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.

 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.

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. 

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.  

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. 

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The heightened epistemic motivation induced by principles-based accounting standards then ultimately increases auditors’ demands for audit evidence. Thus, the results suggest the important influence of accounting standards on auditors’ motivations and consequent program planning decisions. The findings provide valuable information to regulators in their evaluation of how or whether to move forward with potential IFRS adoption or convergence of U.S. GAAP with IFRS. In a principles environment, audit firms must take measures to guard against this potential bias, e.g., review of proposed audit programs and results of tests.

Peytcheva, M., Wright, A. M., & Majoor, B. 2014. The Impact of Principles-Based versus Rules-Based Accounting Standards on Auditors' Motivations and Evidence Demands. Behavioral Research In Accounting 26 (2): 51-72.

There has been considerable discussion about the effects of principles-based versus rules-based accounting standards on financial reporting quality, particularly given the debate concerning the adoption of, or convergence with, International Financial Reporting Standards (IFRS) in the United States. Auditing research has investigated the effects of different accounting standards on auditors’ decisions to constrain aggressive reporting by clients. Missing from this literature is evidence on how the type of accounting standard influences auditors’ cognitive motivations and demand for audit evidence. This study addresses this gap in the literature, which is important since the financial statements are the joint product of management’s and the auditor’s actions.

This is the first study to examine the effects of the type of accounting standard on auditors’ cognitive motivations and information search patterns.  The authors address an important, and missing, piece of the puzzle: are there fundamental differences in the psychological processes employed by auditors who face principles versus rules accounting guidance? If there are differences, are auditors’ motivations under principles-based accounting standards driven by simple self-interest as opposed to a desire to understand the economic substance of the transaction at hand?

The theoretical model is tested using an experiment with 104 auditors from the U.S. and 48 auditors from The Netherlands. The experiment manipulates the type of accounting standard between participants at two levels: rules-based or principles-based. The evidence was gathered prior to January 2014.

Findings from this experiment suggest that principles-based versus rules-based standards lead to significant differences in the judgment processes of professional auditors. In turn, greater process accountability induces higher epistemic motivation in auditors—a desire to obtain a rich and thorough understanding of the problem at hand. High levels of epistemic motivation stimulated by principles-based accounting standards then induce a greater demand for both total desired evidence and diagnostic audit evidence. These findings suggest that, while bright-line rules and thresholds can limit cognitive effort, accounting standards based on broad principles are likely to evoke systematic and thorough information processing, thereby leading auditors to strive for a rich and accurate understanding of the issues under consideration.

The results also indicate that, although auditors exposed to IFRS over a prolonged period (e.g., Dutch auditors) may experience lower process accountability and epistemic motivation when working with principles-based standards than U.S. auditors, principles-based accounting standards still induce greater epistemic motivation than rules-based accounting standards in these auditors, suggesting a greater desire to obtain a rich understanding of the matter at hand.

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This study should be of interest to regulators and policy makers. IFRS adoption influences audit complexity and financial reporting quality, which have countervailing effects on audit fees. On the one hand, IFRS are generally believed to be superior to local accounting standards; hence the adoption of IFRS potentially improves financial reporting quality. This reduces audit risk and thus audit fees. On the other hand, IFRS are comprehensive, fair-value oriented, and principles-based. Using them generally requires accountants and auditors to make more complex estimates and use greater professional judgment. In other words, IFRS adoption increases the complexity of audits, which can increase audit fees. Our results suggest that, on average, the effect of audit complexity dominates the effect of improvement in financial reporting quality, leading to an overall increase in audit fees in the post-IFRS period. Moreover, our cross-country analysis sheds light on how the institutional features of different countries, including legal environments and characteristics of pre-IFRS domestic accounting standards, affect the audit fee increase associated with IFRS adoption.

For more information on this study, please contact Xiaohong Liu.

Kim, J.-B., X. Liu, and L. Zheng. 2012. The impact of mandatory IFRS adoption on audit fees: Theory and evidence. The Accounting Review 87 (6): 2061-2094.

This study examines the impact of International Financial Reporting Standards (IFRS) adoption on audit fees. Over 100 countries now require or permit IFRS reporting for domestically listed companies. Recent academic research mainly focuses on the economic benefits of adopting IFRS. Very few studies directly examine the costs associated with IFRS adoption. A survey conducted by the Institute of Chartered Accountants in England and Wales revealed that EU companies ranked increases in audit fees as one of their largest IFRS-related costs. This study aims to provide systematic evidence on the cost side of mandatory IFRS adoption, with a focus on audit fees. Specifically, we examine changes in external audit fees from 2004 to 2008 to determine whether the EU decision to mandate IFRS increased the fees paid to auditors. In addition, we investigate how the institutional features of different countries affect the audit fee increase associated with IFRS adoption. These institutional factors include (i) the increase in audit complexity arising from IFRS adoption, (ii) the change in financial reporting quality brought about by IFRS adoption, and (iii) the strength of a country’s legal regime. The findings of this study provide insights into the channels through which IFRS adoption impacts audit fees.

We examine audit fee changes from the pre-IFRS adoption period to the post-IFRS adoption period during 2004–2008. We employ a difference-in-difference design to control for the general trend or changes in the economic environment unrelated to IFRS adoption. Specifically, we use IFRS adopter firms from EU countries as the treatment sample and the non-adopter firms from non-EU OECD (Organization for Economic Co-operation and Development) countries as the control sample.

• IFRS adoption causes an increase in audit fees. The audit fee increase is on average 5.44 percent greater for the adopter firms, compared with that for the non-adopter firms in our control sample.
• The IFRS-related audit fee increase is positively related to the increase in audit complexity brought about by IFRS adoption.
• The IFRS-related audit fee increase is negatively related to the improvement in financial reporting quality brought about by IFRS adoption.
• The IFRS-related audit fee increase is negatively related to the strength of a country’s legal regime. 

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The results of this study have important implications for the debate on the globalization of accounting standards and for regulators that are considering a transition towards IFRS. Although the effects of IFRS adoption are not homogenous for all firms, the adoption of one set of accounting standards is likely to generate both information and comparability effects and improve the quality of information intermediation in capital markets.

For more information on this study, please contact Joanne Horton.
 

Horton, J., G. Serafeim, and I. Serafeim. 2013. Does Mandatory IFRS Adoption Improve the Information Environment? Contemporary Accounting Research 30 (1).

With over 120 countries requiring or permitting the use of IFRS by publicly listed companies, the idea of pushing for mandatory IFRS adoption has become a popular topic. Mandatory IFRS adoption has the potential to improve worldwide financial reporting quality and contribute to better functioning capital markets. Potential benefits includes facilitating cross-border comparability, increase reporting transparency, decreasing information costs, and improving the efficiency of the markets. The idea relies on the presumption that mandatory IFRS adoption provides superior information to market participants and/or increased accounting comparability compared to previous accounting regimes. This study examines whether such a global transition towards a single set of accounting standards has been met by these presumed benefits. Based on prior research the authors derived these three hypotheses to test:

1.    Mandatory IFRS adoption provides comparability benefits and as a result affects analyst earnings forecast accuracy for firms adopting IFRS mandatorily.
2.    Mandatory IFRS adoption provides information quality benefits and as a result affects analyst earnings forecast accuracy for firms adopting IFRS mandatorily.
3.    The increase in forecast accuracy following mandatory IFRS is associated with increased opportunities for firms to manage earnings towards a target.
 

To test the three hypotheses above, the authors first needed to verify that adoption of IFRS improves the information environment for the firms in the sample. Specifically, the authors tested for difference in forecast errors before and after mandatory IFRS compliance for nonadaptors, mandatory adaptors, and voluntary adaptors. To test for the effect of IFRS adoption, several models were developed to analyze firm data and forecasting information. Other analysis is conducted to determine whether improvements in information environment could be driven by factors outside of IFRS adoption.   

• The information environment improves for mandatory adopters.
• The larger the difference between IFRS earnings and local GAAP earnings the larger is the improvement in the information environment.
• Forecast accuracy improves more for analyst-firm pairs that are affected by either information or comparability benefits.
• There is no evidence suggesting that the increase in forecast accuracy is driven by earnings manipulation.
   

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The results of this study are important for audit firms to prepare for the adoption of IFRS and/or less precise standards under U.S. GAAP. The results indicate that a move to less precise standards will not necessarily result in more verdicts against auditors. There is only one condition in which an imprecise standard leads juries to return more verdicts against the auditor: when the client’s reporting complies with the precise standard and is inconsistent with the industry reporting norm. The results suggest that auditors can reduce this liability by ensuring that their client’s reporting is consistent with industry reporting norm.

For more information on this study, please contact Kathryn Kadous.
 

Kadous, K., and M. Mercer. 2012. Can Reporting Norms Create a Safe Harbor? Jury Verdicts against Auditors under Precise and Imprecise Accounting Standards. The Accounting Review 87 (2):565-587.

The transition from U.S. GAAP to International Financial Reporting Standards (IFRS) has been a topic of debate among regulatory bodies, standard-setters, firms, and their auditors. IFRS tend to provide less precise guidance than current U.S. accounting standards, so their application requires more professional judgment. Auditors have expressed concern that the adoption of IFRS will result in increased legal liability. This paper addresses this concern by investigating how the level of precision in accounting standards affects jury verdicts in auditor negligence lawsuits. Based on legal studies and the psychology literature, this paper studies how the effect of accounting standard precision on jury verdicts depends on two factors:

• The aggressiveness of the audit client’s reporting choice
• Whether the audit client’s reporting choice is consistent with the industry reporting norm
   

The authors collected their evidence prior to September 2010.  They use a group of undergraduate students to act as jurors in a simulated auditor negligence case. The participants deliberate in juries of six persons. Each jury is asked to assess the auditor’s conduct and to provide a verdict.  

• The authors find that effect of accounting standard precision on jury verdicts depends on both the aggressiveness of the client’s reporting choice and on the industry reporting norm. Jurors use a hierarchy of decision rules. When the accounting standard does not provide a clear decision criterion, jurors seek other decision rules such as whether the client’s accounting is consistent with the industry reporting norm. 
• The authors find that when the client’s accounting is more aggressive and violates the precise standard, a majority of juries return verdicts against the auditor, regardless of whether the industry reporting norm is met. When the client’s reporting is less aggressive and does not violate the precise standard, juries rarely return verdicts against the auditor, regardless of whether the reporting is consistent with the industry reporting norm. 
• The authors find that when the accounting standard is imprecise, compliance with the industry reporting norm is a stronger predictor of jury verdicts. In particular, under the imprecise standard, no juries find against the auditor for allowing the more aggressive client reporting when the reporting is consistent with the industry reporting norm; when the reporting norm is violated, about half of the juries find the auditor negligent.
   

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