Accounting Accruals and Auditor Reporting Conservatism*

Accounting accruals are managers' subjective estimates of future outcomes and cannot, by definition, be objectively verified by auditors prior to occurrence. This causes audits of high-accrual firms to pose more uncertainty than audits of low-accrual firms because of potential estimation error and a greater chance that high-accrual firms have undetected asset realization and/or going concern problems that are related to the high level of accruals. One way that auditors can compensate for this risk exposure is to lower their threshold for issuing modified audit reports, an action that will increase modified reports and, therefore, lessen the likelihood of failing to issue a modified report when appropriate. We call this auditor reporting conservatism and test if high-accrual firms in the United States, are more likely to receive modified audit reports for asset realization uncertainties and going concern problems. Empirical results for a large sample of U.S. publicly listed companies support the hypothesis that auditors are more conservative, that is, more likely to issue both types of modified audit reports for high-accrual firms. Further analyses show that income-increasing accruals are somewhat more likely to result in reporting conservatism than income-decreasing accruals, and that only the Big Six group of auditors show evidence of reporting conservatism. These findings add to our understanding of the audit report formation process and the potentially important role played by accounting accruals in that process.     

A Bargaining Model of Auditor Reporting*

In this paper, I demonstrate that the quasi-rents earned in audits undermine an auditor's independence By considering the incentives of the auditor and the client and the interaction between them, I conclude that auditor will maintain his or her independence if the firm-specific quasi-rents are zero, but compromise his or her independence if the quasi-rents are positive. The extent of the compromise is an increasing function of the quasi-rents, since the auditor will propose that a higher value be reported in the financial statements when the quasi-rents increase. I also show that disputes between the auditor and the client increase as the scope for errors for an auditor's test increases. When the error scope is large, the client becomes more aggressive in preparing a proposal while the auditor becomes more cautious.     

The Association Between Auditor Changes and Reporting Lags*

Abstract. This paper examines audit report lags and earnings announcement lags for a sample of firms that switched auditors. We investigate whether audit report and earnings announcement lags are associated with the timing of auditor changes in relation to firms' fiscal year-ends. It is hypothesized that firms which replace their auditor early (late) in the fiscal year do so for positive (negative) reasons and experience shorter (longer) reporting lags. Conflicts over reporting issues can be difficult to resolve and consequently lead to reporting delays. In other cases, clients may be more concerned about adhering to customary reporting practices or improving reporting timeliness. These are likely to be considerations in auditor realignment decisions and are predictably reflected in the timing of the auditor change. Résumé. Les auteurs s'intéressent aux décalages dans la production des rapports des vérificateurs et dans la publication des bénéfices, pour un échantillon d'entreprises ayant changé de vérificateurs. Ils se demandent si ces décalages sont reliés au choix du moment du changement de vérificateurs par rapport à la date de clôture de l'exercice. Selon leur hypothèse, les entreprises qui remplacent leurs vérificateurs tôt (tard) dans l'exercice le font pour des raisons positives (négatives), et les décalages enregistrés dans la production de l'information sont plus courts (plus longs). Les conflits touchant les questions relatives à l'information à fournir peuvent être difficiles à résoudre et, en conséquence, conduire à des retards dans la publication de l'information. Dans d'autres cas, les entreprises clientes peuvent être davantage préoccupées par le respect des méthodes coutumières de présentation de l'information ou par l'accélération de la publication de l'information. Ces facteurs sont susceptibles d'entrer en ligne de compte dans les décisions de réorientation des vérificateurs, et il est à prévoir qu'ils se refléteront dans le choix du moment du changement de vérificateurs.     

The Political Influence of Voters’ Interests on SEC Enforcement

I examine whether political influence as a response to voters’ interest in employment levels is reflected in the enforcement actions of the SEC. I find that large employers are less likely to experience SEC enforcement actions. Next, I examine whether variations in politicians’ sensitivity to employment levels result in variations in enforcement against large employers. I find that large employers are less likely to face enforcement actions during presidential elections if they are based in politically important states. Large employers also face fewer enforcement actions if they are based in high‐unemployment states during elections of senators who serve on SEC oversight committees. Large employers based in high‐unemployment districts enjoy lower enforcement if their members of Congress serve on SEC oversight committees. The findings suggest that voters’ interests are reflected in SEC enforcement.     

Strategic Tax and Financial Reporting Decisions: Theory and Evidence*

This paper examines the effect of book‐tax differences on the probability that a transaction is audited and the probability that additional taxes are collected. It constructs a stylized model in which the taxpayer reports both financial accounting income and taxable income. The government observes both reports before deciding whether to conduct an audit. The analysis of the equilibrium yields two hypotheses. First, the probability that the government will audit a transaction is higher if the transaction generates a positive book‐tax difference (e.g., an expenditure that is deducted for tax purposes but capitalized for financial reporting purposes) than if the transaction generates no book‐tax difference. Second, conditional on being selected for audit, transactions with and without book‐tax differences are equally likely to have detected understatements of tax liability. These hypotheses are tested using Internal Revenue Service (IRS) data from the Coordinated Examination Program. The empirical tests are consistent with the predictions of the strategic tax compliance model.     

The Impact of Internal Auditor Compensation and Role on External Auditors' Planning Judgments and Decisions*

This paper reports the results of an experiment that investigates how external audit planning is affected when internal auditors have incentives and the opportunity to bias their evaluations. Specifically, we draw on attribution theory to examine how internal auditor eligibility for incentive compensation and participation in consulting (i.e., two factors that provide incentives to bias audit evaluations) affect external audit planning. In addition, we examine the effects of incentive compensation and a consulting role across two routine internal audit tasks — an objective tests of controls task and a subjective inventory valuation task — to evaluate whether their effects are contingent upon task subjectivity (i.e., opportunity to bias audit evaluations). Seventy‐six external auditors from four Big 5 public accounting firms participated in an experiment that manipulated internal auditor compensation (fixed salary versus incentive compensation), the type of work that the internal auditors routinely perform (primarily auditing versus primarily consulting), and audit task subjectivity (objective tests of controls versus subjective inventory valuation). Our results suggest that the nature of internal auditors' compensation and work affect audit planning recommendations differently. The opportunity to receive incentive compensation results in less reliance on internal auditors' work and greater budgeted audit hours, but only for the subjective task. Although a consulting role decreases perceived internal auditor objectivity, it has a limited effect on planning recommendations. Specifically, consulting has no effect on reliance, and leads to greater budgeted audit hours only when incentive compensation is available. We discuss potential explanations for the results as well as implications for audit research, practice, and regulation.     

Impact of Auditor Report Changes on Financial Reporting Quality and Audit Costs: Evidence from the United Kingdom

While substantial revisions to auditor reporting requirements are being implemented internationally, the impact of these reforms on financial reporting quality is unknown. We exploit the United Kingdom's recent auditor reporting changes and find that the United Kingdom's new reporting regime is associated with an improvement in financial reporting quality as proxied by significant decreases in absolute abnormal accruals and the propensity to just meet or beat analyst forecasts, and a significant increase in earnings response coefficients. As for audit costs, we do not find a significant change in audit fees or audit delay surrounding the implementation of the new reporting regime. Taken together, the results of this study suggest that new auditor reporting requirements are associated with a significant improvement in financial reporting quality without detecting a significant increase in audit costs.     

Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC*

Abstract. This study investigates firms subject to accounting enforcement actions by the Securities and Exchange Commission for alleged violations of Generally Accepted Accounting Principles. We investigate: (i) the extent to which the alleged earnings manipulations can be explained by extant earnings management hypotheses; (ii) the relation between earnings manipulations and weaknesses in firms' internal governance structures; and (iii) the capital market consequences experienced by firms when the alleged earnings manipulations are made public. We find that an important motivation for earnings manipulation is the desire to attract external financing at low cost. We show that this motivation remains significant after controlling for contracting motives proposed in the academic literature. We also find that firms manipulating earnings are: (i) more likely to have boards of directors dominated by management; (ii) more likely to have a Chief Executive Officer who simultaneously serves as Chairman of the Board; (iii) more likely to have a Chief Executive Officer who is also the firm's founder, (iv) less likely to have an audit committee; and (v) less likely to have an outside blockholder. Finally, we document that firms manipulating earnings experience significant increases in their costs of capital when the manipulations are made public. Résumé. Les auteurs analysent les entreprises assujetties aux mesures d'exécution prises par la Securities and Exchange Commission dans les cas de présomption de transgression des principes comptables généralement reconnus. Ils s'intéressent aux aspects suivants de la question: i) la mesure dans laquelle les présomptions de manipulations des bénéfices peuvent être expliquées par les hypothèses existantes de gestion des bénéfices; ii) la relation entre les manipulations de bénéfices et les faiblesses des structures de régie interne des entreprises; et iii) la réaction du marché financier à l'endroit des entreprises au sujet desquelles les présomptions de manipulation des bénéfices sont rendues publiques. Les auteurs constatent qu'un incitatif majeur à la manipulation des bénéfices est le désir d'obtenir du financement externe à moindre coût. Ils démontrent que cet incitatif demeure important même après le contrôle des motifs contractuels que mettent de l'avant les travaux théoriques. Ils constatent également que les entreprises qui manipulent les bénéfices sont: i) davantage susceptibles d'avoir des conseils d'administration dominés par la direction; ii) davantage susceptibles d'avoir un chef de la direction qui joue simultanément le rôle de président du conseil; iii) davantage susceptibles d'avoir un chef de la direction qui est également le fondateur de l'entreprise; iv) moins susceptibles d'avoir un comité de vérification; et v) moins susceptibles d'avoir un bloc de titres détenus par un actionnaire extérieur. Enfin, les auteurs établissent le fait que le coût du capital, pour les entreprises qui manipulent les bénéfices, enregistre des hausses appréciables lorsque ces manipulations sont rendues publiques.     

Board Gender Diversity,Auditor Fees,and Auditor Choice

We examine whether the presence of female directors and female audit committee members affect audit quality in terms of audit effort and auditor choice by using observations from a sample of U.S. firms, spanning the years 2001–2011. We find, after controlling for endogeneity and other board, firm, and industry characteristics, that firms with gender‐diverse boards (audit committees) pay 6 percent (8 percent) higher audit fees and are 6 percent (7 percent) more likely to choose specialist auditors compared to all‐male boards (audit committees). Our findings suggest that boards (audit committees) with female directors (members) are likely to demand higher audit quality, ceteris paribus.     

To Comply or Not to Comply: Understanding the Discretion in Reporting Public Float and SEC Regulations

This paper documents how firms exercise discretion in defining affiliates and reporting public float in response to Securities and Exchange Commission regulations. I find that firms with higher expected compliance costs under section 404 of the Sarbanes‐Oxley Act of 2002 tend to classify more shares as affiliated and report lower public float. In contrast, firms issuing seasoned equity are less likely to underreport public float, possibly due to favorable regulatory treatment for large issuers. These incentives are weakened when future regulatory changes render float less important.     

Auditor Reporting and Regulatory Sanctions in the Broker‐Dealer Industry: From Self‐Regulation to PCAOB Oversight

The financial security of the investing public relies on high‐quality service by broker‐dealers (BDs), investors' gateway to the financial markets. The SEC has long required auditors to attest to BDs' internal controls and compliance with regulations (including those privately owned). Following the unraveling of the Madoff Ponzi scheme in 2008, the SEC required auditors of all BDs to register with the PCAOB, and Congressional initiatives signaled imminent transition from private (AICPA) to public (PCAOB) oversight. We investigate whether audit quality increased following this transition by measuring whether auditors report material internal control and compliance problems for BD clients where a deficiency presumably existed (i.e., BDs sanctioned by the Financial Industry Regulatory Authority for transgressions against stakeholders). Overall, we do not find increased reporting quality following the regulatory shift but do observe variation by auditor group and BD ownership. While reporting quality for global network firms (GNFs) increases slightly, lower reporting quality observed prior to the regulatory shift for specialist audit firms (having large BD portfolios but small overall size) is exacerbated afterward. This finding complements results of PCAOB inspections and other research identifying audit quality problems among small, industry‐specialized firms in non‐public client settings. Focusing on deficiencies likely more difficult to detect, we find lower reporting quality for private relative to publicly affiliated BDs prior to PCAOB oversight, and lower reporting quality for very small audit firms relative to GNFs following the regulatory shift.     

A Reexamination of Behavior in Experimental Audit Markets: The Effects of Moral Reasoning and Economic Incentives on Auditor Reporting and Fees*

This study uses experimental markets to investigate how moral reasoning influences auditor reporting under different levels of economic incentives. In each multiperiod market, auditor subjects could either (1) misreport low observed outcomes as high and thereby reap economic advantages at the expense of third‐party investors, or (2) truthfully report low observed outcomes as low but thereby forgo the economic advantages of misreporting. We extend the Calegari, Schatzberg, and Sevcik 1998 experimental‐markets setting to incorporate moral reasoning, and test hypotheses based on the economic model of Magee and Tseng 1990 and the neo‐Kohlbergian moral reasoning framework of Rest, Narvaez, Bebeau, and Thoma 1999. We document a significant effect of moral reasoning on auditor behavior. Specifically, we find that misreporting and premium fees are more likely with higher than with lower moral reasoning subjects, and the moral reasoning effect diminishes as economic penalties increase in the market. These findings provide valuable insights for specifying the determinants of auditor misreporting, the observable behaviors that signal its existence, and the institutions that can prevent its occurrence in the market. We conclude that the relation between moral reasoning and behavior is more complex than commonly assumed in the accounting literature, and identify directions for future research.     

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.     

Auditor Quality and Debt Covenants

This study examines the impact of auditor quality on financial covenants in debt contracts. We conjecture that high‐quality auditors have two related effects on these debt covenants: (i) they encourage fewer and less restrictive covenants by providing assurance to lenders at contract inception and, consequently, (ii) they ensure a lower probability of eventual covenant violations. Consistent with the conjectures, we find that auditor quality is negatively associated with the intensity and tightness of financial covenants. Specifically, high‐quality auditors are associated with fewer covenants (especially performance covenants) and less binding covenants. Additionally, we find that auditor quality is negatively associated with the likelihood of covenant violations. In an ancillary test, we provide evidence that high‐quality auditors mitigate the detrimental effect of covenant violations on the cost of borrowing. Together, these findings highlight the important role of auditors in debt contracting.     

Fixed Cost Magnitude,Fixed Cost Reporting Format,and Competitive Pricing Decisions: Some Experimental Evidence*

Although neoclassical economic theory predicts that fixed cost magnitude and fixed cost reporting format will not influence short‐term pricing decisions, these factors systematically affected pricing decisions in a duopoly experiment. Increasing fixed cost magnitude (a pure sunk cost in this study) across experimental conditions caused participants to first lower, then raise, competitive prices. Consistent with the psychological phenomenon of loss aversion, this change in pricing behavior reduced the frequency of reported losses. This study further reveals that the accounting format for reporting fixed costs influenced pricing behavior. Specifically, participants receiving capacity costing feedback reports established increasingly lower selling prices relative to the prices established by participants receiving contribution margin feedback reports. Given that a very simple cosmetic reporting manipulation produced increasingly significant competitive pricing differences in a market setting, this study provides evidence that functional fixation is not necessarily eliminated by market forces.     

Auditor Liability and Business Investment*

We model a firm's investment decision, an auditor's effort‐rendering behavior, audit fees, and prices of the firms under two auditor liability rules: strict liability and negligence liability. We show that an auditor's effort level is socially optimal under strict liability, while it is not generally so under negligence liability. Furthermore, both the firm owner's expected benefit and the audit fee are higher under strict liability than under negligence liability. We define the legal error under negligence liability as the difference between the assessed audit effort (that is, the estimate of audit effort made by the court) and the actual audit effort and prove that the greater the variance of the legal error, the more incentive an auditor has to exert effort under negligence liability compared with strict liability. Finally, the number of investments being undertaken could be higher under strict liability because more firm owners are willing to hire auditors to go public.     

Legal Damages and Auditor Efforts*

Abstract. Conventional wisdom holds that an auditor's optimal response to an increase in legal exposure is to double his efforts in finding errors in his client's financial reports. This paper's main result is that in a market setting where clients shop for opinions and auditors must compete for clients, the conventional wisdom may fail. Increased damages: affect all auditors reducing the competition among auditors for clients. Thus, an auditor can reduce his legal exposure by reporting more conservatively, instead of working harder. The main result is mitigated if client firms also face legal damages and if clients themselves are more conservative in preparing their unaudited financial statements. If it is more likely that a client claiming “good news” is truly good, the auditor has an incentive to work harder to confirm this good report and satisfy his client. This incentive to work harder to please his client may prevent the auditor from retreating into conservatism when damages are increased. Finally, if the auditors' report space were continuous, as with a continuum of client types, the main result would be reversed: additional damages would (weakly) increase the auditor's efforts. With a continuum of possible reports, the competition is not eliminated as damages increase; only the range of reports that the auditors offer is reduced. Because the competition cannot be eliminated and the incumbent cannot resort to conservatism to reduce his legal exposure, the auditor works hard. Résumé. Par tradition, la sagesse veut que la réaction la plus appropriée d'un vérificateur à une augmentation des risques juridiques soit un redoublement d'efforts pour déceler les erreurs dans les rapports financiers de ses clients. L'auteur en arrive pourtant à la principale conclusion que, dans le contexte d'un marché où les clients font du «magasinage» d'opinion et où les vérificateurs doivent se disputer les clients, la sagesse nous amène à faire fausse route. L'augmentation des dommages touche tous les vérificateurs et atténue la rivalité qui les oppose dans la recherche de clients. Ainsi, un vérificateur peut diminuer le risque juridique auquel il est exposé en usant d'une plus grande prudence dans ses rapports plutôt qu'en travaillant avec plus d'acharnement. L'auteur est cependant moins catégorique à ce sujet lorsque l'entreprise cliente fait aussi l'objet de poursuites en dommages et qu'elle est donc plus prudente dans la préparation de ses états financiers non vérifiés. Il est davantage probable que les nouvelles positives qu'une telle entreprise publie le soient véritablement, de sorte que le vérificateur est, lui, davantage enclin à déployer les efforts nécessaires pour confirmer ces nouvelles positives et satisfaire son client. Cette incitation à travailler avec plus d'énergie pour satisfaire le client peut faire en sorte que le vérificateur ne se replie pas derrière la prudence lorsque les dommages augmentent. Enfin, s'il existe un large éventail de rapports de vérification, comme dans le cas d'une multiplicité de types d'entreprises, la conclusion principale se trouve inversée; l'augmentation des montants de dommages entraîne une (faible) hausse de l'intensité du travail du vérificateur. Dans le cas d'un large éventail de rapports possibles, la concurrence ne s'atténue pas avec l'augmentation des montants de dommages; seul l'éventail des rapports qu'offrent les vérificateurs est réduit. Étant donné que la concurrence ne peut être éliminée, et que le vérificateur attitré ne peut recourir à la prudence pour réduire le risque juridique auquel il est exposé, il redouble d'effort.