The effects of precedents and client position on auditors' financial accounting policy judgment

This paper investigates whether precedents (content, perceived similarity, and source) and the client's preferred accounting policy affects audit partner and manager financial accounting policy judgments. The research employs a combination of an experiment with an analysis of archival data. The experimental results show clear support for precedent content and perceived precedent similarity affecting auditor judgment. The archival data analysis suggests that precedent source and client position may indirectly affect auditor judgment through the precedent generation process. Implications of these findings are discussed.     

The relative effectiveness of persuasion tactics in auditor–client negotiations

In this study, we examine the effectiveness of four persuasive arguments that auditors may use to convince clients to accept their desired position in auditor–client negotiations. In addition, we investigate how the style in which the argument is communicated by the auditor impacts its effectiveness. Our results indicate that the type of persuasion tactic used by auditors significantly impacts the amount of concessions made by clients. Specifically, we find that, while threatening to qualify the audit opinion can result in significant client concessions, a tactic of simply informing the client that other companies have handled the accounting issue in a way consistent with the auditor’s preference is as effective, or more effective, than all of the other tactics examined at eliciting significant concessions as well as engendering positive affect toward the auditor. This result is consistent with findings from the persuasion literature relating to the pervasive power of social validation. We also find that clients offer more concessions, evaluate the auditor more positively, and are more satisfied with the negotiation outcome when auditors communicate their arguments using a cooperative, as opposed to a contentious, communication style. The results of this study indicate that auditors may benefit from training in persuasion tactics in order to achieve more desirable negotiation outcomes.     

The Effects of Business Risk on Audit Pricing

This paper examines the pricing of business risk by homogeneous auditors in a two period model. Incumbent auditors learn the client's business risk type during the course of the engagement. They subsequently compete in prices with prospective auditors. In such an environment, we show that equilibrium audit fees do not fully reflect the cost of business risk. Moreover, there exists differential auditor turnover between high and low risk firms; cross-subsidization of the audit fees of high risk firms by low risk firms; and low-balling by auditors.     

Some Implications of Auditor and Client Lobbying Activities: A Comparative Analysis

This paper examines the degree to which auditor and client lobbying is related in a UK context. This may help to identify any linkage between the wealth of clients and auditors that is affected by accounting standards, as propounded in the ‘economic consequences’ literature. It also might have some implications for the independence question. Three tests are conducted to see if auditors tend to support the lobbying position of the majority, or the most financially influential, of their clients. The third test is also used to identify any evidence that the comments of smaller clients tend to follow the lead of their audit firms/professional advisors. Auditor and corporate client written submissions on 22 proposed accounting standards are included in the study. The analyses are conducted both at an aggregated and also at a disaggregated level. The results do not indicate that auditor and client collusion took place. In particular, the results are consistent with the view that auditors are independent of their clients. Some suggestions are made for further research.     

Auditor Lobbying for Accounting Standards: The Case of Banks and Savings and Loan Associations

This study examines auditor lobbying on seven proposed US accounting standards which affect banks and savings and loan associations. Evidence is provided in support of the Watts and Zimmerman (1982, 1986) theory on auditor lobbying. Watts and Zimmerman (WZ) hypothesise that auditor lobbying is a function of the client-manager position and a set of wealth effect variables. These variables may provide an incentive for auditors to disagree with their clients on proposed accounting issues. The WZ model is modified by including an audit risk variable. Results show that the model is statistically significant and that the identified wealth and audit risk effects are significant explanatory variables of auditor lobbying behaviour.     

Auditor objectivity as a function of auditor negotiation self-efficacy beliefs

This study empirically examines whether an auditor's perceived ability to negotiate discretionary accounting issues with clients (auditor negotiation self-efficacy) is related to auditor objectivity, and whether an auditor's negotiation self-efficacy has a greater impact on her objectivity when the auditor's accuracy motive (professional identity) is strong rather than weak. We tested the hypotheses using a cross-sectional survey design and obtained 146 responses from among 800 surveyed experienced Swedish auditors. The findings indicate that auditors with higher negotiation self-efficacy were more likely to make decisions on a material and discretionary accounting issue contrary to their clients' desires compared to auditors with lower self-efficacy. The relationship between negotiation self-efficacy and auditor objectivity was not moderated by professional-identity strength. These research findings suggest that recruiting and training auditors to increase their negotiation self-efficacy may be an effective method to enhance auditor objectivity without the problems inherent in other methods, such as auditor rotation. Our sample was obtained in Sweden, which allows long auditor tenures. We caution that, although our analysis controlled for auditor tenure, the effect of auditor negotiation self-efficacy may not be generalizable to countries that limit tenure through regulation.     

The effects of trust, client importance, and goal commitment on auditors' acceptance of client-preferred methods

The purpose of this study is to extend our understanding of the factors that impact auditor judgment and decision-making. Specifically, we investigate how two factors, client importance and auditor trust, impact auditors' directional goal commitment and decision-making at the transaction level. We find no impact of client importance on the auditors' goal commitment or acceptance of a client preferred accounting treatment. However, we find that trust in client's management is positively related to the commitment to the goal of supporting the client's preferred method of recognizing revenue. Further, we find that auditors' goal commitment is positively related to their acceptance of a client preferred accounting treatment.     

Hypothesis revision strategies in conducting analytical procedures

A number of accounting tasks require an evaluation of competing hypotheses. For instance, a management accountant considers alternative reasons for a significant standard cost variance while an auditor must determine whether an unexpected fluctuation in a client's account balance was caused by an error, irregularity or a change in economic conditions. In spite of the prevalence of hypothesis evaluation in practice, little is known about the process. In this paper we provide evidence on two issues that could compromise effective and efficient hypothesis evaluation: (1) the revision of beliefs over competing hypotheses given diagnostic evidence; and (2) whether an eliminated hypothesis is subsequently resuscitated (i.e. reconsidered as plausible). To address these issues, 55 auditors were provided audit test results and were asked to evaluate five potential hypotheses that may have caused a material fluctuation in the gross margin ratio of a client. The findings indicate that, when presented with diagnostic evidence about a target hypothesis, auditors were prone to adjusting the likelihood of the target hypothesis but not revising the likelihoods of the competing hypotheses. This non-Bayesian revision strategy, which we label the “one-hypothesis syndrome”, appears to represent a trade-off reflecting competing forces of cognitive strain, efficiency and accountability. While our preliminary results indicate high performance (in identifying the actual cause), additional research in less controlled settings is needed to fully evaluate the effect of this trade-off on efficiency and effectiveness. Finally, contrary to anecdotal evidence from an SEC release, auditors were reluctant to eliminate hypotheses and those who did, did not regard their eliminations as permanent.     

THE IMPACT OF THE FINANCIAL REPORTING REVIEW PANEL ON ASPECTS OF THE INDEPENDENCE OF AUDITORS AND THEIR ATTITUDES TO COMPLIANCE IN THE UK

The UK Financial Reporting Review Panel (FRRP) enforces the regulatory framework for larger companies and requires companies to restate non-compliant accounts. It is authorized to deal with directors but not auditors. Recent UK based research indicates a belief that the FRRP's activities have enhanced auditor independence and changed attitudes to accounting compliance. Defective accounts indicate a lack of audit quality as the auditor must have failed to detect and/or prevent the deficiency. By analysis of fifteen semi-structured interviews with finance directors and audit firm partners with experience of an FRRP inquiry, and by review of publicly available information, the impact of the FRRP on some aspects of audit quality is sought. The FRRP is found to have motivated auditors to improve accounting compliance by increasing the possibility of some errors being exposed. It is also found to have enhanced the independence of auditors at the pre-conventional level of ethical cognition as identified by Ponemon and Gabhart (1990), by changing the cost-benefit for auditors of permitting non-compliance. FRRP inquiries cause auditors to incur non-recoverable costs, can undermine the auditor–client relationship and increase the risk of client loss. Personal embarrassment, possible career damage and the risk of an ICAEW disciplinary inquiry arise for the audit partner. The FRRP is found to provide auditors with an additional negotiating tool in dealing with directors, thus making in easier for auditors at the conventional and post conventional level of ethical cognition to prevent non-compliance. Direct evidence is, therefore, found that the FRRP's activities have provided incentives for all auditors to focus more on accounting compliance (at least for items visible from an inspection of the accounts) and have provided incentives and mechanisms for auditors at lower levels of ethical cognition to be independent.     

Auditor liability: A comparison of judge and juror verdicts

This research examines differences between judges and jurors in rendering liability judgments in auditor litigation cases. While any number of case contexts would allow us to contrast and compare judges and jurors, we chose one that we believed would also address a second timely issue, auditor reliance or non-reliance upon the work of others. Within the general context of litigation of an alleged audit failure, we manipulated, between-participants, external auditor reliance on the work of others (relied on outsourced work, relied on in-house internal auditors’ work or did not rely). Our results show differences in the liability assessments of judges and jurors. Judges assign more liability to auditors that rely on the work of in-house internal auditors, less liability to auditors that rely on outsourced internal auditors and the least liability to auditors that choose not to rely on the work of internal auditors (but re-perform the work themselves) while jurors assess higher liability regardless of the work done by the auditors. Mediation analyses suggests the differences found in the overall liability assessments of jurors and judges are partially driven by their divergent attitudes towards the public accounting profession with jurors’ unfavorable attitudes leading to them assign liability regardless of the work performed. Further analysis suggests juror insensitivity to our reliance manipulations may reflect a strict liability perspective (consistent with prior work by Charron and Lowe (2008)); while judges consider other factors when making liability assessments.     

Strategic Auditor Behavior and Going-Concern Decisions

This paper analyzes a game-theoretic model in which a client can potentially avoid a going-concern opinion and its self-fulfilling prophecy by switching auditors. Incumbent auditors are less willing to express a going-concern opinion the more credible the client's threat of dismissal and the stronger the self-fulfilling prophecy effect. Similarly, the client is more willing to switch auditors the more likely it is that auditors' reporting judgments will differ and the stronger the self-fulfilling prophecy effect. Further, with greater noise in the auditor's forecast of client viability, the auditor tends to express fewer going-concern opinions.     

Substance over form in auditing and the auditor's position of public trust

Auditors are placed by society in a special position of public trust. In their public role auditors are required to base their opinions on the substance rather than the form of the transactions underlying accounting numbers. An argument using the economics of trust (implicit contract theory) is constructed to show why it is required by society that auditors opine on substance. Forces exist, however, that deflect the auditor from fulfilling his or her public role into a “rule-dominated” practice in which substance is neglected. An empirical study confirms that auditors neglect substance and perceive little exposure to litigation in doing so. It is concluded that if auditors continue on their current path, their legitimacy before society will eventually erode to nothing.     

The Impact of Audit Quality Indicators on the Timeliness of Goodwill Impairments: Evidence from the German Setting

This study investigates whether goodwill impairments are perceived as timely and whether specific auditor characteristics affect the perceived timeliness. It therefore contributes to central questions in accounting research: is managerial discretion over accounting numbers (accounting choice) good or bad for stakeholders and does audit quality have an impact on this relationship? It is motivated by the IASB's post-implementation review on business combinations and the Goodwill and Impairment project based on it, the ongoing debate on the decision usefulness of impairment testing, and the question whether auditors have an impact on firms’ reporting of impairment losses. Based on a sample of German listed firms for the period 2006 to 2013, the results indicate that goodwill impairments are not recognized in a timely manner and delayed by at least one to two years. Moreover, the findings suggest that the recognition of impairment losses is influenced by auditor characteristics. In particular, firms seem to report goodwill impairments in a more timely fashion when they are audited by a Big 4 auditor, whereas the timeliness seems to decrease with a higher non-audit fee ratio and a longer auditor tenure. Moreover, additional analyses indicate that higher audit fees lead to more timely impairments.     

The influence of judges' attitudes on liability assessments related to failed audits exhibiting significant audit team over-time or significant use of off-shore auditors

This study provides evidence on how audit firms' decisions to use offshore (outsourced) auditors or to assign on-site (local) auditors extensive overtime affect judges' evaluation of auditor legal liability I conduct a behavioral experiment in which actual judges responded to a hypothetical audit lawsuit. The results suggest auditors may be penalized during the litigation process depending on the extent of overtime or off-shoring and judges' attitude toward the public accounting profession. Judges with a positive attitude toward public accounting assessed more liability for an audit firm that used offshore (outsourced) auditors than for the use of extensive overtime for on-site auditors or a control condition. However, judges with a negative attitude toward the auditing profession assessed higher liability for auditors except when on-site auditors bore significant overtime in the final weeks of the audit.     

Common auditors and internal control similarity: Evidence from China

This study investigates how important common auditors are to internal control similarity between two firms. Based on a less concentrated audit market in China, we find that firm-pairs with common auditors enforce a similar internal control system. This inference holds after accounting for other social connections, examining internal control components, using alternative measures of internal control, adopting finer industry classifications, constructing alternative internal control similarity, running auditor switch tests, and addressing endogeneity problems. Additional analyses indicate that auditor style and information sharing serve two underlying mechanisms to undergird the documented relationship. Finally, our evidence suggests that high-centrality firms in auditor networks are associated with better financial reporting.     

The Impact of Consulting Services on Audit Quality: An Experimental Approach

We use experimental markets to examine whether providing consulting services to a non‐audit client impacts audit quality. Our paper directly addresses concerns raised by the Public Company Accounting Oversight Board that the largest public accounting firms’ growth in their consulting practices threatens audit quality. We conduct an experiment proposed using a registration‐based editorial process. We compare a baseline where the auditor does not provide consulting services to conditions where auditors provide consulting to audit clients or where auditors only provide consulting services to non‐audit clients. Our unique design provides evidence on whether providing consulting to non‐audit clients strengthens the salience of a client‐cooperative social norm that reduces audit quality. We do not find differences in audit quality by condition in our planned analysis, however we find greater variation in audit quality in the conditions where auditors provide consulting services compared to the baseline. In unplanned analyses, our results suggest providing consulting services increases auditor cooperation with managers, increasing audit quality when managers prefer high audit quality and decreasing audit quality when managers prefer low audit quality.     

The effect of mandatory auditor assignment and non-audit service on audit fees: Evidence from Korea

In Korea, regulators could assign auditors to firms. We investigate the relationship among audit fees, mandatory auditor assignment, and the joint provision of non-audit and auditor services in Korea. We find that assigned auditors charge significantly higher audit fees than freely selected auditors. We also find that the joint provision of non-audit and audit services does intensify the relation between auditor assignment and audit fees. Combined with the results of other studies that have shown that firms audited by assigned auditors report smaller amounts of discretionary accruals than firms audited by freely selected auditors, our results suggest the possibility that mandatory auditor assignment may improve auditor independence.     

Auditor litigation: Evidence that revenue restatements are determinative

This study extends the Palmrose and Scholz (2004) general litigation and general restatements study by focusing on auditor litigation and revenue restatements. We investigate all potential accounting issues, individually, instead of by their group method, with regard to auditor litigation. The impact of the individual accounting issues implicated in restatements is of concern to auditors and audit standard setters in gauging auditor litigation risk and audit risk. It also is important for financial analysis and securities valuation because investors' losses are greater, and recovery of losses on a percentage basis is lower, when the auditor is a defendant, and especially when the auditor has a more severe, negative litigation experience (Commolli et al., 2012). We examine financial reporting lawsuits filed from 2001 to 2008 and find that revenue restatements—far more than any other kind of restatements—are associated with auditors being named defendants and also auditors experiencing a more severe, negative outcome in the litigation.     

Determinants and consequences of voluntary switches to Chinese auditors in Hong Kong

Hong Kong market regulators have permitted 12 large Chinese accounting firms to audit the financial statements of Chinese firms that cross list in Hong Kong (i.e., H-share firms) since 2010. This paper examines the characteristics of H-share firms that voluntarily replaced their Hong Kong (HK) auditors with Chinese auditors, and the market reaction to auditor switches following this policy. We find that 38 out of 147 H-share firms voluntarily switched to Chinese auditors during 2011–2013. Switching firms are larger in size and are less likely to use Big4; they also have less need for external financing, a longer cross listing history, and a lower percentage of foreign revenue. We also find that investors negatively react to the auditor switches from HK non-Big4 to China non-Big4, but do not react to the auditor switches from HK Big4 to China Big4. This suggests that investors perceived lower audit quality for China non-Big4.     

Note on Self‐Selection of Auditors in the Municipal Sector*

The objective of this article is to revisit the literature on Big‐N audit fee premiums in the municipal setting using a methodology that controls for self‐selection bias. Because auditor choices can be predicted based on certain client characteristics, using standard one‐stage ordinary least squares regressions to draw inferences about the presence or absence of such a premium in the extant public‐sector audit fee studies may not be appropriate. Results indicate that, after controlling for a self‐selection bias, Big‐6 (non‐Big‐6) municipal clients on average pay a fee premium, compared to the case if they were to retain a non‐Big‐6 (Big‐6) auditor. Results continue to hold when we conduct further analyses on a subset of municipalities with access to both Big‐6 and non‐Big‐6 auditors in a local market defined by a 60‐km radius, rather than over a province‐wide audit market. The existence of non‐Big‐6 audit fee premiums has not been documented previously in the private‐ or public‐sector audit fee literature. We surmise that it may be caused by the dominance (79.4 percent) of non‐Big‐6 auditors in the Ontario municipal market, compared to most private‐sector audit markets where their market share generally does not exceed 20 percent. The strong market position of non‐Big‐6 firms in turn may have allowed these auditors to command a fee premium for the subset of municipalities that self‐selects to be audited by them. An implication from our study is that Ontario municipalities often choose to be audited by more costly auditors, even though they could have paid lower audit fees by switching to an alternative auditor type. These results do not support those reported by Chaney et al. (2004) , who find that U.K. private firms are audited by the least costly auditor type. The conflicting findings may be attributable to the fact that the Ontario municipal audit market is subject to regulation by not just the audit profession but also the Ontario government and that, unlike business corporations, municipalities receive funding from provincial governments to fulfil much of their financial requirements. Thus, municipal clients may be relatively more willing to accept higher audit fees provided their chosen auditor (or auditor type) matches their needs.