PCAOB Inspections: Public Accounting Firms on “Trial”

The objective of our article is to obtain a better understanding of how auditors anticipate the potential for PCAOB inspection, experience the inspection, cope with the consequences of the inspection, and understand the PCAOB's influence within the context of professionalism. We use a qualitative approach that uses both surveys (55) and interviews (20) of auditors (of varying rank and firm) across a five‐year period (2012–2017). Respondents suggest that PCAOB inspectors are powerful, representing the “prosecution,” “judge,” and “jury” of the auditing profession. We therefore use a structural metaphor of the PCAOB inspection as a judicial “trial.” By controlling the criteria used to evaluate performance, inspectors have the power to repeatedly “subpoena,” “interrogate,” and return a “verdict” on the firm (auditor); those judged as “guilty” require supervised “probation.” This process is perceived as having improved audit quality but at a cost. Passing an inspection is so important that auditors (firms) have resorted to impression management strategies and “functionally stupid” work practices (e.g., excessive documentation, a decrease in critical thinking as a result of a “box ticking” approach to auditing). Furthermore, some respondents believe that being a good auditor has come at the expense of being a good accountant; the emphasis on audit process and concurrent de‐emphasis on technical accounting could ultimately lead to audits themselves falling short. In addition, it is evident that inspectors and auditors differ in their perceptions of risk, likely manifesting because inspectors are standards‐focused while auditors (firms) are methodology‐focused. Finally, the inspection process has created excessive stress and tension, beyond budget and fee pressures, which some auditors perceive as affecting the pool of talented auditors that firms may be able to attract and retain in the future.     

R&D and the Export Decision of New Firms

Recent literature on the firm‐level decision to export has focused on identifying factors that influence the export decision by firms regardless of the number of years they have been in operation. This article, alternatively, examines the factors that influence new firms to export within the first four years of operation. The results support two key findings that have commonly emerged from entrepreneurial case studies: (1) There is a positive link between research and development (R&D) and early internationalization, and (2) international ties of managers, as is evidenced by the effect of foreign‐born owners, positively impact the firm's decision to export. The former result is the emphasis of this article. In addition, we find that innovation spillovers from neighboring firms impact the export decision of new firms that engage in R&D.     

Independence Threats,Litigation Risk,and the Auditor's Decision Process*

This study examines the effect of independence threats and litigation risk on auditors' evaluation of information and subsequent reporting choices. Using a Web‐based experiment, I tracked auditors' information gathering and evaluation leading to a going‐concern reporting decision. Specifically, 48 audit managers assessed client survival likelihood, gathered additional information, and suggested audit report choices. I found that auditors facing high independence threats (fear of losing the client) evaluated information as more indicative of a surviving client and were more likely to suggest an unmodified audit report, consistent with client preferences. In contrast, auditors facing high litigation risk evaluated information as more indicative of a failing client and were more likely to suggest a modified audit report. In addition, the association between risk and report choice was fully mediated by final information evaluation. This suggests that it is unlikely that different reporting choices resulted from a conscious choice bias, but rather that motivated reasoning during evidence evaluation plays a key role in the effect of risk in auditor decision making.     

Crash Risk and the Auditor–Client Relationship

This study examines whether the term of the auditor–client relationship (i.e., auditor tenure) is associated with future stock price crash risk measured both ex ante and ex post. Using a large sample of U.S. public firms with Big 4 auditors, we find robust evidence that auditor tenure is negatively related to one‐year‐ahead stock price crash risk. The evidence is consistent with monitoring‐by‐learning where development of client‐specific knowledge over the term of the auditor–client relationship enhances auditors’ ability to detect and deter bad news hoarding activities by clients, thereby reducing future crash risk. This result holds even after controlling for endogeneity of the tenure/crash risk relation. We further provide evidence indicating that option market investors do not fully incorporate the information contained in the term of auditor–client relationship in predicting future stock price crash risk. Our empirical results have important policy implications for regulators concerned with ensuring auditor independence.     

Office Size of Big 4 Auditors and Client Restatements

Francis and Yu (2009) and Choi, Kim, Kim, and Zang (2010) report evidence that Big 4 audits are of higher quality when the engagement office is of larger size. Specifically, client earnings quality is higher and auditors in larger offices are more likely to issue going‐concern audit reports. We extend this line of research to test if larger Big 4 offices have fewer client restatements. A client restatement provides more direct evidence of a low‐quality audit than earnings quality metrics or going‐concern reports, because a restatement indicates the client's auditor did not effectively enforce the correct application of GAAP at the time the original financial statements were issued. We analyze 2,557 firm‐year restatements in a sample of 23,190 financial statements originally issued by U.S. firms from 2003 to 2008. We find that Big 4 office size is associated with fewer client restatements after controlling for innate client characteristics that may affect restatements (client size, financial performance, industry membership, nonfinancial measures, off‐balance sheet activities, and market‐related measures), and a set of controls for other auditor factors such as fees and industry expertise. The study raises important questions about the ability of smaller offices to deliver high‐quality audits for SEC registrants.     

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.     

An Examination of Factors Affecting Audit Practice Development*

In this study, we examine the possibility that audit managers' judgments may be affected by practice development objectives. Given the competitive nature of public accounting, the extent to which auditors are inclined to be aggressive in the domain of practice development may be a function of their superiors' preferences. This study builds on the exploratory work of Hooks, Cheramy, and Sinich 1994 and Asare, Hackenbrack, and Knechel 1994 by examining the delicate balance that exists between a public accounting firm's need to “grow its business” and its need to maintain its objectivity and professionalism. An experiment is conducted to determine whether the auditor's willingness to tender a bid on an engagement is affected by (1) the nature of the auditor-auditee relationship (i.e., do existing clients receive the same treatment as potential clients?), or (2) the audit partner's aggressiveness with respect to practice development, which also includes elements of ethics and competence. Seventy-four audit managers from two Big-Six firms participated in the study. The results indicate that the type of client (current or potential) and the type of partner (more or less aggressive with respect to practice development) significantly affected the auditors' judgments. Specifically, subjects in the “current client” condition, as well as those who are accountable to a more aggressive partner, are more likely to recommend bidding for the client. The experimental results of this study are based on a case where the client was proposing a relatively aggressive position with respect to accounting for research and development (R&D) costs. Our findings also suggest that the judgements related to bidding on the client are not independent of the auditor's willingness to accept the client's accounting treatment. These results also provide further evidence that the influence of accountability is important in the professional audit environment.     

M&A Due Diligence,Post‐Acquisition Performance,and Financial Reporting for Business Combinations

Before completing merger and acquisition (M&A) transactions, acquiring firms conduct due diligence. This process provides acquiring firms with a more informed assessment of the expected costs, benefits, and risks of an acquisition and offers one last opportunity to renegotiate or terminate an M&A transaction. However, acquiring firms must trade off the costs and benefits of performing additional due diligence versus completing the acquisition. Based on an analysis of the time to negotiate the acquisition agreement and complete the transaction, I predict and find that competitive pressures, short‐term financial reporting incentives, and agency problems are associated with less due diligence. I also find that less due diligence is associated with lower post‐acquisition profitability, a higher probability of acquisition‐related goodwill impairments, and lower quality fair value estimates for the acquired assets and liabilities. These findings highlight due diligence as an important factor explaining cross‐sectional variation in post‐acquisition performance and financial reporting for business combinations.     

The Effect of CFO Personal Litigation Risk on Firms’ Disclosure and Accounting Choices

In Gantler v. Stephens (2009), the Delaware Supreme Court makes explicit that corporate officers owe the same fiduciary duty to the firm and shareholders as do board members. The decision increased the risk of non‐board‐serving officers being added as named defendants to investor litigation but did not change the risk of corporate litigation. Analyzing the effect of the Gantler ruling on non‐board‐serving CFOs, we find a significant change in their behavior as well as in their firms’ disclosure and accounting choices. Specifically, speech tone during earnings calls of non‐board‐serving CFOs becomes more negative when compared to board‐serving CFOs and the firm's CEO, and non‐board‐serving CFO firms disclose bad news earlier and report more conservatively. Results are stronger for firms incorporated in Delaware. Our findings suggest that CFOs respond to personal litigation risk over and above corporate litigation risk.     

Nonaudit Services and Earnings Management: UK Evidence*

Using a sample of UK firms for the period 1996‐98, we provide empirical evidence on the relation between nonaudit services (NAS) purchase and three proxies for earnings management: (1) the likelihood that client firm accounting practices during the sample period were publicly criticized or subject to regulatory investigation; (2) the likelihood that client firms were required to restate prior financial statements or adjust current year results upon adoption of Financial Reporting Standard (FRS) No. 12, which was intended to curb opportunistic use of provisions; and (3) the mean absolute value of client discretionary working capital accruals over the sample period. The level of NAS purchase is measured, alternatively, as (1) the ratio of nonaudit to total auditor fees, (2) the natural log of NAS fees, and (3) the decile rank of a particular client's NAS fees given all NAS fees received by the audit firm practice office. With one exception, we find that all three measures of earnings management are positively and significantly associated with the three measures of NAS purchase.     

Nonaudit Services and Earnings Conservatism: Is Auditor Independence Impaired?*

We examine whether the provision of nonaudit services (NAS) by incumbent auditors is associated with a reduction in the extent to which earnings reflect bad news on a timely basis (that is, news‐based conservatism). Reduced conservatism is expected to occur if relatively high levels of NAS result in reduced auditor independence and, ultimately, lower‐quality auditing. Because client‐specific demand for NAS is expected to vary, our proxy for the auditor‐client economic bond is the extent to which NAS purchases (relative to audit fees) are greater or less than expected. Using several different methods for identifying news‐based conservatism, we consistently find that higher than expected levels of NAS are not associated with reduced conservatism. This result is robust to allowing for endogenous NAS demand, as well as several explicit factors that may be associated with differences in conservatism. Similar conclusions arise from tests that use alternative measures of the economic bond between auditors and their clients, as well as in tests confined to either the Big 6 or non‐Big 6 audit firms. Our results are consistent with factors such as market‐based incentives, the threat of litigation, and alternative governance mechanisms offsetting any expected benefits to the audit firm from reducing its independence. We therefore conclude that recent legislative intervention aimed at restricting the supply of NAS is unlikely to result in increased independence in fact, although independence in appearance may be improved.     

Making Sense of One Dollar CEO Salaries

We examine the determinants and outcomes of Chief Executive Officers (CEOs) accepting a $1 salary, a compensation practice that occurs relatively frequently in high‐profile firms and is debated by regulators, investors, and the media. Using a hand‐collected sample of 93 CEOs from 91 firms between 1993 and 2011, we examine the triggers preceding the $1 salary decision, the factors associated with the decision, subsequent stock returns, and the outcomes for the CEOs. Our evidence is consistent with two explanations for the phenomenon: (i) it is a gesture of sacrifice by CEOs of firms in crisis, and (ii) it is a signal of better future performance by CEOs of growing firms. Our analyses highlight the two different circumstances and shed light on an interesting debate that has thus far been supported only by anecdotal evidence.     

Role of Institutional Quality in Determining the R＆D Investment of Chinese Firms

This study adds to the understanding of China ＂s innovation prospects by examining how variations in institutional quality within China impact on the R ＆D efforts of firms located in different provincial regions. In the process of identifying the effect of institutional quality, the roles of other factors such as ownership types and market structures are revealed, which provides interesting insight into firms ＂ R＆D behavior. The key findings suggest that institutional quality positively affects the decision offirms to engage in R＆D activities. Once firms start to engage in R ＆D, the subsequent expansion of firm-level R ＆D intensity depends on factors such as market structure. Therefore, strengthening domestic institutional quality is the first critical step towards the goal of building a knowledge-intensive economy in China. Efforts to nurture market development are also important for achieving this goal.     

Remote markets as shelters for local distortions: Evidence from China

We study how the presence of state-owned enterprises (SOEs) distorts private firms' decision on interprovincial sales in China. Using data from World Bank Investment Climate Survey and Annual Survey of Manufacturing Firms in China, we find evidence that the prevalence of SOEs in a city-industry where private firms reside will affect these firms' decision on the allocation of sales between interprovincial markets versus adjacent market. The direction of the effect on private firms, however, depends crucially on the private firms' access to credit. Specifically, the prevalence of SOEs leads to a higher propensity to sell to remote markets for firms with adequate financial access, whereas the opposite is true for firms who are credit constrained. We build a parsimonious model which links political/market distortion, market access, and credit constraint to explain these patterns, and argue that remote markets can serve as shelters for local distortions resulted from SOEs presence for some private firms.     

Debt Covenant Violations,Firm Financial Distress,and Auditor Actions

We conduct a comprehensive study on the associations between debt covenant violations (“violations”) and auditor actions for financially distressed and nondistressed firms. Our study is motivated by a lack of research on the consequences of violations resulting from auditors' actions. We find that firms with violations have significantly higher audit fees, a greater likelihood of receiving a going‐concern opinion, and a greater likelihood of experiencing an auditor resignation. Importantly, the positive associations hold for all types of firms, including financially nondistressed firms. In fact, we find that, after controlling for other financial information, the relation between violations and an increased likelihood of a going‐concern opinion is stronger for nondistressed versus distressed firms. Our evidence is consistent with belief‐revision research in auditing that finds auditors react more strongly to information that is inconsistent with their prior beliefs. This study provides further evidence on the indirect yet significant consequences of covenant violations on firms resulting from auditor actions.     

Words and Numbers: Financialization and Accounting Standard Setting in the United Kingdom

How is it possible that British policymakers resisted market‐based measurement for decades while financial economic concepts of decision making and valuation still gained widespread acceptance as a justification for accounting standard setting? This study introduces the concept of “technologies of financialization” to develop the theorizing of the rise of finance in the domain of accounting. Based on a genealogical history of narrative reporting in the United Kingdom, it demonstrates how references to qualitative reporting techniques helped to address recurring crises of measurement from 1969 to 1993, and ultimately contributed to the practical acceptance of market‐based measurement in the UK standard‐setting context. The data are interpreted through a cultural economy framework that directs attention to the power of referring to financial reporting as a combination of words and numbers in sustaining its theoretical redefinition “from below”—that is, by relating it to the experience of practicing accountants rather than accounting theory. As a technology of financialization, narrative reporting made financial economic ideals of market‐based measurement, decision usefulness, and future orientation appear operable in a real‐life reporting context. Whenever measurement reached its practical limits, narratives were relied on to explain the impact of price‐level changes, frame economic decisions, and relate unobservable future cash flows to present‐day strategies and resources. The insight into how narrative reporting practices have been laced into the reasoning of capital markets for over 40 years is timely because it illustrates that narratives can also play a more encompassing role and drive the turn toward wider corporate accountability on social and environmental impacts while hard measurements in this area are still being figured out.     

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.     

Powerful Chief Executive Officers and Firm Performance: Integrating Agency and Stewardship Theory

Do agency and stewardship behaviors coexist at firms, or does one dominate the other? We use data from listed companies in China over the period 2007–2016 to show that powerful chief executive officers (CEOs) simultaneously incur self‐interested agency costs while acting as stewards to benefit the firm. In balancing the push‐and‐pull forces of stewardship and agency behaviors, powerful CEOs in Chinese firms ultimately improve short‐term and long‐term firm performance. Our results have important implications for understanding how CEOs affect firms and how cultural factors can motivate CEOs to work in the interest of the firm.     

The Impact of R&D Intensity on Demand for Specialist Auditor Services*

The audit fee research literature argues that auditors' costs of developing brand name reputations, including top‐tier designation and recognition for industry specialization, are compensated through audit fee premiums. Audited firms reduce agency costs by engaging high‐quality auditors who monitor the levels and reporting of discretionary expenditures and accruals. In this study we examine whether specialist auditor choice is associated with a particular discretionary expenditure ‐ research and development (R&D). For a large sample of U.S. companies from a range of industries, we find strong evidence that R&D intensity is positively associated with firms' choices of auditors who specialize in auditing R&D contracts. Additionally, we find that R&D intensive firms tend to appoint top‐tier auditors. We use simultaneous equations to control for interrelationships between dependent variables in addition to single‐equation ordinary least squares (OLS) and logistic regression models. Our results are particularly strong in tests using samples of small firms whose auditor choice is not constrained by the need to appoint a top‐tier auditor to ensure the auditor's financial independence from the client.     

Land costs,government intervention,and migration of firms: The case of China

By using unique firm relocation data in China, we first document the relocation behavior of Chinese firms and show that less government intervention (relative to market forces) can improve economic efficiency by facilitating industrial relocation which saves on costs. Ever since China joined the World Trade Organization (WTO) in 2001, investments have poured into the coastal region, which in turn, have almost tripled land costs in the major coastal cities. We exploit this land cost shock in the early 2000s to identify its effect on the relocation behavior of firms. Specifically, we instrument land price growth with the access of a city to foreign markets (approximated by distance to Shanghai), and then estimate the differential impact of land costs on firms regarding land reliance. Our major findings are as follows: (1) the migration rate of Chinese firms in China is on average 3.2%, (2) Rising land costs drive firms to migrate, and firms that use more land-intensive technology are more compelled to migrate, and (3) in regions where the local government intervention is stronger (the market is less developed), the relocation decision of Chinese firms is distorted in the sense that firms are less likely to relocate despite surging land prices due to government intervention.