and reliability to comply with accelerated filing dates.

    Design/Method/ Approach:

    The analyses use a sample of 17,216 firm-year observations from 12/15/2002 to 12/14/2007. The authors run a regression analysis predicting the likelihood of a restatement for accelerated filers and large accelerated filers relative to non-accelerated filers. The model incorporates controls for other known determinants of changes in likelihood of restatement.

    Findings:

    The authors find:

    • Accelerated filers had a higher likelihood of a misstatement following the filing deadline shift from 90 to 75 days.
    • Accelerated filers had a reduced likelihood of a misstatement following implementation of SOX.
    • Large accelerated filers did not experience a change in likelihood of a misstatement following the filing deadline shift from 75 to 60 days.

    The results suggest that the concerns of filers and their auditors regarding the potential for lower-quality information resulting from accelerated filing was valid, although only temporarily. In the long run, companies were able to file reports in a timelier manner without a corresponding increase in the likelihood of misstatement.

    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Impact of SEC Actions, Restatements
  • Jennifer M Mueller-Phillips
    Admitting Mistakes: Home Country Effect on the Reliability...
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Admitting Mistakes: Home Country Effect on the Reliability of Restatement Reporting.
    Practical Implications:

    The study highlights that a positive relationship between restatements and financial reporting quality depends on the reliable detection and disclosure of misstatements. Foreign firms are less likely to restate, a finding that has implications for investors and regulators. The results imply that U.S.-listed foreign firms may be under-scrutinized by U.S. public and private enforcement mechanisms. The findings suggest that companies from countries with weaker domestic rule of law are a potential focus area for investors and regulators to better identify firms with opportunistic restatement behavior. Fewer restatements lowers investors’ ability to hold managers and auditors accountable for poor financial reporting through CEO turnover or securities litigation, since restatements are a major trigger for both these mechanisms.

    Citation:

    Srinivasan, S., Wahid, A. S., & Yu, G. 2015. Admitting Mistakes: Home Country Effect on the Reliability of Restatement Reporting. Accounting Review 90 (3): 1201-1240.

    Keywords:
    accounting quality, accounting restatements, earnings management, enforcement, internal control weakness, SOX 404
    Purpose of the Study:

    Accounting rules in the U.S. require firms to issue a restatement correcting prior material errors upon discovery. Timely detection and reporting of accounting errors and irregularities ensure that a firm’s reported financials are free of any misstatements. Without enforcement that ensures the prudent correction of existing misstatements, there will likely be systematic underreporting of restatements, which will allow bad type firms to pool with good type firms and possibly lower investors’ faith in the reported financials. Therefore, understanding the determinants of reporting restatements is important to better assess the reliability of reported financials.

    The authors use the large number of restatements in recent years by both U.S. and foreign firms listed in the U.S. to examine the reliability of restatement reporting in a cross country setting. The self-reported nature of restatements provides a good setting to assess how home country characteristics influence the financial reporting of foreign firms listed in the U.S. Further, since foreign firms are subject to the disclosure requirements set forth by the Securities and Exchange Commission (SEC), this setting allows the authors to examine the effect of home country characteristics on the financial reporting of foreign registrants while generally holding the extent of U.S. regulation constant. In particular, the authors examine whether restatement reporting varies by country-level factors that influence how firms comply with the restatement reporting rules.

    Design/Method/ Approach:

    The sample comprises 7,453 firm-year observations for U.S.-listed foreign firms from 51 countries between 2000 and 2010. The authors include both American Depository Receipts and firms directly listen on U.S. exchanges. To classify firms as foreign, the authors use Compustat to find the headquarters. The restatement sample is obtained from Audit Analytics.

    Findings:
    • Foreign firms report accounting restatements in 4.7 percent of firm-years, compared to 7.3 percent for a matched sample of U.S. firms.
    • Firms from weak rule of law countries are less likely to restate, with 4.2 percent of firms restating, compared to 7.5 percent for the matched sample of U.S. firms. On the other hand, firms from strong rule of law countries show a smaller difference in their restatement frequency compared to matched U.S. firms (5.0 percent versus 7.2 percent of firm-years).
    • Firms from weak rule of law countries are 42 percent less likely to restate compared to firms from strong rule of law countries.
    • The lower frequency of restatements in weak rule of law countries is due to weaker compliance with restatement reporting, rather than an absence of accounting misstatements.
    • Foreign firms, especially those from weak rule of law countries, are less likely to report accounting irregularity restatements than comparable U.S. firms.
    • The sensitivity of earnings management to accounting irregularity restatements is positive and significant only for U.S. firms and foreign firms from strong rule of law countries. For foreign firms from weak rule of law countries, the authors find no relation between earnings management and the likelihood of accounting irregularity restatements. This suggests that avoidance of restatement is not limited to errors; it exists even for accounting irregularities.
    Category:
    Accountants' Reporting
    Sub-category:
    Restatements
  • Jennifer M Mueller-Phillips
    Associations between Internal and External Corporate...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements
    Practical Implications:

    Prior studies’ conflicting results regarding the association between corporate governance measures and restatements are explained (at least partially) by the time period in which the relationship is examined. The relationship is different before and after Sarbanes Oxley (2002). However, this paper cannot determine whether the change in relationship was caused by Sarbanes Oxley or whether it happened for another reason.

    For more information on this study, please contact William R. Baber.
     

    Citation:

    Baber, W. R., L. Liang, and Z. Zhu. 2012. Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements. Accounting Horizons 26 (2): 219-237.

    Keywords:
    corporate governance; governance regulation; accounting restatements
    Purpose of the Study:

    Prior studies have found conflicting results as to whether corporate governance characteristics are related to accounting restatements. Some of these prior students examine restatements prior to Sarbanes Oxley (2002), and some examine restatements afterwards. This study seeks to reconcile the findings of previous research and determine whether the relationship between corporate governance and accounting restatements has changed over time.

    Design/Method/ Approach:
    • Authors examine corporate governance data from 1997 and 2005 to compare differences in governance over time.
    • Corporate governance characteristics are divided between factors that affect internal governance (defined as characteristics that presumably govern the efficacy of board of director oversight of management) and factors that affect external governance (defined in terms of the ability of shareholders to intervene in decisions by both management and the board of directors)
    • Investigate the association between 1997 corporate governance and the probability that financial statements from 1995-1999 are restated; also investigate the association between 2005 corporate governance and the probability that financial statements from 2003-2007 are restated.
       
    Findings:
    • There is a substantial increase in internal governance during the period when changes were imposed by stock exchanges and by the U.S. Congress in the Sarbanes-Oxley Act (2002). The change in internal governance is offset by a less substantial, yet statistically significant, decrease in external governance which is consistent with the observation that shareholder oversight is recently declining.
    • In 1997, internal and external governance characteristics are substitutes for each other (firms tend to do one or the other); in 2005, however, internal and external governance is not related.
    • Corporate governance characteristics in 1997 (prior to Sarbanes Oxley) are unrelated to the probability of financial statement restatements, whereas the correlation between corporate governance characteristics and restatements is statistically significant in 2005 (after Sarbanes Oxley).
      • Thus, the cross-sectional relationship between governance characteristics and restatement changed between 1997 and 2005.
    • The relationship between corporate governance measures in 2005 and restatements in 2003-2007 is not significant if interactions between internal and external governance measures are omitted from the model.
       
  • Jennifer M Mueller-Phillips
    Board Interlocks and Earnings Management Contagion.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.05 Board/Audit Committee Oversight in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Board Interlocks and Earnings Management Contagion.
    Practical Implications:

    The evidence on the firm-to-firm spread of financial reporting behavior via board networks contributes to a little-studied area in accounting that should be important. The authors contribute to the corporate governance literature by offering evidence that contagion effects vary with board positions. They show that board supervision of management is important for ensuring high-quality financial reporting and that board linkages affect the success of this supervision. Regulators concerned about improving financial reporting quality should consider the board connectivity of companies.

    Citation:

    Chiu, P. C., S. H. Teoh, and F. Tian. 2013. Board Interlocks and Earnings Management Contagion. Accounting Review 88 (3): 915-944.

    Keywords:
    board interlocks, board networks, contagion, earnings management, governance, restatements, social networks
    Purpose of the Study:

    In the corporate world, behavior may spread through board of director networks. A board link exists between two firms whenever a director sits on both firms’ boards. A typical board in the sample has nine directors, and the median number of interlocks with other boards is approximately five. In this way, firms are widely connected by their board networks, which potentially serve as conduits for spreading behaviors from firm to firm.

    In this study, the authors investigate whether financial reporting behavior spreads through interlocking corporate boards. The test design emphasizes contagion of bad financial reporting choices, specifically, earnings management that results in a subsequent earnings restatement, although it also allows for inferences about good reporting contagion. The authors use restatements to identify firms that have managed earnings and the period when the manipulation occurred. They refer to a firm that later restates earnings as contagious. The authors define the contagious period as starting in the first year for which earnings are restated and ending two years after. Any firm that shares an interlocked director with the contagious firm during the contagious period is therefore exposed to an earnings management infection via the board network. They consider a multiyear contagious period to allow the earnings management infection to incubate, which is analogous to an epidemiological setting for viral infections. The key test investigates whether an exposed firm is more likely to manage earnings during the contagious period as compared to an unexposed firm.

    Design/Method/ Approach:

    The authors use the U.S. Government Accountability Office’s (GAO) first release of restatements between January 1, 1997 to June 30, 2002 to identify contagious firms and their contagious periods. They keep only the earliest restatement within the sample period when a firm has multiple restatements. The authors obtain director names from Risk Metrics. In the 19972001 sample period the authors identify a sample of 118 observations.

    Findings:
    • The authors find strong evidence that a firm is more likely to manage earnings when exposed within a three-year period to earnings management from a common director with an earnings manipulator. The contagion effect is economically substantial.
    • The regression odds ratio suggests that a board link to a manipulator doubles the likelihood that the firm will manage earnings.
    • The authors also find evidence for good financial reporting contagion. A board link to a non-manipulator significantly decreases the likelihood of the firm being a manipulator.
    • Both bad and good accounting behaviors are contagious across board networks.
    • Earnings management contagion is stronger when the shared director has a leadership position as board chair or audit committee chair, or an accounting-relevant position as an audit committee member, in the exposed firm.
    • The contagion is also stronger when the linked director is the board chair or CEO of the contagious firm, but not when the linked director is the CEO of the exposed firm.
    • Earnings management contagion is exacerbated when the exposed firm is located within 100 miles of the contagious firm and shares a common auditor with the contagious firm.
    • The evidence supports the proposition that earnings manipulation spreads through board networks.
    Category:
    Accountants' Reporting, Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Board/Audit Committee Composition, Board/Audit Committee Oversight, Earnings Management, Earnings Management, Restatements
  • Jennifer M Mueller-Phillips
    Bringing Darkness to Light: The Influence of Auditor Quality...
    research summary posted June 2, 2014 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance, 13.01 Board/Audit Committee Composition in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Bringing Darkness to Light: The Influence of Auditor Quality and Audit Committee Expertise on the Timeliness of Financial Statement Restatement Disclosures
    Practical Implications:

    This objective of this study is to determine whether auditor quality and audit committee financial expertise are associated with improved restatement disclosure timeliness as reflected in reduced dark periods. Recent actions by regulatory agencies suggest that the timeliness of financial reporting remains a top priority of investors and regulators. This study finds evidence that both the auditors and audit committees can provide significant value to clients and improve timely disclosure of restatement details. 

    Citation:

    Schmidt, J., and M. S. Wilkins. 2013. Bringing Darkness to Light: The Influence of Auditor Quality and Audit Committee Expertise on the Timeliness of Financial Statement Restatement Disclosures. Auditing 32 (1).

    Keywords:
    accounting expertise; audit committees; audit quality; financial expertise; financial reporting timeliness; financial statement restatements
    Purpose of the Study:

    Several recent regulatory actions suggest that the timely reporting of financial data is a top priority of investors and regulators. This study investigates whether auditor quality and audit committee expertise are associated with improved financial reporting timeliness as measured by the duration of a financial statement’s “dark period.” The restatement dark period represents the length of time between a company’s discovery that it will need to restate financial data and the subsequent disclosure of the restatement’s effect on earnings. This dark period restatement setting helps to address the fundamental question of whether better governance helps companies resolve financial reporting problems. 

    Design/Method/ Approach:

    The authors selected a sample of 154 firms announcing dark restatements disclosed between 2004 and 2009. This sample was used to test the following hypotheses:

    • H1: Restatement dark periods are shorter for clients of Big 4 auditors. 
    • H2a: Restatement dark periods are shorter when the audit committee contains a larger proportion of financial experts. 
    • H2b: Restatement dark periods are shorter when the audit committee contains a larger proportion of accounting financial experts.
    • H3: Restatement dark periods are shorter when the audit committee chair has accounting financial expertise. 

    A multivariate model was then used to investigate the determinants of the length of restatement dark periods of the selected sample. 

     

    Findings:
    • Dark periods are shorter in the presence of Big 4 auditors.
    • Restatement dark periods are shorter among clients that have audit committees with more financial accounting experts. 
    • The relationship between the audit committee financial expertise and restatement dark periods is primarily attributable to the presence of an audit committee chair who is an accounting financial expert. 
    • With these factors present, restatement disclosures are provided up to 38 percent faster
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes, Governance
    Sub-category:
    Board/Audit Committee Composition, Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements
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  • Jennifer M Mueller-Phillips
    Determinants and Market Consequences of Auditor Dismissals...
    research summary posted February 24, 2015 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Determinants and Market Consequences of Auditor Dismissals after Accounting Restatements
    Practical Implications:

    The results of this study are important for regulators and audit committee members who are concerned with the ability of the audit market to self-regulate. Specifically, the evidence suggests that firms with higher switching costs and fewer replacement auditor choices are less likely to dismiss their auditors after a restatement. This evidence informs the debates about the costs of mandatory auditor rotation and the limited competition in the audit market. Additionally, the evidence of a positive market reaction to dismissals after severe restatements is consistent with firms restoring financial reporting credibility by replacing their auditors, and this should be of interest to audit committee members considering various corrective actions after a misstatement.

    Citation:

    Hennes, K., A. Leone, and B. Miller. 2014. Determinants and Market Consequences of Auditor Dismissals after Accounting Restatements. The Accounting Review 89 (3): 1051­–1082.

    Keywords:
    restatements, auditor dismissals, corporate governance
    Purpose of the Study:

    Auditors play an integral role in assuring the integrity of financial reporting, and market participants continue to debate the ability of the audit market to self-regulate adequately. One of the challenges in evaluating audit performance is that audit quality is difficult to observe and measure. Restatements, however, provide a visible signal of poor audit quality that can impose significant costs on firms. Firms respond to restatements with a variety of corrective actions, including the possible reconsideration of the external auditor. The purpose of this study is to provide evidence on the circumstances under which boards dismiss auditors in response to restatements and to examine how the market responds to those dismissals. 

    Design/Method/ Approach:

    This study examines a sample of public-company restatements occurring between 1997 and 2010. The authors focus only on restatements where the incumbent auditor opined on at least one annual period prior to the restatement announcement. Firm and restatement characteristics and executive and auditor turnover data is gathered from publicly available information.

    Findings:
    • The authors find that auditors are more likely to be dismissed after more severe restatements but that the severity effect is primarily attributable to the dismissal of non-Big 4 auditors rather than Big 4 auditors.
    • The authors document that among corporations with Big 4 auditors, those that are larger and more complex operationally are less likely to dismiss their auditors.
    • The study also examines contemporaneous executive turnover and finds evidence that boards view auditor dismissals as complementary rather than substitute responses to restatements.
    • Lastly, the study documents that the market reaction to an auditor dismissal (with a contemporaneous engagement of a comparable-sized auditor) is significantly more positive following more severe restatements (5.9%) than less severe restatements (0.6%). 
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements
  • Jennifer M Mueller-Phillips
    Do Clients Avoid “Contaminated” Offices? The Economic Con...
    research summary posted January 20, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Do Clients Avoid “Contaminated” Offices? The Economic Consequences of Low-Quality Audits.
    Practical Implications:

    The results of this study are important to audit regulators and auditors as the PCAOB considers disclosure of additional audit quality indicators. The results of this study indicate that clients do respond to publicly available indications of audit quality as they avoid audit firm offices that are associated with restatements. Additionally, auditors may be interested in the findings of this study as it relates to the economic implications of contaminated offices. The findings of this study provide evidence about the importance of local office reputation as client retention and new client additions decrease when offices are associated with audit failures.

    Citation:

    Swanquist, Q.T. and R.L. Whited. 2015. Do Clients Avoid “Contaminated” Offices? The Economic Consequences of Low-Quality Audits. The Accounting Review 90(6): 2537-2570.

    Keywords:
    auditor reputation, audit offices restatements
    Purpose of the Study:

    Audit firms have an incentive to protect their reputational capital in order to maintain and improve their economic circumstances. A client restatement is a common public signal that may negatively impact the audit firm’s reputation for audit quality. Previous research suggests that office-level characteristics in particular contribute to audit quality. Therefore, when restatements occur, the audit firm office involved in the restatement is likely to be “contaminated” and suffer the most from reputational and economic damage. Specifically, the authors:

    • Examine the effect of local office contamination (measured as client restatement announcements) on local office market share.
    • Examine the effect of local office contamination on client retention and client acquisition in the local office.
    • Examine the relationship between contamination and changes in local office market share in the face of differing levels of competition.

    Additionally, the authors use their findings to demonstrate how clients perceive and react to public information related to audit quality which is a recent focus of the PCAOB.

    Design/Method/ Approach:

    The authors proxy for contamination within an office using the number of restatements announced by an office’s clients during the year. They collected office location, audit fees, restatement announcements, and auditor dismissals from several Audit Analytics databases. Client financial reporting data were obtained from Compustat, and the metropolitan statistical area information was obtained from the U.S. Census Bureau’s website. The information collected on these audit offices and related clients was for years 2003-2011.

    Findings:
    • The authors find that contaminated offices lose market share following client restatement announcements. In addition, there are significant economic penalties associated with signals of audit failure.
    • The authors find that the percentage of clients dismissing their auditor increases with office contamination (both for clients that had a restatement and those that did not have a restatement). Similarly, clients selecting a new auditor are less likely to select one from a contaminated office. This suggests that the reduction in market share is a result of the auditor’s impaired ability to both retain and attract clients.
    • The authors find that the negative consequences of contamination are reduced in geographies where there is low competition among auditors and for larger clients.
    • The authors provide some evidence that though Big 4 and non-Big 4 offices are affected by contamination; the impact is diminished for Big 4 offices.
       
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements
  • Jennifer M Mueller-Phillips
    Do Financial Restatements Lead to Auditor Changes?
    research summary posted March 9, 2015 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 12.05 Changes in Reporting Formats in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Do Financial Restatements Lead to Auditor Changes?
    Practical Implications:

    Since the reasons for auditor changes are rarely publicly revealed, the authors acknowledge that this study only shows an association, and not a causal relationship, between restatement announcements and subsequent auditor changes. While the authors attempt to control for all known determinants of auditor changes in the empirical testing, it is possible that the results are biased due to omitted variables.

    For more information on this study, please contact Vivek Mande.

    Citation:

    Mande, V. and M. Son. 2013. Do Financial Restatements Lead to Auditor Changes? Auditing: A Journal of Practical & Theory 32 (2): 119-145. 

    Keywords:
    restatement; auditor switch; dismissal; resignation; abnormal market returns
    Purpose of the Study:

    This study examines whether financial restatements are associated with subsequent auditor changes. A financial restatement represents a breakdown in a company’s financial reporting, but, importantly, also of its audit. The paper argues that in response to pressure from capital markets, restating firms will dismiss their auditors to increase audit quality and restore reputational capital lost when the restatements are announced to the investing public. 

    Design/Method/ Approach:

    The sample includes 3,492 auditor changes. The authors model the likelihood of an auditor change as a function of one-period lagged restatements and a set of predetermined lagged control variables used by previous studies. The research relates auditor changes to restatements in the previous year rather than the current year to rule out the possibility that the restatements may have occurred at the urging of the new auditor.

    The first set of control variables relates to auditor characteristics. It is expected that auditor changes occur more frequently when: audit opinions are not clean, auditor tenure is either short or long, audit fees are high, and the auditor does not have industry expertise. The study also includes controls for clients’ financial risks and mergers and acquisitions (M&A). Year and industry dummies are included as controls in the model.

    Findings:

    Using a large sample of restatements and auditor changes, the study finds that the likelihood of auditor-client realignments increases after firms announce restatements. It is also found that the positive association between restatements and auditor turnovers is more pronounced when restatements are more severe and the quality of corporate governance is high. Finally, the study finds that stock market returns surrounding auditor changes increase as the severity of restatements increases. 

    Category:
    Accountants' Reporting
    Sub-category:
    Changes in Reporting Formats, Changes in Reporting Formats, Restatements
  • Jennifer M Mueller-Phillips
    Does Auditor Explanatory Language in Unqualified Audit...
    research summary posted March 30, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk?
    Practical Implications:

    The results suggest that explanatory language modifications, although less apparent than opinion qualifications, are informative of misstatement risk.  Under the present-day audit reporting requirements, auditors do communicate some risk-related information to financial statement users.  This finding had implications for standard-setters who are currently considering revising the audit reporting model to make future audit reports more informative.  The authors also highlight that auditors use unqualified audit reports to indicate heighted risk, building upon findings from prior research showing that auditors use going concern explanatory language to communicate risk.

    Citation:

    Czerney, K., J. Schmidt, and A. Thompson. 2014. Does auditor explanatory language in unqualified audit reports indicate increased financial misstatement risk? The Accounting Review, 89 (6): 2115–2149.

    Keywords:
    explanatory language; audit opinions; financial misstatements
    Purpose of the Study:

    Investor advocates believe the present-day auditor’s report is boilerplate and uninformative.  However, over 60% of audit opinions in the authors’ sample make use of explanatory language within an unqualified audit opinion to emphasize matters to financial statement users.  According to professional standards, explanatory language should not affect the auditor’s unqualified opinion on the financial statements and theoretically should not be indicative of increased financial statement risk.  But because the Securities and Exchange Commission (SEC) precludes publicly traded companies from releasing financial statements with any audit opinion except unqualified, adding explanatory language is the auditor’s only practical mechanism to communicate risk, and often is the only distinguishing feature among audit reports.  The purpose of this study is to:

    • Determine if financial statements accompanied by unqualified audit reports with explanatory language are more likely to be subsequently restated than those without explanatory language,
    • Investigate whether the likelihood of subsequent restatement differs based on the type of explanatory language, and
    • Examine whether the financial statement accounts referenced in auditor explanatory language are the financial statement accounts subsequently restated.
    Design/Method/ Approach:

    Using data from publicly-traded companies in the United States over the time period from 2000-2009, the authors investigate the association between opinions with explanatory language and the likelihood that the corresponding financial statements are subsequently restated.  The authors then classify audit opinions by the type of explanatory language based on Auditing Standard AU Section 508 into four categories: (1) Inconsistency with previously issued financial statements, (2) ‘‘Emphasis of matters’’ in financial reports, (3) Audit-related information, and (4) Other language to determine if the likelihood of subsequent restatement differs based on the type of explanatory language.  Finally, the authors conduct an additional analysis to examine whether the financial statement accounts referenced in the explanatory language are those most likely to be subsequently restated.

    Findings:

    The authors report the following findings:

    • Financial statements that have audit opinions with explanatory language are more likely to be subsequently restated than those with audit reports without explanatory language, but this association is limited to certain types of explanatory language.
    • Specifically, they find that a subsequent restatement is more likely if the auditor emphasizes inconsistency with previously issued financial statements by referencing changes in accounting principles and previous restatements in the audit report.
    • However, financial statements whose audit reports include other types of inconsistencies, such as references to fresh-start accounting or use of a non-GAAP accounting basis, are less likely to be subsequently restated.
    • The likelihood of subsequent restatement is higher for financial statements with audit reports that include ‘‘emphasis of matter’’ language referencing mergers, related-party transactions, and management’s use of estimates, but only if the restatement relates to the same account referenced in the explanatory language.
    • A subsequent restatement is more likely if the auditor divides responsibility for the opinion, but not for any other type of audit-related explanatory language.
    • The authors do not find an association between subsequent restatements and explanatory language that references supplemental information, going concern, and/or financial distress.
    • The financial statement accounts discussed in the explanatory language correspond to the financial statement accounts subsequently restated.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Restatements