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  • 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
    Chief Audit Executives’ Evaluations of Whistle-Blowing A...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 12.0 Accountants’ Reports and Reporting, 12.04 Investigations, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Chief Audit Executives’ Evaluations of Whistle-Blowing Allegations
    Practical Implications:

    The findings of this study should be of interest to boards of directors, audit committees, and senior management who are accountable to investors and other parties for the timely and unbiased examination of whistle-blowing allegations. Prior research has shown that audit committee members can be biased in their evaluations of whistle-blower allegations and in the allocation of resources to investigate those allegations. However, the results of this study show that CAEs do not exhibit the same bias as audit committee members for allocating resources to investigate whistle-blower allegations. The audit committee often relies on the CAE to investigate whistle-blowing reports, and this study suggests that CAEs may be a better choice for managing the evaluation of whistle-blowing allegations relative to members of the audit committee. CAEs’ decisions are not shrouded in secrecy, and CAEs report to both management and the audit committee, creating multiple levels of accountability. They are less able to ignore allegations that pose personal threats than are directors.

    Citation:

    Guthrie, C. P., C. S. Norman, and J. M. Rose. 2012. Chief Audit Executives’ Evaluations of Whistle-Blowing Allegations. Behavioral Research in Accounting 24(2): 87-99.

    Keywords:
    Chief audit executive; internal controls; whistle-blowing.
    Purpose of the Study:

    Section 301(4) of the Sarbanes-Oxley Act of 2002 (SOX) requires that public companies establish procedures for receiving and reviewing complaints regarding accounting and controls, and SOX requires firms to establish a confidential and anonymous channel for reporting such complaints. Prior research has shown that audit committee members evaluate anonymous whistle-blower allegations as less credible than non-anonymous allegations. Additionally, prior research has shown that when whistle-blowing allegations threaten the reputations of corporate directors, the directors justify decisions to limit the investigation of allegations by ascribing low levels of credibility to the allegation. Therefore, the purpose of this study was to evaluate how Chief Audit Executives (CAE) evaluate whistle-blowing allegations and whether CAEs are subject to the same judgment biases that audit committee members exhibit. The authors studied CAE credibility assessments of:

    • Anonymous vs. non-anonymous whistle-blower allegations.
    • Whistle-blower allegations that threaten the reputations of the CAE.

    The authors also evaluated the amount of resources that CAEs planned to allocate to investigate these whistle-blower allegation reports.
     

    Design/Method/ Approach:

    The authors conducted an experiment that took place sometime before March 2012 with CAEs and deputy CAEs from both public and private companies. The participants had an average of 12.76 years of internal audit experience. About 60 percent of the participants were CPAs and about 50 percent of the participants were CIAs. The participants read a case in which they were informed of a whistle-blower allegation that management of the organization had committed fraud, and the participants then assessed the credibility of the allegation and allocated resources to investigate the claim. 

    Findings:
    • The CAEs ascribed a lower level of credibility to anonymous whistle-blowing reports relative to non-anonymous reports.
    • When the allegations threatened their reputations (meaning that the whistle-blowing reports suggested the wrongdoing was perpetrated by the exploitation of weaknesses in previously evaluated internal controls rather than by the circumvention of internal controls) CAEs further lowered their assessed credibility of the allegations.
    • CAE perceptions of lower credibility for allegations that threatened their reputations did not lead the CAEs to make smaller allocations of resources to investigating these allegations. In fact, the CAEs allocated more resources to allegations for which they would be held more responsible.
       
    Category:
    Accountants' Reporting, Governance, Standard Setting
    Sub-category:
    Impact of SOX, Internal auditor role and involvement in controls and reporting, Investigations
  • Jennifer M Mueller-Phillips
    Cumulative Prospect Theory and Managerial Incentives for...
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 12.0 Accountants’ Reports and Reporting, 12.04 Investigations in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Cumulative Prospect Theory and Managerial Incentives for Fraudulent Financial Reporting.
    Practical Implications:

    The study extends the fraudulent financial reporting literature by formulating fraud incidence as a function of performance outcomes using peer performance as a reference point. By testing CPT's individual-level behavioral implications on firm-level archival data, the study re-conceptualizes the investigation of fraudulent financial reporting in terms of risk attitude and extends prior investigations of CPT from laboratory experiments to a real-world setting of fraudulent financial reporting.

    Citation:

    Fung, M. K. 2015. Cumulative Prospect Theory and Managerial Incentives for Fraudulent Financial Reporting. Contemporary Accounting Research, 32 (1): 55-75.

    Keywords:
    fraud, probability theory, reporting, restatements
    Purpose of the Study:

    Risk-taking is fundamental to the survival and development of a firm. Nevertheless, some managerial risk-taking behaviors, like fraudulent financial reporting with an intention to deceive or mislead investors, are potentially disastrous to firm value. Fraudulent reporting of financial results is a risky way to improve the firm’s financial appearance, and thus the incidence of fraudulent reporting is expected to be associated with the manager’s propensity to take risks. In the current study, reference gains and losses (i.e., performance outcomes) are respectively defined as positive and negative deviations of the firm’s actual accounting-based performance from a reference point. The reference point is defined as the mean performance of industry peers. The study extends the cumulative prospect theory, CPT, fourfold pattern of managerial incentives to fraudulent financial reporting, hypothesizing that a manager is more likely to engage in fraudulent financial reporting over low-probability reference gains or high-probability reference losses, and is less likely to do so over high-probability reference gains or low-probability reference losses. The intuition is that a manager is more likely to be risk-seeking when he is faced with a high (low) probability of underperforming (outperforming) the rivals, and is more likely to be risk-averse if he is faced with a high (low) probability of outperforming (underperforming) the rivals.

    Design/Method/ Approach:

    To compile the misstatement sample, a list of firms that have restated their financial statements during the period of 19972005 for accounting irregularities was taken from the U.S. Government Accountability Office (GAO), which were then matched with the COMPUSTAT database. The sample contains 12- misstating firms and 152 misstated firm-years. The outcomes are framed as gains and losses relative to a reference point, defined as the mean performance of industry peers.

    Findings:
    • The findings show that fraud incidence is positively related to the probability of a loss; more sensitive to the probability of a loss; and more sensitive to an extra unit of the probability at a high- or low- probability level (i.e., nonlinear probability weighting function.
    • The findings also show that fraud incidence is negatively related to the probability of a gain; less sensitive to the probability of a gain; and less sensitive to an extra until of the probability at a medium- probability level.
    • The study empirically substantiates the fourfold incentive pattern characterized by loss aversion and shows that fraud incentives are nonlinear in the probabilities of performance outcomes due to CPT’s nonlinear probability weighting function.
    • Imperfect information faced by managers about competitors’ performance is a possible concern arising from framing performance outcomes relative to peer performance.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Management Integrity, Restatements
  • Jennifer M Mueller-Phillips
    SEC Division of Corporation Finance Monitoring and CEO...
    research summary posted September 21, 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, 12.04 Investigations in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    SEC Division of Corporation Finance Monitoring and CEO Power.
    Practical Implications:

    This research is important for several reasons. First, the authors provide insight into how a monitoring mechanism, such as the staff of the DCF, adds to the oversight of the financial reporting process. The findings illuminate the importance of understanding the conflict between boards and CEOs by suggesting that a strong CEO's influence over a board may adversely affect the effectiveness of board oversight. The authors provide evidence that the DCF may target companies with strong CEOs and weak board monitoring for more intensive review. Second, the results imply that the discovery of the need to restate is different for DCF-instigated restatements. DCF-prompted restatements lead companies to re-evaluate their governance structure.

    Citation:

    Cheng, X., L. Gao, J. E. Lawrence, and D. B. Smith. 2014. SEC Division of Corporation Finance Monitoring and CEO Power. Auditing: A Journal of Practice & Theory 33 (1): 29-56.

    Keywords:
    CEO, DCF, governance, monitoring, investigations, restatements
    Purpose of the Study:

    Section 408 requires the Securities and Exchange Commission (SEC) to review the filings of all SEC registrants every three years. The SEC Division of Corporation Finance (and not the Division of Enforcement) is the part of the SEC charged with carrying most of the burden of the Section 408 monitoring. This study investigates this SEC monitoring role and differs from past SEC research by focusing on the SEC Division of Corporation Finance (DCF) rather than the Division of Enforcement and specifically on DCF's "review and comment" monitoring role.

    The authors argue that the DCF appears to realize powerful CEOs have more opportunity to deceive due to their greater board control and, therefore, they are viewed as experiencing less monitoring by other sources. In other words, the DCF appears to be naturally drawn to the firms where strong CEOs dominate the financial reporting process and firm-level monitoring by auditors and boards may be relatively lax.

    Design/Method/ Approach:

    The sample of 980 observations includes restatements from 2000 through 2007 obtained from GAO reports and Audit Analytics. The authors restrict the companies to those found in a Russell index. 209 observations were DCF prompted and 771 observations were other monitor prompted. Of the 980 observations, 825 were used in the analysis of the changes in CEO power as a response to restatement.

    Findings:
    • The authors find evidence that a powerful CEO may be able to bargain for less board scrutiny through fewer board meetings.
    • In the year prior to the discovery of the need to restate, firms with restatements prompted by the DCF have stronger CEO power and exhibit some evidence of weaker board monitoring.
    • Compared to firms with restatements prompted by other monitors, firms with restatements prompted by the DCF tend to have strong CEOs in the period prior to the discovery of restatements.
    • The authors find that companies with restatements prompted by DCF (versus other monitors) are more likely to terminate strong CEOs following the discovery of restatements.
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Impact of SEC Actions, Investigations, Restatements
  • Jennifer M Mueller-Phillips
    When the PCAOB Talks, Who Listens? Evidence from Stakeholder...
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 11.0 Audit Quality and Quality Control, 11.10 Impact of Quality Reviewers, 11.11 Impact of Firm and External Inspection Programs, 12.0 Accountants’ Reports and Reporting, 12.04 Investigations in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    When the PCAOB Talks, Who Listens? Evidence from Stakeholder Reaction to GAAP-Deficient PCAOB Inspection Reports of Small Auditors.
    Practical Implications:

    The authors provide initial empirical evidence that Securities and Exchange Commission (SEC) registrants found GAAP-deficient PCAOB inspection reports to be a useful signal of audit quality for triennially inspected auditors. This evidence indicates that PCAOB inspection reports created heterogeneity in auditor brand name that did not previously exist. Also, this paper is the first to empirically link audit committee characteristics to PCAOB inspection report severity and auditor choice. The authors believe this is an increasingly relevant finding as audit committees have been granted much greater auditor dismissal and hiring authority due to SOX. This study indicates that a PCAOB inspection report may serve as an audit quality signal for auditors of broker-dealers, who were previously exempt from the inspection process. Such a finding has current relevance given the PCAOB has recently sought to expand the inspection program to foreign auditors, such as those based in China whose clients are cross-listed on U.S. security exchanges or are listed due to a reverse merger.

    Citation:

    Abbott, L. J., K. A. Gunny, and T. C. Zhang. 2013. When the PCAOB Talks, Who Listens? Evidence from Stakeholder Reaction to GAAP-Deficient PCAOB Inspection Reports of Small Auditors. Auditing: A Journal of Practice & Theory 32 (2): 1-31.

    Keywords:
    audit quality signals, PCAOB inspection process
    Purpose of the Study:

    The PCAOB is a private regulatory agency, independent of the accounting industry. Congress bestowed upon the PCAOB the ability to inspect the work of all accounting firms that audit publicly traded companies. Inspections are conducted annually for Big 4 and national auditors with greater than 100 publicly held registrants (annually inspected auditors). The inspection process is conducted every three years for auditors with fewer than 100 publicly held clients (triennially inspected auditors). The authors classify inspection reports into three categories according to severity. In a clean report, the PCAOB finds no audit deficiencies. In a GAAS-deficient report, the PCAOB notes that the financial statements audited by the auditor are free of material error, but that the audit process did not fully follow GAAS-recommended audit procedures. In a GAAP-deficient report, the PCAOB states that the auditor “failed to identify a material departure from GAAP” or that the audited company “restated certain of its financial statements to make changes relating to” matters/audit deficiencies uncovered by the PCAOB inspection.

    The current study examines the PCAOB in the context of whether GAAP-deficient PCAOB inspection reports of triennially inspected auditors are enough of a deleterious audit-quality signal to prompt dismissals of these auditors. This study then identifies the successor triennially inspected auditor and uses the three-tiered categorization scheme to denote an increase in auditor quality. Specifically, the authors create a dichotomous dismissal-based dependent variable coded “1” in cases where the dismissal results in a higher-quality triennially inspected successor auditor, and “0” otherwise.

    Design/Method/ Approach:

    The authors obtain all inspection reports from the PCAOB website from January 21, 2005 to December 31, 2007. A total of 521 triennially inspected nonforeign accounting firm PCAOB inspection reports were filed, of which 256 (49.1 percent) were clean, and 61 (11.7 percent) were GAAP-deficient. The 54 GAAP-deficient, triennially inspected auditors are included in the sample. The 54 GAAP-deficient auditors report 525 publicly held clients per their PCAOB inspection reports.

    Findings:
    • The authors find that GAAP-deficient, triennially inspected auditors are more likely to be dismissed by their clients and are overwhelmingly replaced by a triennially inspected successor that has not received a GAAP-deficient inspection report.
    • They also document that the dismissal rate for the clean PCAOB inspection report sample is 17.9 percent, while the dismissal rate for the GAAP-deficient sample is a significantly higher 44.3 percent.
    • The authors find that greater agency conflicts, the presence of an independent and expert audit committee, and blockholdings magnify the likelihood of dismissing a GAAP-deficient, triennially inspected auditor in favor of a triennially inspected auditor that is not GAAP-deficient.
    • Interestingly, the authors find that opinion shopping or fee shopping does not differentially impact the likelihood of dismissing a GAAP-deficient, triennially inspected auditor in favor of a triennially inspected auditor that is not GAAP-deficient.
    • The authors link the use of PCAOB inspection reports to an agency-based demand for audit quality signals.
    Category:
    Accountants' Reporting, Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of Firm & External Inspection Programs, Impact of PCAOB, Impact of Quality Reviewers, Investigations