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Abstract:
This paper challenges the findings of Frankel, Johnson and Nelson (FJN) (2002). The results of our discretionary accruals tests differ from FJN's when we adjust discretionary current accruals for firm performance. In our earnings benchmark tests, in contrast to FJN we find no statistically significant association between firms meeting analyst forecasts and auditor fees. Our market reaction tests also provide different results than those reported by FJN. Overall, our study indicates that FJN's results are sensitive to research design choices, and we find no systematic evidence supporting their claim that auditors violate their independence as a result of clients purchasing relatively more nonaudit services.

independence, audit fees, discretionary accruals, biased financial reporting

Abstract:
This paper reports the results of experimental economic markets designed to examine whether an auditor's objectivity (independence) is impacted by uncertainty regarding the appropriate accounting treatment for a client. In particular, we are interested in whether the auditor exploits this uncertainty by agreeing with her client's preferred accounting treatment even when her evidence suggests an alternative treatment is more likely to be correct. We examine the effect of accounting uncertainty in a setting where the auditor not only wants to satisfy her client but also wants to maintain a reputation for audit objectivity in the market.

The results provide strong evidence that the level of accounting uncertainty impacts auditor independence. Specifically, when accounting uncertainty did not exist, auditors maintained their independence by truthfully reporting the observed value. Auditors appeared to remain independent due to concerns about their reputations with managers and investors. However, when accounting uncertainty existed, auditors impaired their independence by misreporting the observed value in favor of the manager. Our results specify some initial boundary conditions for the impact of auditor reputation and investor pricing on auditor independence, and suggest that regulators should focus on enhancing auditor incentives to maintain independence when faced with accounting uncertainty. It appears that regulators do not need to be as concerned about independence violations when accounting pronouncements provide unambiguous guidance. An auditor's concern about her reputation provides adequate incentive to prevent independence impairment when she is certain about the appropriate accounting treatment. Our results also suggest future research should assess the ability of other audit market forces to reduce the propensity of auditors to violate independence when faced with accounting uncertainty.

Abstract:
We examine the relation between audit firm industry specialization and client disclosure quality. Our motivation for conducting this research arises from the claims made by each of the Big5 public accounting firms that industry specialization enables each to provide superior service and quality to clients in its target industries.

We document a positive association between industry-specialized audit firms and analysts' rankings of disclosure quality in unregulated industries, but no relation in regulated industries. Alternative measures of auditor industry specialization support our conclusions. Our results suggest industry-specialized audit firms add value to clients in unregulated industries in the form of improved disclosure quality.

Abstract:
We describe related party (RP) transactions and investigate financial incentive and monitoring determinants for firms engaged in RP transactions. Our sample consists of 1,261 firms included in the S&P 1500. RP transactions are common in our sample, but vary substantially as to transaction type and disclosure. The most common RP transactions are loans, which are now largely prohibited by Section 402 of Sarbanes Oxley. Method of disclosure - financial statement footnote or proxy - appears largely driven by dollar-based materiality concerns. We also analyze two broad classes of determinants of RP transactions - financial incentives and monitoring. We find weaker corporate governance is associated with RP transactions, an inverse relationship between CEO and director's cash compensation and RP transactions, and a positive association between CEO stock options and RP transactions. However, director and officer ownership are not associated with RP transactions. Overall our results suggest associations between director and officer compensation, corporate governance and related party transactions.

related party, disclosure, governance

Abstract:
We examine related party (RP) transactions using agency and contracting theory as guides. Agency theory suggests opportunistic behavior can generate RP transactions; however, RP transactions can also result from or be managed via contracting. We therefore investigate associations between RP transactions and compensation-based incentives, monitoring mechanisms, and links to executive compensation for a sample of 1,261 firms. We find RP transactions are associated with weaker corporate governance, CEO stock options, and inversely associated with CEO and director's cash compensation. In a direct analysis of CEO compensation, we find a positive association between unexpected CEO compensation and RP transactions with companies the firm partially owns (i.e. investments) suggesting that CEO's are compensated for running more complex organizations. Finally, we examine returns in the period following RP disclosure. The results suggest lower future returns for simple RP transactions involving directors, officers and major shareholders. However, future returns are marginally higher for companies engaged in RP transaction with investments. Our compensation and returns analyses suggest related party transactions with investments appear to be associated with efficient contracting, while simple transactions with directors, officers and shareholders are associated with opportunism.

Related party, disclosure, governance

Abstract:
This paper examines IPO assurance fees to assess the use of industry specialization as a differentiation strategy by audit firms. Theory suggests that as an audit firm's share of a client industry increases their costs will decrease and their service quality to that industry will increase. In this setting, the impact of industry specialization on fees is indeterminate. We extend existing theory by considering both the supply and the demand for industry specialization. We conclude that the market for audit services is generally price-competitive, suggesting that auditors will be forced to share cost savings with clients. However, when an audit firm is able to differentiate its services from competitors it should be able to earn a modest premium. We test and find support for our conjectures using U.S. IPO audit fee data from 1991 to 1997.

industry specialization, economies of scale, strategy, audit fees, initial public offerings

Abstract:
This paper reports the results of experiments designed to examine whether investor selection of auditors enhances auditor independence. The experimental design enables us to explore the effect on independence of different institutional rules over who hires and fires the auditors and to directly measure independence violations. The results suggest that transferring the power to hire and fire the auditor from managers to investors significantly decreases the portion of independence violations. Additional analysis suggests that a reduction in independence violations increases the overall surplus generated in the markets examined.

Auditor independence, auditor objectivity, experimental economics

Abstract:
This paper reports the results of experiments designed to examine whether investor selection of auditors enhances auditor independence. The experimental design enables us to explore the effect on independence of different institutional rules over who hires and fires the auditors and to directly measure independence violations. The results suggest that transferring the power to hire and fire the auditor from managers to investors significantly decreases the portion of independence violations. Additional analysis suggests that a reduction in independence violations increases the overall surplus generated in the markets examined.

auditor independence, auditor objectivity, experimental economics

Abstract:
We use experimental economic markets to test the Datar, Feltham and Hughes (DFH) (1991) model of entrepreneur choice of auditor and retained ownership in initial public offering markets. The mixed evidence provided by prior research using archival data motivated our experimental approach. Experimental markets inherently exhibit considerably more control over the model's decision variables than do archival studies. This enables us to test whether the model adequately describes human behavior and examine the effect of an important decision variable cited by prior research.

Our results provide considerable support for the DFH model of entrepreneur behavior in treatments where investors are programmed to price consistent with the DFH equilibrium. We also found support in similar treatments for a modified DFH model that included the impact of client risk on auditor fees. However, the model was far less predictive of entrepreneur behavior in markets with human investors instead of programmed investors. The results suggest that human entrepreneurs and investors adapt to the choices each made within a particular market, such that less than half of the markets conformed to DFH's predictions while the rest followed an alternative equilibrium where only the entrepreneur's choice of auditor signaled firm value. Our results suggest that in signaling models like DFH, theorists should consider market environments and interactions that can lead to one equilibrium versus another.

Abstract:
We use experimental markets to examine stock-based compensation's impact on the objectivity of participants serving as audit committee members. We compare audit committee member reporting objectivity under three regimes: no stock-based compensation, stock-based compensation linked to current shareholders, and stock-based compensation linked to future shareholders. Our experiments show that student participants serving as audit committee members prefer biased reporting when compensated with stock-based compensation. Audit committee members compensated with current stock-based compensation prefer aggressive reporting, and audit committee members compensated with future stock-based compensation prefer overly conservative reporting. We find that audit committee members who do not receive stock-based compensation are the most objective. Our study suggests that stock-based compensation impacts audit committee member preferences for biased reporting, suggesting the need for additional research in this area.

Audit Committee, Stock Compensation, Independence

Abstract:
We examine competition for Andersen's public clients during and after its failure in 2002. This setting provides a natural experiment to examine audit market dynamics at the local level. We construct a database documenting Big4 purchases of local Andersen offices. After exploring the factors associated with office purchases, we examine the impact of office purchases on public client market share gains and changes in audit fees. We find that three Big4 firms - Deloitte, Ernst & Young, and KPMG - purchased approximately 60% of Andersen's offices while PricewaterhouseCoopers did not purchase any. The probability that a firm purchased a specific office is greater in markets where the acquiring firm: 1) already had a presence, 2) had a lower ratio of local Andersen clients to the purchaser's clients, and 3) had already acquired relatively more local former Andersen public clients than other firms prior to the purchase. Our fee analysis expands the United States Government Accountability Office (GAO) post-Andersen audit market study by documenting that the former Andersen clients' change in audit fees is associated with the differences in client acquisition method.

Andersen, market concentration, competitive strategy, audit

Abstract:
We examine competition for Andersen's public clients during and after its failure in 2002. This setting provides a natural experiment to examine audit market dynamics at the local level. We construct a database documenting Big4 purchases of local Andersen offices. After exploring the factors associated with office purchases, we examine the impact of office purchases on public client market share gains and changes in audit fees. We find that three Big4 firms - Deloitte, Ernst & Young, and KPMG - purchased approximately 60% of Andersen's offices while PricewaterhouseCoopers did not purchase any. The probability that a firm purchased a specific office is greater in markets where the acquiring firm: 1) already had a presence, 2) had a lower ratio of local Andersen clients to the purchaser's clients, and 3) had already acquired relatively more local former Andersen public clients than other firms prior to the purchase. Our fee analysis expands the United States Government Accountability Office (GAO) post-Andersen audit market study by documenting that the former Andersen clients' change in audit fees is associated with the differences in client acquisition method.

Andersen, market concentration, competitive strategy, audit

Abstract:
We examine the impact of an ethics education program on reporting behavior using two groups of students: 4th year Masters of Accounting students who just completed a newly-instituted ethics education program, and 5th year students in the same program who did not receive the ethics program. In an experiment providing both the opportunity and motivation to misreport for more money, we design two social condition treatments – anonymity and public disclosure – to examine whether or to what extent ethical values are internalized by students. We find that when participants are anonymous, misreporting rates are nearly the same regardless of ethics program participation. However, when their reporting behavior is made public to the cohort, participants who completed the ethics program misreported at significantly lower rates than those who did not receive the ethics program. The results suggest that ethics education does not necessarily result in internalized ethical values, but it can impact ethical behavior.

ethics education, anonymity, public disclosure, integration, ethical values

Abstract:
This paper develops a theory that explains why the government, on behalf of the public it serves, demands audits of public companies. Our theory argues that the government demands audits as a way to minimize private and public transaction costs defined as "the cost of measuring the valuable attributes of what is being exchanged and the costs of protecting rights and policing and enforcing agreements" (Dahlman 1979). The reduction of both types of transaction costs is a logical purpose of government as it maximizes the overall wealth of its citizens. The two different types of transaction costs, in turn, lead to two types of audits: private stewardship audits and public transparency audits. While stewardship audits employ contractual standards and fiduciary obligations to resolve agency problems, public audits employ generally promulgated standards for recognition, measurement and public disclosures that facilitate contracting among many constituents. Public audits also generally require auditor independence to objectively resolve broader economic, measurement, and communication issues. Our paper extends the theories of Jensen and Meckling (1976) and Watts and Zimmerman (1983, 1986) to incorporate public transaction costs and the effects of public disclosure and standards on independence. Our theory suggests a public policy emphasis on reducing transaction costs through independence, objective standards, and public accountability.

Stewardship audits, transparency audits, transaction costs

Abstract:
This paper examines the relationship between the 1994 change in audit firm legal structure from general partnerships to limited liability partnerships (LLPs) on underpricing in the initial public offering (IPO) market. The change in legal structure of audit firms reduces an audit firm's wealth at risk from litigation damages and reduces the incentives for intrafirm monitoring by partners within an audit firm. Prior research suggests that underpricing protects underwriters from litigation damages, and that the level of underpricing varies inversely with both the amount of implicit insurance provided by the audit firm and the quality of the audit services provided. We hypothesize the change in audit firm legal structure reduced the assets available from audit firms in IPO-related litigation and indirectly reduced audit quality by lowering intrafirm monitoring. As a result, underwriters have incentives as a joint and several defendant with the audit firms to increase IPO underpricing, particularly for high-litigation-risk IPOs, following audit firms' shifts to LLP status. Our findings are consistent with this hypothesis.

audit firm limited liability, initial public offering (IPO), underpricing, insurance hypothesis, audit quality

Abstract:
We investigate the impact of the Big8 to the Big4 consolidation of public accounting firms and the Sarbanes Oxley Act of 2002 (SOX) on auditor industry concentration levels. We find that auditor industry concentration levels increase as the number of Big N auditors decrease. However, the gains are not shared equally among the remaining firms. Specifically, firms with large pre-consolidation industry market shares gain industry market share, while firms with low pre-consolidation shares do not gain industry market shares. Consolidation produces an increasing market share differential between the industry leaders and the lower ranked auditors in the industry. We then explore whether the increase in industry concentration impacts the ability of the largest clients in each industry to employ different auditors. Despite increased industry concentration among industry leading auditors, the commonality of auditors serving the largest two companies does not change significantly as a result of the three major consolidations. Only the Big6 mergers increases the commonality of auditors among the largest four companies. Our evidence suggests that consolidation increases auditor industry concentration levels, but the largest clients, in general, maintain diversity in auditors.

Auditing, Industry Concentration, Competition

Abstract:
This paper challenges the findings of Frankel, Johnson and Nelson (FJN) (2002). The results of our discretionary accruals tests differ from FJN's when we adjust discretionary current accruals for firm performance. In our earnings benchmark tests, in contrast to FJN we find no statistically significant association between firms meeting analyst forecasts and auditor fees. Our market reaction tests also provide different results than those reported by FJN. Overall, our study indicates that FJN's results are sensitive to research design choices, and we find no systematic evidence supporting their claim that auditors violate their independence as a result of clients purchasing relatively more nonaudit services.

independence, audit fees, discretionary accruals, biased financial reporting

Abstract:
This paper reports the results of experimental economic markets that examine whether accounting uncertainty impacts an auditor's objectivity in a setting where the auditor also has an incentive to build and maintain a reputation for objectivity. In particular, we explore if an auditor's reputation impacts her decision of whether to exploit uncertainty regarding the appropriate accounting treatment for a client by agreeing with her client's preferred accounting treatment even when her evidence suggests an alternative treatment is more likely to be correct. While a wide range of research has examined the impact of uncertainty on auditor objectivity, our research is the first to explicitly incorporate auditor reputation into the research design. Our research design captures a professional auditor's incentives to build and maintain a reputation that may mitigate her incentives to violate her objectivity in the presence of accounting uncertainty. The results provide strong evidence that accounting uncertainty impacts auditor objectivity even though the lack of objectivity diminishes the auditor's reputation which in turn damages market participants. Specifically, our markets suggest that when accounting uncertainty does not exist, an auditor maintains her objectivity by truthfully reporting. It appears that she remains objective due to concerns about her reputation with managers and investors. However, when accounting uncertainty does exist, an auditor impairs her objectivity by misreporting in favor of managers. Our results specify boundary conditions for the impact of auditor reputation on auditor objectivity, and suggest that regulators should focus on enhancing auditor incentives to maintain objectivity when faced with accounting uncertainty. It appears that due to reputation effects, regulators do not need to be as concerned about objectivity violations when accounting pronouncements provide unambiguous guidance. Our results suggest that future research should assess the ability of other forces to reduce the propensity of auditors to violate objectivity when faced with accounting uncertainty.

Auditing; Independence; Objectivity; Reputation

Abstract:
This study describes and critiques the audit procedures applied to a set of material transactions from the Lincoln Savings and Loan (LSL) audit failure. Auditor deposition testimony and audit working papers produced in the civil litigation against the auditors of LSL provide the basis for this analysis. The public availability of the deposition testimony and audit working papers creates a unique opportunity to study and evaluate audit procedures and decisions from an audit failure. To date, evaluating actual audit procedures from an audit failure has proven nearly impossible for accounting researchers because audit workpapers are owned by the defendant audit firm and are usually sealed in the litigation and/or destroyed when a case is settled. In spite of objections from the audit firms' legal counsel, U.S. District Judge Richard Bilby released to the public deposition transcripts and associated audit working papers from the civil litigation against the former auditors of LSL. We use these documents as the basis for our analysis. To our knowledge, this is the first study to examine audit procedures documented in depositions and working papers from litigation over the adequacy of an auditor's performance.

Our access to LSL's auditor's depositions and work papers enables us to evaluate the audit procedures that were applied by LSL's auditors and the information they used. More importantly, we are able to identify the information that was not used and procedures that were not performed. Other researchers have been unable to study audit procedures associated with audit failures, in spite of the compelling importance of such an inquiry, using traditional research methods. Our ability to study these issues highlights the potential value of a detailed analysis of legal documents from a single case. Moreover, the current approach enables us to generate alternative procedures that may have averted the failure. Our ability to draw such inferences is a unique characteristic of this type of research. This study is one of the first to identify procedures or omissions associated with an audit failure. For this reason, the analyses in this study, although imperfect, provide an important basis upon which future research can build.

The main conclusion of our analysis is that the most significant shortcoming in the LSL audit was the auditor's failure to obtain and use knowledge of LSL's business, the industry in which it operated, and the economic forces that influenced this industry/business. It is our view that had the auditors obtained this understanding and applied it to an evaluation of the substance of LSL's main source of profits during this period, sales of undeveloped Arizona land, the auditors would have reached different revenue recognition conclusions. More specifically, if the auditors had compared LSL's wholesale sales of undeveloped land to trends in Arizona's retail residential real estate market; it would have been apparent that the reported profit margins were "too good to be true." Furthermore, analysis of the substance of these transactions, including consideration of the motivations of LSL and its transacting parties, would have provided additional evidence that immediate revenue recognition on these transactions was inappropriate. Instead, the auditors evaluated the compliance of each material real estate transaction's form with the mechanical aspects of SFAS No. 66 "Accounting for Sales of Real Estate" (e.g. the down payments appeared to meet the requirements of SFAS No. 66). Our evaluation suggests that understanding a client's business is an effective audit procedure that provides reliable audit evidence both in the absence and presence of management fraud.