Who Cares about Auditor Reputation?*

I provide evidence on the demand for auditor reputation by examining the defections of Arthur Andersen LLP's clients following the accounting scandals and criminal conviction marring the auditor's reputation in 2002. About 95 percent of clients in my sample did not switch auditors until after Andersen was indicted for criminal misconduct regarding its failed audit of Enron Corp. I test whether the timing of client defections and the choice of a new auditor are consistent with managers' incentives to mitigate potentially costly information and agency problems. I find that clients defected sooner, mostly to another Big 5 auditor, if they were more visible in the capital markets; such clients attracted more analysts and press coverage, had larger institutional ownership and share turnover, and raised more cash in recent security issues. However, my proxies for agency conflicts — managerial ownership and financial leverage — are not associated with the timing of defections or the choice of new auditor. Overall, my study suggests that firms more visible in the capital markets tend to be more concerned about engaging highly reputable auditors, consistent with such firms trying to build and preserve their own reputations for credible financial reporting.     

Did Houston Clients of Arthur Andersen Recognize Publicly Available Bad News in a Timely Fashion?*

Despite the allegations of audit failure and the enormous publicity surrounding Arthur Andersen's indictment, there is no systematic empirical evidence on characteristics of accounting information of clients of Arthur Andersen vis‐à‐vis other Big 6 auditors. I examine whether earnings of Andersen's Houston‐based clients are timely in reporting bad news about future cash flows. I find that relative to a control group consisting of Houston‐based clients audited by other Big 6 auditors, earnings of Andersen clients are less timely in reporting bad news. Further, it appears that operating accruals of Andersen clients are less effective in accelerating the timely recognition of bad news than operating accruals of non‐Andersen clients. The findings suggest that the clients of Andersen's Houston office engaged in aggressive accounting practices, including delayed recognition of publicly available bad news.     

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.     

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.     

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.     

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.     

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.     

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

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

When Are Audit Firms Sued for Financial Reporting Failures and What Are the Lawsuit Outcomes?

We examine how often audit firms are sued in a large sample of accounting lawsuits that allege financial reporting failures. We find an insignificant relation between the likelihood of auditor litigation and restatements, but the likelihood of auditor litigation is strongly related to the types of alleged accounting deficiencies. We also find that the auditor's type influences the probability of the auditor being sued and the size of the payouts from auditor and nonauditor defendants. In particular, the Big N firms are approximately 7 percent less likely than non–Big N firms to be named as co-defendants, and the auditor's contribution to the plaintiff's payout is significantly larger when a Big N firm is sued. Overall, our findings suggest that auditors are rarely blamed when there are allegations of financial reporting failures, but the types of accounting deficiencies and the auditor's type significantly influence the probability of the audit firm being sued and the outcomes of the lawsuits.     

Do Investors Care about the Auditor's Economic Dependence on the Client?*

In this study, we investigate whether investor perceptions of the financial reporting credibility of Big 5 audits are related to the auditor's economic dependence on the client as measured by nonaudit as well as total (audit and nonaudit) fees paid to the incumbent auditor. We use the client‐specific ex ante cost of equity capital as a proxy for investor perceptions of financial reporting credibility and examine auditor fees both as a proportion of the revenues of the audit firm and as a proportion of the revenues of the audit firm's practice office through which the audit was conducted. Our findings suggest that both nonaudit and total fees are perceived negatively by investors' that is, the higher the fees paid to the auditor, the greater the implied threat to auditor independence, and the lower the financial reporting credibility of a Big 5 audit. Furthermore, our findings appear to be largely unrelated to corporate governance: investors do not perceive the auditor as compensating for weak governance. Separately, recent anecdotal evidence suggests that declining revenues from nonaudit services' as a result of recent regulatory restrictions” are being offset by substantial increases in audit fees. Other things being equal, rising audit fees imply higher profit margins for audit services, indicating that the audit function may no longer be a loss leader. Thus, to the extent that investors perceive total fees negatively, recent regulatory initiatives to limit nonaudit fees may not have adequately addressed the perceived, if not the actual, threat to auditor independence posed by fees.     

审计师行业专长、客户重要性与审计质量

本文以中国上市公司2006--2009年数据为样本,检验了审计师行业专长、客户重要性对审计质量的影响以及审计师行业专长对审计质量的影响是否受制于客户重要性。研究结果发现,总体而言,审计师行业专长能够抑制客户的盈余管理行为,提高审计质量,审计师对客户的经济依赖性并不会影响到独立审计判断。但行业专长审计师只针对大客户提供高质量审计服务,而对小客户这种效应则并未体现,这是具有行业专长审计师基于中国审计市场环境作出的最优选择。进一步研究发现,上述研究结论仅存在于“十大”样本组中。     

Did the 1998 Merger of Price Waterhouse and Coopers & Lybrand Increase Audit Quality?

We examine the effects of the 1998 merger of Price Waterhouse (PW) and Coopers & Lybrand (CL) on the audit quality of the merged firm PricewaterhouseCoopers (PwC) at both the firm and office levels, where audit quality is surrogated by the auditor's propensity to issue a going‐concern opinion, clients’ likelihood of meeting or beating analysts’ earnings forecasts, and clients’ accrual quality. At the firm level, we find that the merger increased audit quality for PwC relative to the audit quality of the other Big N firms. At the office level, our findings, albeit mixed, collectively suggest that the improvement in firm‐level audit quality was likely driven by the improvement in audit quality at PwC's overlapping offices, that is, offices in cities where both PW and CL had separate offices prior to the merger. Further, our findings suggest that although the PW/CL merger increased auditor concentration in local audit markets with PwC overlapping offices, the merger improved (rather than hurt) audit quality in those markets. Overall, our study contributes to the extant sparse literature on the effect of Big N mergers on audit quality, and is of potential interest to regulators.     

Awareness of SEC Enforcement and Auditor Reporting Decisions

We find that non‐Big 4 audit offices with greater awareness of SEC enforcement are more likely to issue first‐time going‐concern reports to distressed clients; where SEC “awareness” is measured using (i) audit office proximity to SEC regional offices, and (ii) proximity to specific SEC enforcement actions against auditors. We also show that these non‐Big 4 audit offices issue more going‐concern opinions to clients who do not subsequently fail, indicating a conservative bias that reduces the informativeness of audit reports. This conservative reporting bias is also associated with higher audit fees and higher auditor switching rates. These findings are important because non‐Big 4 firms now audit 39 percent of SEC registrants and issue 88 percent of going‐concern audit reports. For Big 4 offices, we find some evidence that awareness of SEC enforcement may improve reporting accuracy by reducing Type II errors (failing to issue a going‐concern report to a company that fails), although the number of cases is small.     

Independence in Appearance and in Fact: An Experimental Investigation*

In this study, we use experimental markets to assess the effect of the Security and Exchange Commission's (SEC's) new independence rule on investors' perceptions of independence, investors' payoff distributions, and market prices. The new rule requires client firms to disclose in their annual proxy statements the amount of nonaudit fees paid to their auditors. The new disclosure is intended to inform investors of auditors' incentives to compromise their independence. Our experimental design is a 2 3 between‐subjects design, where we control the presence (unbiased reports) or absence of auditor independence in fact (biased reports). While independence in fact was not immediately observable to investors, we controlled for independence in appearance by varying the public disclosure of the extent of nonaudit services provided by the auditor to the client. In one market setting, investors were not given any information about whether the auditor provided such nonaudit services; in a second setting, investors were explicitly informed that the auditor did not provide any non‐audit services; and in a third setting, investors were told that the auditor provided nonaudit services that could be perceived to have an adverse effect on independence in fact. We found that disclosures of nonaudit services reduced the accuracy of investors' beliefs of auditors' independence in fact when independence in appearance was inconsistent with independence in fact. This then caused prices of assets to deviate more from their economic predictions (lower market efficiency) in the inconsistent settings relative to the no‐disclosure and consistent settings. Thus, disclosures of fees for nonaudit services could reduce the efficiency of capital markets if such disclosures result in investors forming inaccurate beliefs of auditor independence in fact ‐ that is, auditors appear independent but they are not independent in fact, or vice versa. The latter is the maintained position of the American Institute of Certified Public Accountants (AICPA), which argued against the new rule. Further research is needed to assess the degree of correspondence between independence in fact and independence in appearance.     

The Effect of Joint Auditor Pair Composition on Audit Quality: Evidence from Impairment Tests

Using a sample of firms from France, where the law requires the use of two auditors, we study the effect of auditor pair composition on audit quality by examining a specific account, goodwill impairment. We document that firms audited by a Big 4–non‐Big 4 auditor pair (BS) are more likely to book an impairment and book a larger impairment than firms audited by a Big 4–Big 4 auditor pair (BB) when low‐performance indicators suggest a greater likelihood of impairment. Moreover, firms audited by a BB pair reduce impairment disclosures when they book impairments, while firms audited by a BS pair do not, suggesting lower transparency for firms audited by a BB pair. Our results inform investors and firms in mandatory joint audit regimes, as well as regulators who are considering requiring joint audits.     

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

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

Board Characteristics and Audit Fees*

This paper examines the relations between three board characteristics (independence, diligence, and expertise) and Big 6 audit fees for Fortune 1000 companies. To protect its reputation capital, avoid legal liability, and promote shareholder interests, a more independent, diligent, and expert board may demand differentially higher audit quality (greater assurance, which requires more audit work) than the Big 6 audit firms normally provide. The audit fee increases as the auditor's additional costs are passed on to the client, such that we expect positive relations between audit fees and the board characteristics examined. We find significant positive relations between audit fees and board independence, diligence, and expertise. The results persist when similar measures of audit committee “quality” are included in the model. The results add to the growing body of literature documenting relations between corporate governance mechanisms and various facets of the financial reporting and audit processes, as well as to our understanding of the determinants of audit fees.     

Auditor Choice and Its Implications for Group‐Affiliated Firms

We examine which of two opposing financial reporting incentives that group‐affiliated firms experience shapes their accounting transparency evident in auditor choice. In one direction, complex group structure and intragroup transactions enable controlling shareholders to pursue diversionary activities that they later hide by distorting reported earnings. In the other direction, as outside investors price‐protect against potential expropriation, controlling shareholders may be eager to improve financial reporting quality in order to alleviate agency costs. To empirically clarify whether group affiliation affects company insiders' incentives to address minority shareholders' concerns over agency costs, we examine auditor selection of group firms relative to stand‐alone firms. In comparison to nongroup firms, our evidence implies that group firms are more likely to appoint Top 10 audit firms in China, especially when their controlling shareholders have stronger incentives to improve external monitoring of the financial reporting process. After isolating group firms, we find that the presence of a Top 10 auditor translates into higher earnings and disclosure quality, higher valuation implications for related‐party transactions, and cheaper equity financing, implying that these firms benefit from engaging a high‐quality auditor. In additional analysis consistent with our predictions, we find that group firms that are Top 10 clients pay higher audit fees and their controlling shareholders are more constrained against meeting earnings benchmarks through intragroup transactions and siphoning corporate resources at the expense of minority investors. Collectively, our evidence supports the narrative that insiders in firms belonging to business groups weigh the costs and benefits stemming from auditor choice.     

PCAOB Inspections and the Differential Audit Quality Effect for Big 4 and Non–Big 4 US Auditors*

In this study, we investigate whether the increase in regulatory scrutiny epitomized by the initial PCAOB inspection impacted audit quality differentially for Big 4 and non–Big 4 auditors to better understand the consequences of PCAOB inspections for different audit firm types. Because of competing views on the effect of PCAOB inspections, the relation between PCAOB inspections and the audit quality differential between Big 4 and other auditors is an empirical issue. Empirically, we take the endogenous choice of auditor as a given and utilize a difference‐in‐differences specification that takes into account the staggered timing of the initial PCAOB inspection for different‐sized auditors in the United States. Our results suggest that the initial PCAOB inspection improved audit quality more for Big 4 auditors than for other annually inspected or triennially inspected non–Big 4 auditors. We also examine annually and triennially inspected non–Big 4 auditors separately, and find that the pre‐post Big 4/non–Big 4 differential audit quality effect is more pronounced for the triennially inspected non–Big 4 firms. In the larger context of the highly concentrated US audit market, our findings that PCAOB inspections accentuate the Big 4/non–Big 4 audit quality differential are of potential interest to public company audit clients contemplating an auditor change, investors interested in learning about the consequences of PCAOB inspections, regulators concerned about the Big 4 dominance of the US audit market, and academics investigating audit quality differences.     

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.