Auditor Reputation,Auditor Independence,and the Stock‐Market Impact of Andersen's Indictment on Its Client Firms*

In this paper, we study a broad sample of Arthur Andersen clients and investigate whether the decline in Andersen's reputation, due to its criminal indictment on March 14, 2002, adversely affected the stock market's perception of its audit quality. Because these reputa‐tional concerns are more of an issue if an auditor's independence is impaired, we investigate the relationship between the abnormal market returns for Andersen clients around the time of the indictment announcement and several fee‐based measures of auditor independence. Our results suggest that when news about Andersen's indictment was released, the market reacted negatively to Andersen clients. More importantly, we find that the indictment period abnormal return is significantly more negative when the market perceived the auditor's independence to be threatened. We also examine the abnormal returns when firms announced the dismissal of Andersen as an auditor. Consistent with the audit quality explanation, we document that when firms quickly dismissed Andersen, the announcement returns are significantly higher when firms switched to a Big 4 auditor than when they either switched to non‐Big 4 auditors or did not announce the identity of the replacement auditor. Our empirical results support the notion that auditor reputation and independence have a material impact on perceived audit quality and the credibility of audited financial statements, and that the market prices this.     

An Empirical Investigation of Audit Fees,Nonaudit Fees,and Audit Committees*

This study examines the association between audit committee characteristics and the ratio of nonaudit service (NAS) fees to audit fees, using data gathered under the Securities and Exchange Commission's (SEC's) fee disclosure rules. Issues related to NAS fees have been of concern to practitioners, regulators, and academics for a number of years. Prior research suggests that audit committees possessing certain characteristics are important participants in the process of managing the client‐auditor relationship. We hypothesize that audit committees that are independent and active financial monitors have incentives to limit NAS fees (relative to audit fees) paid to incumbent auditors, in an effort to enhance auditor independence in either appearance or fact. Our analysis using a sample of 538 firms indicates that audit committees comprised solely of independent directors meeting at least four times annually are significantly and negatively associated with the NAS fee ratio. This evidence is consistent with audit committee members perceiving a high level of NAS fees in a negative light and taking actions to decrease the NAS fee ratio.     

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.     

Audit Fees: A Meta‐analysis of the Effect of Supply and Demand Attributes*

We evaluate and summarize the large body of audit fee research and use meta‐analysis to test the combined effect of the most commonly used independent variables. The perspective provided by the meta‐analysis allows us to reconsider the anomalies, mixed results, and gaps in audit fee research. We find that, although many independent variables have consistent results, several show no clear pattern to the results and others only show significant results in certain periods or particular countries. These variables include a loss by the client and leverage, which have become significant in comparatively recent studies; internal auditing and governance, both of which have mixed results; auditor specialization, regarding which there is still some uncertainty; and the audit opinion, which was a significant variable before 1990 but not in more recent studies.     

The Impact of Financial and Tax Reporting Incentives on Option Grants to Canadian CEOs*

This study explores the effects of financial and tax reporting incentives on options granted to chief executive officers in Canada. Extant studies with a similar objective (Yermack 1995; Matsunaga 1995) explore predominantly nonqualified U.S. option grants that are deductible to the extent that the options are in the money at the time of exercise. In contrast, Canadian firms do not get a tax deduction for their stock option grants at any time. In both countries, no expense is recorded for financial reporting purposes. As a result, the financial reporting and tax reporting trade‐off is more pronounced in the Canadian setting of this study compared with the U.S. setting. We measure option granting behavior as the ratio of the Black‐Scholes value of stock option grants to the sum of cash compensation and the value of stock option grants. Using a sample of 806 firm‐year observations during the period 1993‐95, we find that observed option grants are significantly correlated with proxies for short‐run financial reporting incentives. We also find evidence that option granting behavior is correlated with proxies for tax incentives.     

The Riskiness of Large Audit Firm Client Portfolios and Changes in Audit Liability Regimes: Evidence from the U.S. Audit Market*

We investigate whether the financial riskiness of large U.S. audit firm clienteles varied with the changing audit litigation liability environment during the period 1975‐99. Partitioning the period of study into four distinct periods (a benchmark period (1975‐84), a period of increasing concerns about litigation liability (1985‐89), a period of lobbying for reform (1990‐94), and a post‐relief period (1995‐99)), we find some evidence of risk decreases during 1985‐89, strong evidence of risk decreases during 1990‐94, and strong evidence of risk increases during 1995‐99. However, we also find that over the period of our study, a time during which Big 6 market shares grew appreciably, the proportion of litigious‐industry clients in Big 6 client portfolios grew at about the same rate as the proportion of such clients in the population. Moreover, the Big 6 share of the financially riskiest clients in the economy did not grow as fast as the overall Big 6 market share. In sum, although our evidence is consistent with the hypothesis that the riskiness of Big 6 client portfolios responded to changes in the audit litigation liability environment, we find no systematic evidence of a "race to the bottom" or "bottom fishing" by these firms in a bid to increase their market shares.     

JIT Adoption: The Effects of LIFO Reserves and Financial Reporting and Tax Incentives*

Using matched samples of JIT adopters and nonadopters, we examine the association of JIT adoption with firms' financial reporting and tax incentives, earnings‐management histories, and LIFO reserve levels. We find evidence that adoption decisions are influenced by the interaction of firms' LIFO reserves with their income smoothing, debt covenant, and tax incentives. We also find that adoption is less likely for firms historically engaging in high degrees of earnings management, particularly when such firms have no substantial LIFO reserves. Our study extends earlier research demonstrating a relation between inventory valuation method and year‐end inventory transactions, and documents a relation between earnings‐management incentives and a fundamental supply‐chain design choice.     

Competition in the Market for Audit Services: The Effect of Supplier Concentration on Audit Fees*

Abstract. This article investigates the relationship between supplier concentration and competition in the market for audit services. The study is motivated by the concern that high levels of concentration may be detrimental, resulting in lower levels of competition, which could harm clients through higher fees and lower levels of service. However, a counterargument is that high levels of concentration may not be detrimental but may result because market leaders display exceptional performance, providing lower-priced audits (perhaps due to economies of scale) and/or enhanced service to clients. We obtained audit fee and financial data on 140 life and health insurance companies and 101 property and casualty insurance companies. Our findings indicate that concentration is negatively associated with fees, suggesting that higher levels of concentration are related to higher levels of price competition (i.e., lower fees). Additionally, we address the validity of concentration as a surrogate for competition by examining competition among the market leaders. Our analysis examines the fees paid by 47 insurance companies that switched auditors during the sample period. We investigate the effect of industry specialization on fees paid by clients that switch auditors, finding evidence of significant fee cutting among market leaders for each others' clients but no evidence of fee reductions for clients switching from nonleaders to market leaders. This is consistent with the claim that there is significant price competition for clients among the market leaders, suggesting that high concentration need not result in low levels of price competition (i.e., higher fees). Résumé. Les auteurs analysent la relation entre la concentration des fournisseurs et la coocurrence sur le marché des services de vérification. L'étude découle de la préoccupation suivant laquelle des niveaux élevés de concentration pourraient être préjudiciables et donner lieu à une intensité plus faible de la concurrence qui risquerait de léser les clients, en augmentant les honoraires et en diminuant la qualité du service. L'argumentation opposée veut qu'un degré élevé de concentration ne soit pas préjudiciable et puisse être attribuable au fait que les chefs de file du marché affichent une performance exceptionnelle, offrant des services de vérification à meilleur prix (peut-être en raison d'économies d'échelle) et (ou) mettent l'accent sur le service à la clientèle. Les auteurs ont recueilli des données relatives aux honoraires de vérification et des données financières provenant de 140 sociétés d'assurances vie et maladie et 101 sociétés d'assurances I.A.R.D. (incendie, accidents et risques divers). Les résultats de leurs recherches indiquent que la concentration est en relation négative avec les honoraires, ce qui donne à penser que des niveaux plus élevés de concentration sont reliés à des niveaux plus élevés de concurrence relative au prix (c'est-à-dire à des honoraires inférieurs). Les auteurs se sont également penchés sur la validité de la concentration à titre de substitut à la concurrence en examinant la concurrence que se livraient les chefs de file sur le marché. Ils ont analysé les honoraires versés par 47 sociétés d'assurance qui ont changé de vérificateurs au cours de la période analysée. Us ont étudié l'incidence de la spécialisation sectorielle sur les honoraires versés par les clients qui changent de vérificateurs; les résultats de l'étude démontrent que les cabinets chefs de file réduisent leurs honoraires de façon appréciable à l'intention des clients de leurs concurrents appartenant au groupe des chefs de file; ces résultats ne permettent cependant pas de conclure à des réductions d'honoraires pour les clients qui passent de vérificateurs n'appartenant pas aux chefs de file à des vérificateurs chefs de file sur le marché. Ces constatations sont conformes à l'hypothèse selon laquelle les chefs de file sur le marché se livrent une âpre concurrence relative au prix pour attirer la clientèle, ce qui laisse croire que la concentration élevée ne donne pas nécessairement lieu à une faible intensité de la concurrence relative au prix (c'est-à-dire à des honoraires supérieurs).     

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.     

An Economic Analysis of Audit and Nonaudit Services: The Trade‐off between Competition Crossovers and Knowledge Spillovers*

In this paper, I present a model in which both markets for audit services and nonaudit services (NAS) are oligopolistic. Accounting firms providing both audit services and NAS will employ oligopolistic competition in each of these markets. In addition to auditors' gaining “knowledge spillovers” from auditing to consulting or vice versa, oligopolistic competition in one market will influence the counterpart in the other market ‐ what I call “competition crossovers”. Although scope economies due to knowledge spillovers (for example, cost savings) are always beneficial to auditors, such benefits can entice accounting firms to adopt strategies (for example, price reductions) to compete aggressively in the audit market so that some, or all, firms become worse off. A trade‐off arises between these two economic forces in the two oligopolistic markets. Given the trade‐off between competition crossovers and knowledge spillovers, accounting firms may not reduce their audit prices, even though supplying NAS enables firms to decrease auditing costs — a nontrivial impact of oligopolistic competition in two markets on audit pricing. The empirical implication of my results is that because of competition‐crossover effects between the auditing and consulting service markets, finding empirical evidence for knowledge‐spillover benefits is likely to be difficult. Control variables for “audit‐market concentration” concerned with competition‐crossover effects and “auditor expertise” concerned with knowledge‐spillover benefits should be included in audit‐fee regressions to increase the power of empirical tests. With regard to policy implications, my analyses help explain the impact of the Sarbanes‐Oxley Act on “market segmentation” and, hence, the profitability of accounting firms.     

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.     

委托人-代理人双重身份下的最优激励与激励相容——相互持股道德风险问题的博弈分析

在明确相互持股和委托人一代理人双重身份的情况下,本文从代理人的转移支付方式、委托人最优激励选择和激励相容条件的变化及其存在条件等方面分析了企业内部激励问题的变化,其目的在于揭示委托人一代理人双重身份下的企业内部激励效率的变化,从企业内部激励问题的角度分析相互持股的效率。     

The Disposition of Audit‐Detected Misstatements: An Examination of Risk and Reward Factors and Aggregation Effects*

While professional standards indicate that auditors have the responsibility to both detect and report material errors, empirical evidence shows that auditors waive approximately 50 percent of material errors (Wright and Wright 1997). Unlike prior research that has examined factors that may affect auditors' decisions to waive single material misstatements, the current study examines auditors' propensity to waive proposed adjusting journal entries (henceforth PAJEs) that exceed materiality, either individually or in aggregate, under several different aggregation contexts. These contexts are represented in the form of different cases that vary in terms of the materiality and income direction of the individual and aggregate PAJEs. The current paper posits that auditors will be more likely to waive PAJEs in excess of materiality (i.e., make a “non‐GAAS” decision) when there is potential reward for doing so or when there is little litigation risk from doing so. The case decisions of 155 audit partners and managers indicate that they are not affected by potential reward (Client's Relative Fees), but are affected by potential risk (the Client's Financial Health, the PAJE's Subjectivity, and the PAJEs' Aggregate Directional Effect on Income). However, these factors are not equally influential across all aggregation contexts. Additionally, auditors are more likely to make non‐GAAS decisions when they are evaluating immaterial PAJEs that aggregate to a material level than when they are evaluating a single material PAJE.     

The Synergistic Effects Between Insurance and Credit Markets on Economic Growth: Evidence from China

Insurance and credit markets share some common roles in stimulating economic growth, whether they are complementary or not is worth researching further. Based on the generalized method of moments, this paper investigates the synergistic effects between insurance and credit markets on economic growth in Chinese different regions using an interaction term in the regression model. Moreover, to understand the different economic roles of life and nonlife insurance sectors, we include them into estimation model as well. The results indicate that total insurance and credit markets are substituted, life insurance and credit markets are substituted, and nonlife insurance and credit markets are complementary in the whole region. Specifically, the synergistic effects between insurance and credit markets on economic growth vary considerably across different regions. These findings offer several useful insights for policy-makers.     

The Effect of Information Systems on Honesty in Managerial Reporting: A Behavioral Perspective*

This study examines the behavioral impact of an information system, and how that impact varies with the information system's precision, in an internal reporting environment. We propose that a manager's reporting decisions are affected by his or her trade‐off of the benefits of appearing honest against the benefits of misrepresentation. The information system affects the manager's trade‐off by improving the owner's ability to make an inference regarding the manager's level of honesty. Thus, to the extent that the manager perceives benefits to appearing honest, the presence of an information system can increase managerial honesty. As the information system becomes more precise, however, the manager must forgo greater benefits of misrepresentation in order to achieve the same appearance of honesty. For managers under a precise system, this will shift the trade‐off decision toward the benefits of misrepresentation and away from the benefits of appearing honest. Notably, in our experiment, the only benefit of appearing honest is an intrinsically motivated desire for social approval. We find that, although the existence of an information system increases managerial honesty, honesty is lower under a precise than under a coarse information system. We also compare profit earned by the owners in our experiment, which relies on a behavioral role of an information system, with the maximum profit theoretically possible given a contractual use of the information system. This comparison suggests that, unless the available information system is sufficiently precise, the owner will obtain greater profits by not contracting on its output, even if that output is fully contractible.