The Effects of Exposure to Practice Risk on Tax Professionals' Judgements and Recommendations*

Tax professionals are responsible for objectively evaluating tax authorities and evidence relevant to their application and for serving as client advocates. We predict that practice risk — that is, exposure to monetary and nonmonetary costs of making inappropriate recommendations — will affect tax professionals' ability to meet these responsibilities by influencing the manner in which they process information about a tax situation as well as their resulting recommendations for clients. We conduct an experiment in which we manipulate practice risk through client characteristics. We also manipulate provision and nature of outcome information. We find that tax professionals process information differently for clients of different risk levels. Specifically, tax professionals weight negative outcome information more heavily when forming likelihood assessments underlying recommendations for a high‐risk client, relative to a low‐risk client. Further, risk directly affects recommendations in that tax professionals more strongly recommend an aggressive position for a low‐risk client. Differential processing of information for clients with identical transactions but different risk levels may protect the tax professional from the higher expected costs of making inappropriate recommendations to high‐risk clients. However, it indicates that tax professionals do not evaluate evidence objectively for all types of clients.     

Discussion of “The Psychology of Billing”

Hansen, Jackson, Schaefer, and Stewart (2018) examine the effects of three contextual features on tax professionals’ billing decisions in a case involving issue‐specific tax research. In this discussion, we present a tax fee model. In contrast to determining a bill, our model views tax fees in a more comprehensive perspective. We subsequently use this model to discuss the design choices and limitations of their study and to provide suggestions for future research.     

Taxpayers' Prepayment Positions and Tax Return Preparation Fees*

Individuals who have their tax returns professionally prepared often overpay estimated income taxes, effectively giving the government an interest‐free loan. To understand why tax professionals may place their clients in positive prepayment positions, we draw on mental accounting theory. Mental accounting theory suggests that by placing taxpayers in positive prepayment positions, tax professionals induce a favorable mental representation of tax return preparation fees, perhaps allowing them to collect larger fractions of billable time and costs incurred on taxpayers' behalves. Thus, we hypothesize that tax return preparation fees are higher for taxpayers in positive prepayment positions than for taxpayers in negative prepayment positions. Regression results using tax return data for 68,736 taxpayers provide strong support for this hypothesis. To more fully understand the general nature of the relationship between taxpayers' prepayment positions and tax return preparation fees, we adapt the prospect theory value function to the tax domain and formulate three additional hypotheses. Consistent with theory, regression results indicate that the relation between taxpayers' prepayment positions and tax return preparation fees is (1) positive, (2) stronger for taxpayers who receive refunds that are less than fees than it is for taxpayers who receive refunds that are greater than fees, and (3) stronger for taxpayers in negative prepayment positions than for taxpayers in positive prepayment positions.     

The Consequences of Audit‐Related Earnings Revisions

In this study, we investigate the consequences that auditors and their clients face when earnings announced in an unaudited earnings release are subsequently revised, presumably as a result of year‐end audit procedures, so that earnings as reported in the 10‐K differ from earnings as previously announced. Specifically, we examine whether the likelihood of an auditor “losing the client” is greater following such revisions, and whether the likelihood of dismissal is influenced by revisions that more negatively impact earnings, that cause the client to miss important earnings benchmarks, by greater local auditor competition, or by auditor characteristics. We also examine audit pricing subsequent to audit‐related earnings revisions for evidence of pricing concessions to retain the client. Finally, we examine whether client executives experience a greater likelihood of turnover following an audit‐related earnings revision. Consistent with expectations, we find that auditor dismissals are more likely following audit‐related earnings revisions. We also find that dismissals are more likely when revisions cause clients to miss important benchmarks and when there is greater local auditor competition. Among nondismissing clients, we find that future audit fees are lower when the effect of the revision on earnings is more negative, consistent with auditors offering price concessions to retain clients when revisions are more displeasing. We also find a greater likelihood of future chief financial officer (CFO) turnover as the effect of the revision worsens. Our findings offer important insights into the consequences that auditors face when balancing their responsibility for high audit quality and client satisfaction, as well as into the consequences that CFOs face when releasing inflated but not fully audited earnings.     

The Influence of Nonaudit Service Revenues and Client Pressure on External Auditors' Decisions to Rely on Internal Audit*

This paper investigates how external auditor provision of significant nonaudit services and client pressure to use the work of internal audit influence external auditors' use of internal auditors' work. More specifically, we study how external audit evidence gathering choices are influenced by nonaudit fees and client pressure. Our research is motivated by an observation that the magnitude of nonaudit services provided to audit clients introduces the risk that client management may leverage its position with the external auditor and potentially affect the audit process. We address this issue by extending prior research and focusing on the importance of various explanatory variables, including nonaudit service revenues, client pressure, internal audit quality, and coordination, to the external auditor's decision to rely on the work of internal audit. We use data primarily obtained through surveys completed by internal and external auditors. The survey responses represent 74 separate audit engagements. Our findings reveal that when significant nonaudit services are not provided to a client, internal audit quality and the level of internal‐external auditor coordination positively affect auditors' internal audit reliance decisions. However, when the auditor provides significant nonaudit services to the client, internal audit quality and the extent of internal ‐ external auditor coordination do not significantly affect auditors' reliance decisions. Furthermore, when significant nonaudit services are provided, client pressure significantly increases the extent of internal audit reliance. Thus, external auditors appear to be more affected by client pressure and less concerned about internal audit quality and coordination when making internal audit reliance decisions at clients for whom significant nonaudit services are also provided.     

The Earnings Quality Information Content of Dividend Policies and Audit Pricing

Recent studies indicate dividends are associated with higher‐quality earnings. Our study extends the literature by examining whether dividends' information is associated with auditors' assessment of their clients' earnings quality. Our results show that auditors charge lower fees to dividend‐paying clients than to nondividend‐paying clients and the average fee discount ranges from 6.0 to 10.6 percent. More importantly, we find dividends have an interactive effect with respect to earnings persistence and earnings manipulation: the negative association between audit fees and earnings persistence is more pronounced for dividend firms; and dividend payouts mitigate the positive relation between earnings manipulation risk and audit fees. Our results imply dividends reduce audit risk by enhancing clients' earnings quality information. We contribute to the literature by showing that auditors reflect the earnings quality information content of firms' dividend policies in their pricing decisions.     

The Effect of Competitive Bidding on Engagement Planning and Pricing*

This paper investigates how clients' choices regarding whether or not to engage in competitive bidding affect a bidding firm's decisions about planned engagement effort and pricing. Specifically, we investigate whether competitive bidding is associated with higher planned engagement effort and lower fees relative to noncompetitive bidding, and whether competitive bidding is associated with increased sensitivity of effort and fees to cost drivers and the components of service production. There is little available evidence regarding the effects of competitive versus noncompetitive bidding in the current market, and none that focuses on both quality and pricing effects associated with competitive bidding across a broad array of clients. We address these issues using data from a sample of one firm's evaluations of prospective clients, made during 1997‐98. During that period, about half of the firm's bids were competitive and half were noncompetitive, providing a unique opportunity to study how the bidding environment affects engagement planning and pricing. Our findings reveal that competitive bidding is associated with higher planned engagement effort and lower fees. In addition, we find that in competitive bidding situations there are stronger associations between cost drivers and planned engagement effort, and between the components of service production and fees.     

Future Nonaudit Service Fees and Audit Quality

Prior to the Sarbanes–Oxley Act of 2002, audit partners experienced economic pressure to grow revenue from the sale of nonaudit services to their audit clients. To an auditor who is highly rewarded for revenue generation and growth, nonaudit services may represent a particularly strengthened economic bond with the client. Prior research shows that, in general, nonaudit service fees received in the current period do not impair audit quality. We examine a different setting. We propose that auditor independence can become impaired, and audit quality compromised, when clients that currently purchase relatively low amounts of nonaudit services, increase their purchases of nonaudit services from the auditor in the subsequent period. We test our prediction in the context of earnings management as a proxy for audit quality, measured by (a) performance‐adjusted discretionary accruals and (b) classification shifting of core expenses. Our results indicate that prior to the Sarbanes‐Oxley Act, rewards to the auditor in the form of future additional nonaudit service fees from current‐year high fee‐growth‐opportunity clients adversely affects audit quality. This effect is particularly strong among companies with powerful incentives to manage earnings. Our findings indicate that regulators should consider the multiperiod nature of the client–auditor relationship when contemplating policies that restrict nonaudit services, as well as the overall environment in which audit partners operate. This might include partner compensation arrangements that put pressure on audit partners to focus on increasing revenue at the expense of audit quality.     

Auditor Independence and Fair Value Accounting: An Examination of Nonaudit Fees and Goodwill Impairments

Inadequate testing of fair value accounting estimates, including goodwill, is often cited as an audit deficiency in PCAOB inspection reports, and, in some cases, these deficiencies have led to enforcement actions against the auditor. As a result of these issues, the PCAOB recently proposed a new auditing standard for fair value accounting. While these regulatory actions suggest that auditors are challenged by the fair value regime of accounting for goodwill, they also highlight an area where the auditor could be influenced by their financial ties to a client. In this study, we test whether nonaudit fees are associated with goodwill impairment decision outcomes. Our results indicate that the nonaudit fees a client pays are inversely related to the likelihood of impairment in settings where goodwill is likely to be impaired. Additional examinations suggest that the negative relation between nonaudit fees and auditor independence is driven by clients who are most incentivized to exert their influence over the auditor.     

Market Structure and Audit Fees: A Local Analysis*

This study conducts a local analysis of the relation between market structure and audit fees. The research question of interest to us is how audit fees are determined by each practicing local office, after taking into account the auditor's own position in a local market and the influence exerted by his or her clients. Appealing to the economic theories of monopoly and monopsony power, we hypothesize a positive audit fee‐concentration relation, and a negative audit fee‐client influence relation. Results indicate that auditor market concentration is positively associated with the non‐Big 6 audit fees but is unrelated to the Big 6 audit fees. Evidence is mixed concerning the client influence hypothesis. When this construct is proxied by the number of rival auditors operating within a geographic area centered on the municipality, the prediction of negative audit fee‐client influence relation is strongly supported for both groups of auditors. Results are much weaker using measures developed based on the relative importance of a municipal client to its auditor's audit portfolio. The issues addressed in this study are important at a time when the Canadian municipal sector is undergoing major changes because of municipal amalgamation, altering the underlying market structure for audit services and the bargaining position of a municipality vis‐Ã‐vis its auditor. More broadly speaking, our analysis implies that when assessing an auditor's report for signs of client pressure, the professional oversight bodies and regulatory authorities need to consider the relative, rather than the absolute, bargaining position of the client in question.     

“金税三期”税收征管对上市公司审计费用的影响

税收征管作为公司外部治理手段,能够作用于公司经营环节,进而影响审计师面临的业务风险和审计风险,由此影响到公司的审计费用。但目前鲜有文献研究税收征管对公司审计费用的影响。本文借助"金税三期"工程这一"准自然实验",以2010—2019年A股上市公司为样本并使用双重差分法,研究发现"金税三期"工程提高了上市公司的审计费用。机制分析表明,"金税三期"工程推高了上市公司实际税率,降低了上市公司的盈利水平,提高了审计师的业务风险,进而提高了审计费用。同时,"金税三期"工程强化涉税信息监管,提高了上市公司会计信息质量,降低了审计师的审计风险,从而降低了审计费用。综合来看前者对审计费用的影响大于后者,导致了上市公司审计费用的提高。进一步分析发现,"金税三期"工程对审计费用的这一影响,在非国有上市公司和由非国际四大会计师事务所审计的上市公司中更为显著。     

Pricing of Initial Audit Engagements by Large and Small Audit Firms*

We investigate the extent to which auditors of U.S. companies reduce fees on initial audit engagements (“fee discounting”). We hypothesize that rivalries among sellers, in terms of client turnover and price competition, are more intense among small audit firms. The data support this hypothesis. New clients account for 34 percent of all clients for small audit firms, but only 9 percent of all clients for large audit firms. We theorize that differences in client turnover rates between large and small audit firms can be explained by the market structure of the audit industry, which consists of an oligopolistic segment dominated by a few large audit firms and an atomistic segment composed of many small audit firms. We further hypothesize and confirm that fee discounting is more extensive in the atomistic sector, and our results confirm this hypothesis. Our analysis of audit fee changes indicates that clients who switch auditors within the atomistic sector receive on average a discount of 24 percent over the prior auditor's fee. However, clients who switch auditors within the oligopolistic sector receive on average a discount of only 4 percent. Given that price competition is known to be less intense in oligopolistic markets than in atomistic markets, we believe that market structure theory can explain why fee discounting is lower when larger audit firms compete for clients.     

Auditor Fees and Fraud Firms

The issue of whether auditor fees affect auditor independence has been extensively debated by regulators, investors, investment professionals, auditors, and researchers. The revised Securities and Exchange Commission (SEC) requirements that resulted from the implementation of the Sarbanes‐Oxley Act (2002) limit nonaudit services (NAS) and mandate NAS fee disclosure. The SEC's requirements are based on the argument that auditor independence could be impaired—and hence audit quality may be reduced—when auditors become economically dependent on their clients or audit their own work. Economic bonding leads to reduced independence, which can lead to reduced audit quality. We study a sample of firms sanctioned by the SEC for fraudulent financial reporting in Accounting and Auditing Enforcement Releases (SEC‐sanctioned fraud firms) and examine whether there is a relationship between auditor fee variables and the likelihood of being sanctioned by the SEC for fraud. We use SEC sanction as a measure of audit quality that has not previously been used in the auditor fee literature and is more precise than some of the other proxies used for flawed financial/auditor reporting. We find, in univariate tests, that fraud firms paid significantly higher (total, audit, and NAS) fees. However, in multivariate tests, when controlling for other fraud determinants and endogeneity among the fraud, NAS, and audit fee variables, we find that while NAS fees and total fees are positively and significantly related to the likelihood of being sanctioned by the SEC for fraud, audit fees are not. These findings suggest that higher NAS fees may cause economic bonding, thereby leading to reduced audit quality. Our findings of significantly higher NAS fees and total fees in fraud firms hold after controlling for latent size effects and other rigorous testing. These results contribute to the literature that examines the SEC's concerns regarding NAS and can be used by policy makers for additional consideration.     

Auditors' Fee Premiums and Low‐Quality Internal Controls*

We examine the relation between low‐quality internal controls and audit fee premiums. Using a novel data set of audit hours and audit fees we find, consistent with the audit risk model, that auditors increase their effort (hours) owing to low internal control quality. We find that auditors also charge a significant fee premium to clients with internal control weaknesses. This premium is observed for severe internal control weaknesses and companies with low‐quality alternative governance mechanisms. The results are robust to multiple methods to address endogeneity, including company fixed effects, difference‐in‐differences design, and a propensity score‐matched sample. Taken as a whole, low internal control quality leads to fee premiums, which are a deadweight loss to client companies.     

Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions

This study examines the persistence and economic consequences of variations in reporting style across audit partners in individual engagements. Our results show that both aggressive and conservative audit reporting, measured by the pattern of prior Type 2 and Type 1 audit reporting error rates in auditor‐specific clienteles, persist over time and extend to other clients of the same partner. Analyses of abnormal accruals and persistence of client firms’ accrual estimates corroborate this finding, and hold both for private and publicly listed companies. Further, our results also show that the market penalizes client firms susceptible to aggressive audit partner reporting decisions. In particular, we find that our proxies for aggressive audit reporting are related to higher interest rates, worse credit ratings and less favorable forecasts of insolvency for private client companies, and a lower Tobin's Q for publicly listed client companies. Collectively, these results imply that audit partner aggressive or conservative reporting is a systematic audit partner attribute and not randomly distributed across engagements.     

Learning by Doing and Audit Quality*

In this study, we present a nonstrategic, dynamic Bayesian model in which auditors' learning on the job and their choice of professional services jointly affect audit quality. While performing audits over time, auditors accumulate client‐specific knowledge so that their posterior beliefs about clients are updated and become more precise (that is, precision is our surrogate for audit quality) — what we call the learning effect. In addition, auditors can enrich their knowledge accumulation by performing nonaudit services (NAS) that, in fact, may influence clients' managerial decisions — what we call the business advisory effect. This advisory effect permits auditors to anticipate and to learn about changes in clients' business models, which in turn improves their advisory capacity. These dual “learning” and “advisory” effects are interdependent and mutually reinforcing. The advisory effect of NAS may increase or reduce auditors' engagement risk. We show that large professional fees can induce auditors to provide NAS that increase engagement risk and diminish audit quality. However, when NAS reduce engagement risk and increase audit quality, auditors may provide NAS without charging clients. The feature that distinguishes our study — the interdependence between the learning and advisory effects — provides new insight into the trade‐off between audit fees and audit quality. Consequently, our analysis helps explain why the scope of the audit has evolved over time and why the boundaries between audit and NAS are constantly shifting. A recent example of such a shift is that the Sarbanes‐Oxley Act adds control attestation to audits for public companies traded in U.S. markets.     

Evidence of Industry Scale Effects on Audit Hours,Billing Rates,and Pricing

Using a proprietary data set consisting of all private firm audit engagements in 2000 from one Big 4 firm in Belgium, we investigate (i) whether audit office industry scale is associated with a reduction of total, partner, and staff audit hours and thus with efficiency gains triggered by organizational learning from servicing more clients in an industry and (ii) whether the extent of efficiency pass‐on from the auditor to its clients depends on the audit firm's market power. We find that auditor office industry scale is associated with efficiency gains and a reduction of the variable costs (i.e., fewer total audit hours, partner hours, and staff hours), ceteris paribus. Our results also suggest that, on average, realized efficiencies are entirely passed on, as evidenced by a nonsignificant effect of auditor industry scale on the auditor's billing rate. Furthermore, we find that the extent of the efficiency pass‐on decreases with the market power of the audit firm in the industry market segment as we document a higher billing rate for auditors with high market power (versus low market power). In addition, we find that the lower audit hours associated with auditor industry scale do not compromise audit quality.     

The Relative Effectiveness of Simultaneous versus Sequential Negotiation Strategies in Auditor‐Client Negotiations

Since most audit engagements identify multiple proposed audit adjustments, auditors must decide how best to present and negotiate these adjustments with their clients. Prior research indicates that auditors can negotiate adjustments individually (a sequential strategy) or can negotiate multiple adjustments within the same negotiation setting (a simultaneous strategy). This paper examines the relative effectiveness of a simultaneous versus sequential negotiation strategy in eliciting concessions from clients and engendering greater client satisfaction. Participants negotiated audit adjustments with a simulated auditor who employed one of the two negotiation strategies. We find evidence that a simultaneous strategy elicits significantly greater total concessions from client managers and also generates more positive attitudes toward the auditor. We also manipulate the magnitude of the issues negotiated and find that significantly greater concessions are offered when larger issues are presented first. These findings have important implications for auditors, as they suggest that negotiating issues simultaneously and presenting larger issues first can result in significantly improved negotiation outcomes.     

Audit Office Reputation Shocks from Gains and Losses of Major Industry Clients

Our study reports evidence on the dynamic effects of client switches on auditor reputations and fee premia. Offices of large accounting firms that lose (gain) major industry clients experience a reputation shock leading to more same‐industry client losses (gains) over the next two years. There is also a shift in audit fees charged to other same‐industry clients when a major client loss (gain) results in an audit office losing (gaining) city‐level industry leadership. A major client loss or gain also creates a short‐term capacity shock to an audit office's ability to supply high‐quality audits. However, there is no evidence of reputation spillovers to other‐industry clients in the audit office, or to clients in other offices of the accounting firm.     

Do Mutual Fund Investors Care About Auditor Quality?

We study the influence of perceived auditor quality on investment decisions by bond mutual fund investors. Audits of bond mutual funds require significant auditor expertise. Fund managers estimate daily the fair market values of holdings that are often opaque and illiquid. Managers can use their discretion to manipulate their fund's performance results. While it is known that investment flows into funds that report good past performance, little evidence exists about whether investors' confidence in the reliability of fund financial reports is influenced by auditor quality. Using hand‐collected data from SEC filings, we find that the positive association between reported performance and investment flows is stronger for funds with auditors who are industry specialists and are longer‐tenured, as well as for funds that pay higher audit fees. We do not find that auditor office size strengthens the association. We also find that the presence of industry‐specialist auditors, long‐tenured auditors, and higher audit fees lead to additional disclosure in the form of emphasis‐of‐matter. This study contributes to the streams of research investigating perceived audit quality, fund investment decisions, and auditing for financial services.