Rotate back or not after mandatory audit partner rotation?

Many countries have implemented rules that require an audit partner to rotate off the audit of a specific client after a certain period of time in the belief that rotation will improve independence and will allow for a fresh look at the audit. The rules are either silent on whether or when a partner can rotate back or else they specify a cooling-off period after which the rotated-off partner can resume the audit. Using archival data from China, a country with a 2-year cooling-off period, this paper explores the determinants of whether the audit partner rotates back or not when the cooling-off period expires, and whether audit quality is weakened by the audit partner rotation-back practice. We find that the audit partner rotation-back practice can be explained by factors relating to switching costs, agency conflicts, client desirability, and the audit partner’s capacity constraint considerations. Interestingly, we find that clients suffering greater audit adjustments immediately prior to the expiration of the cooling-off period are more likely to be associated with subsequent audit partner rotation-back. Furthermore, we find that rotation-back partners tend to treat former clients more favorably than non-rotation-back cases using modified audit opinions as our proxy for audit quality. Overall, our findings offer preliminary explanations for and shed light on the consequences of rotation-back practice arising from mandatory audit partner rotation requirements and lend support to regulatory concerns on rotation-back practice among audit partners.     

Can clients of economically dependent auditors benefit from voluntary audit firm rotation? An experiment with lenders

This study utilizes a nationwide random selection of 111 lenders in a 2?×?2 between-subjects experiment to determine whether the level of an auditor's economic dependence on a client and type of auditor rotation affect lenders’ independence and reliability perceptions and decisions to lend money to a potential borrower. Previous literature shows that financial statement users use client importance as a measure of audit quality when revenue streams are not equal across clients. This can negatively affect perceptions of independence and financial statement reliability. As United States regulators look for ways to improve audit quality under the current partner rotation mandate, this study explores whether an audited entity that voluntarily adopts a policy of firm rotation can mitigate the negative effects of the auditor's dependence on the client. Findings suggest that lenders view clients of economically dependent auditors (CEDA) as less independent from its auditor and perceive its financials as less reliable than clients without a dependent auditor (non-CEDA). Lenders are less likely to grant a loan to CEDA. However, under firm rotation, there is not only an increase in lenders’ perceptions of reliability of CEDA financials, but also no difference in perceptions of reliability of CEDA and non-CEDA financials.     

Does the mandatory disclosure of audit information affect analysts' information acquisition?

This paper explores the effect of public information on analysts' information acquisition. By introducing the implementation of the Key Audit Matters (KAM) Disclosure Standards for China's firms cross-listed in Hong Kong in 2017, we present evidence that KAM disclosure reduces analysts' firm visits, which is an important channel of information acquisition. The effect is particularly pronounced for firms with audit partner rotation and low institutional ownership. KAM disclosure by industrial leaders has a spillover effect on analyst visits for peer firms. Disclosure also improves the frequency and quality of analysts' forecasts and firms' information environments, indicating that KAMs are informative and audit information is an important determinant of analysts' information acquisition. Our study reveals the real effect of KAM disclosure on analyst decisions, which may be of interest to regulators concerned with the mandatory disclosure of audit information and capital market efficiency.     

Do investors perceive a change in audit quality following the rotation of the engagement partner?

Though Section 203 of the Sarbanes-Oxley Act (SOX) calls for the rotation of the audit partner every five years, we do not know whether investors value audit partner rotation. This is an important issue since many in the auditing profession believe that mandatory rotation of the audit partner is unnecessary and may in fact impair audit quality. We identify a sample of firms that disclosed changes in the engagement partner in the proxy statement and examine whether equity investors perceive a change in audit quality following the partner rotation. We find a significant increase in earnings informativeness following audit partner rotation. We also find that short sellers regard earnings in the post-rotation to be of higher quality than earnings prior to the rotation. Finally, cost of equity capital is lower following partner rotation. Our findings have important implications for the regulators, auditors, and investors.     

Do jumps contribute to the dynamics of the equity premium?

This paper investigates whether risks associated with time-varying arrival of jumps and their effect on the dynamics of higher moments of returns are priced in the conditional mean of daily market excess returns. We find that jumps and jump dynamics are significantly related to the market equity premium. The results from our time-series approach reinforce the importance of the skewness premium found in cross-sectional studies using lower-frequency data; and offer a potential resolution to sometimes conflicting results on the intertemporal risk-return relationship. We use a general utility specification, consistent with our pricing kernel, to evaluate the relative value of alternative risk premium models in an out-of-sample portfolio performance application.     

To switch or not to switch? The effect of audit firms’ economies of scale on audit firm switches after audit price deregulation in China

We exploit the unique setting of China’s 2014 audit price deregulation policy to examine whether audit firms use their economies of scale (EOS) to compete for clients. We find a significant increase in client firms switching from a non-EOS auditor to an EOS auditor after the audit price deregulation policy was implemented. The additional analyses show that EOS audit firms are more likely to offer audit fee discounts than non-EOS audit firms while retaining audit quality. We also find that the auditors’ EOS effect is more pronounced for highly homogeneous industries and firms paying high abnormal audit fees, firms in financial distress, and firms receiving less capital market attention than for less homogeneous industries and firms paying low abnormal audit fees, financially stable firms, and firms receiving more capital market attention. Finally, we find that the presence of state-owned enterprises and political connections both separately and jointly moderate the effect of audit firm–client realignments from a non-EOS auditor to an EOS auditor after the audit price deregulation. Overall, our study provides important insights for policymakers and regulators reviewing and developing new policies on audit services.     

Can central banks be heard over the sound of gunfire?

In this study, we examined the effectiveness of central bank communications during times of significant adverse shocks. Specifically, we examined how the National Bank of Ukraine (NBU) regulated foreign exchange (FX) markets during the Russo-Ukrainian War in 2022. Data collected from both the black and authorized FX markets suggested that the content of the NBU's announcements significantly impacted FX market agents. Announcements aimed at maintaining a fixed (floating) FX rate prompted an increase (decrease) in the black market premium in cash transactions. Moreover, the NBU's announcements influenced the sale side of foreign currency more than any other aspect, an area where the black market FX traders held near monopolistic power.     

Are audit partners’ compensation and audit quality related to their consulting revenues?

Recent accounting scandals have triggered renewed interest in the debate concerning whether audit firms should be banned from providing consulting services. Compared to the voluminous studies on consulting services to audit clients (i.e., non-audit services, hereafter NAS), little has been done to investigate consulting services to non-audit clients (hereafter CS). This study examines whether audit partners' revenues from CS are associated with: i) partners' compensation, and ii) audit quality (AQ), while controlling for revenues from NAS and auditing. We choose the Norwegian setting because of the unique and proprietary data on CS at the audit partner level. Our results provide initial evidence that partners' compensation is positively associated with their revenues generated from CS. Regarding AQ, our findings indicate no relation between AQ and partners' revenues from CS. This study contributes to the recent debate on multidisciplinary audit firms and should be of interest to regulators, audit firms, and users of audited financial statements.     

Do investment in and the sourcing arrangement of the internal audit function affect audit delay?

This paper investigates the association between the internal audit function attributes and audit delay using a sample of 432 publicly traded firms in Malaysia in 2009. In this unique setting, we capitalize on the publicly available data concerning the investment in and the sourcing arrangement of internal audit function. We find a negative relationship between the costs incurred for the internal audit function and audit delay. However, we do not find any significant association between the internal audit function sourcing arrangements and audit delay. Additionally, we find that greater audit committee independence and longer auditor–client tenure shorten audit delay, and more frequent audit committee meetings and higher misstatements in the preliminary unaudited earnings are associated with a longer audit delay.     

Is artificial intelligence improving the audit process?

Review of Accounting Studies - How does artificial intelligence (AI) impact audit quality and efficiency? We explore this question by leveraging a unique dataset of more than 310,000 detailed...     

Which workers get insurance within the firm?

Industry-level time series data suggest that low-skilled workers get less insurance within the firm than high-skilled workers. In particular, wages respond relatively more to productivity shocks in low-skilled industries than high-skilled industries. Our theory is that low-skilled workers get relatively less insurance from their firms because they have relatively lower displacement costs. Under limited commitment, lower displacement costs make the workers' outside options more attractive, and hence decrease the amount of risk sharing sustainable within the firm. Evidence on average displacement costs by industry support the theory's predictions.     

Transition to IFRS and compliance with mandatory disclosure requirements: What is the signal?

The present study examines 153 Greek listed companies' compliance with all IFRS mandatory disclosure requirements during 2005 and complements and extends prior literature in the following way. The unique setting i.e., measuring compliance with IFRS mandatory disclosure requirements during the first year of IFRS implementation, allows for examination of the possibility that the changes in the 2004 shareholders' equity and net income, as a result of the adoption of IFRS, constitute explanatory factors for compliance. Thus, this study hypothesises that, in addition to the financial measures and other corporate characteristics that prior literature identifies as proxies for explaining compliance, a significant change in fundamental financial measures, because of the change in the accounting regime, may also explain compliance based on the premises of the relevant disclosure theories. The findings confirm these hypotheses. This study also makes a methodological contribution on measuring compliance with all IFRS mandatory disclosure requirements by using two different disclosure index methods and pointing out the different conclusions may be drawn as a result.     

How does the type of equity compensation of audit committee affect audit fees?

Based on agency theory, if equity compensation aligns audit committee members' interests with those of shareholders, the audit committee will provide effective oversight and demand more thorough audit coverage and scope. This will result in higher audit fees paid to the external auditor. This study specifically examines the associations between the types of equity compensation of audit committee members and audit fees. Our findings show differential impacts of equity compensation of audit committee in the forms of option grants and stock awards on audit fees. Specifically, equity compensation using stock awards is more effective than using option grants in aligning the interests of audit committee members with the interests of shareholders to provide better oversight of financial reporting.     

Is the objectivity of internal audit compromised when the internal audit function is a management training ground?

We conduct an experiment with 74 internal auditors to examine the effects of using the internal audit function as a training ground for future senior managers. Specifically, we investigate internal auditors' willingness to resist current management's aggressive revenue recognition policies, assuming that internal auditors expect to move into senior management positions in the future. We also examine whether increasing the power of the board of directors can reduce threats to internal auditors' objectivity. This is the first study to empirically examine whether training grounds influence internal auditors objectivity. Results of our study indicate that internal auditors are less objective (i.e. they are more likely to side with management's aggressive revenue recognition policies) when they expect to move into senior management positions, relative to when internal auditing is not used as a training ground. We also find that empowering the audit committee further decreases the objectivity of internal auditors. These results suggest that board power can have unintended consequences on the behaviour of internal auditors and that board empowerment does not guarantee improved governance or improved oversight of financial reporting.     

How important is capital structure policy to firm survival?

If there is an economically important optimal capital structure, then firms that deviate too far from the optimum will face greater risk of failure or acquisition. Using data from the oil industry we find no significant evidence that capital structure policy affects acquisition or failure probability. Firms appear to increase leverage when they face attractive growth opportunities or when poor operating performance reduces equity value or compels borrowing. Firms are acquired when rapid growth has reduced financial slack. In a clinical examination, we address the question of how firms with persistently low leverage can operate and survive for many years without being targeted for acquisition. Our evidence supports the pecking-order hypothesis, including acquisition among potential financing sources.     

Why do firms repurchase stock to acquire another firm?

This study investigates firms that repurchase their stock to finance an acquisition. Since research shows that cash-financed acquisitions perform better than stock-financed acquisitions, why do firms that have available cash initiate the extra transactional step. I find these firms are well compensated for their efforts, especially in the long run. On average, these firms have negative abnormal returns prior to their repurchase announcements and thus may choose repurchasing to signal undervaluation. Furthermore, the stock acquisition step allows these firms to share risk, counteract the negative effects of dilution, and enjoy a tax advantage for their efforts.

Do private firm valuations contain incremental information content over routine analyst valuations?

In this study, we seek to investigate whether private expert valuations commissioned for specific transactions outside the exchange contain incremental information content over public analyst valuations published routinely by investment houses. First, we find that public valuations are based to a larger extent on financial statements and market quotes, whereas private valuations tend to be based on other, non-public information. Second, we show that investors’ response to both public and private valuations is cautious in the short-run as well as in the long-run. Third, we provide evidence that despite the fact that private valuations have the advantage of time, human resources, and better access to non-public information, they do not provide different results than those obtained from public valuations. We conclude that while private valuations may be captured as more accurate and reliable, their superiority over public valuations is questionable at best.     

Does the use of peer groups contribute to higher pay and less efficient compensation?

We provide empirical evidence on how the practice of competitive benchmarking affects chief executive officer (CEO) pay. We find that the use of benchmarking is widespread and has a significant impact on CEO compensation. One view is that benchmarking is inefficient because it can lead to increases in executive pay not tied to firm performance. A contrasting view is that benchmarking is a practical and efficient mechanism used to gauge the market wage necessary to retain valuable human capital. Our empirical results generally support the latter view. Our findings also suggest that the documented asymmetry in the relationship between CEO pay and luck is explained by the firm's desire to adjust pay for retention purposes and is not the result of rent-seeking behavior on the part of the CEO.     

Market reactions to the closest peer firm’s analyst revisions

Prior analyst literature focuses on the impact of financial analysts on the firms they cover, and prior information-transfer literature concentrates on the externalities of information provided by management. This paper fills gaps in both streams of literature by examining the focal firm’s market reactions to the closest peer firm’s (identified by product similarity) analyst revisions. We find that the focal firm’s stock price reacts to the closest peer’s analyst revisions made by analysts who are not covering the focal firm. The focal firm’s cumulative abnormal return for a five-day window centered on the revision date is 0.54% higher if the peer firm’s analyst revision magnitude is in the top decile than if it is in the bottom decile. Cross-sectional tests show that the sensitivity of the focal firm’s market reactions to the peer firm’s revisions increases with the revision informativeness and the similarity between the focal firm and the peer firm. In addition, we find that focal firms do not react to peer firms’ revisions in industries with strong competition where the competitive effects cancel out the spillover effects. Finally, we find that the focal firm’s market reactions can predict its own future analyst revisions, suggesting that the reactions are at least partially rational.