Auditor Incentives Research Articles

Non-Audit Services, Incentives and Audit Quality

I develop a framework that provides new insights into the consequences of the provision of non-audit services (NAS) by audit firms to audit clients. The investors of a client firm may optimally let the auditor provide NAS because of an incentive effect. Indeed, the possibility of providing NAS contingent on detecting financial misstatements increases the auditor's incentives to exert audit effort. However, the provision of NAS also reduces auditor independence, which may decrease audit quality and in turn render the provision of NAS by auditors undesirable. Thus, my analysis uncovers an interesting tradeoff for regulators between the positive incentive effect and the decrease in auditor independence. Removing the current restriction on contingent audit fees may offset the ex post decrease in audit quality while preserving the ex ante incentives. My analysis also generates a number of testable empirical predictions.

Auditor Incentives and the Structure of the Audit Market A Basic Model for Investigating Simultaneous Effects of Audit Market Regulations

For decades, legislators worldwide have been discussing the merits of regulating their national audit markets. In this debate, the focus has primarily been on the regulations’ effects on incentives, both those of preparers of financial statements to report truthfully and those of auditors to detect errors or even fraud and to correctly report their findings to the public. For some of the proposed measures, the empirical evidence as to whether they indeed improve such incentives remains inconclusive. In addition, there is a concern that certain regulations could negatively affect the structure of the audit market. Changes in the market structure, in turn, can either attenuate or reinforce the regulations’ effects on preparers’ and auditors’ incentives. To a large extent, this unintended side-effect has been neglected in the discussions. We adapt a spatial competition model to the audit market. This model allows simultaneously analyzing the incentive and market structure effects resulting from regulations and thus determining their overall impact.

The Interplay between Financial Reporting Biases and Audit Quality

We show that a firm's optimal financial reporting bias and an auditor's choice of audit effort are inextricably intertwined. Aggressive or conservative accounting practices influence the auditor's optimal choice of audit effort, and the auditor's incentive and ability to detect misstatements in turn influence the firm's optimal accounting bias. Due to this interplay, a shift to more aggressive accounting can reduce, rather than increase, the incidence of overstatements and hence overinvestment and investor litigation. While ex ante litigation risk is typically considered to be a major driver of conservative accounting practices in corporations, we derive conditions under which a heightened threat of litigation can encourage more aggressive accounting.

Auditor Settlements of Securities Class Actions

Some corporate law scholars have concluded that auditors do not have sufficient legal incentive to detect securities fraud and should be governed by a strict liability standard. This study assesses this argument by examining a dataset of 554 class actions alleging an accounting restatement filed from 1996 through 2007. Because some but not all of these restatement cases named an auditor defendant, it is possible to analyze whether variables such as the liability standard affect both the decision to name an auditor defendant as well as the outcome of the case. Despite the narrowing of auditor liability under Rule 10b‐5, auditors are still often named as defendants and pay substantial settlements in Rule 10b‐5 cases. A more restrictive liability standard is associated with a modest reduction in the rate at which auditors are named as defendants and the rate at which auditor cases end in settlement. If a Rule 10b‐5 case against an auditor is strong enough to result in a settlement, the legal standard does not affect the size of the settlement. The auditor's payment is correlated with nonlegal factors such as whether the issuer is bankrupt and the issuer's market capitalization. These results are best explained by the tendency of judges to read narrow liability provisions broadly in cases where the size and impact of the alleged fraud are significant. The evidence thus does not support the conclusion that a strict liability standard is necessary to generate sufficient incentives for auditors to detect substantial frauds.

What's in a Name? Reputation and Monitoring in the Audit Market

We demonstrate a tension between monitoring and reputation incentives when moving from collective reputation environments to individual reputation environments by analyzing a new rule. After January 2017, the name of the engagement partner has to be disclosed in all audit reports issued in the USA. We study the resulting change in auditor incentives and show that while the consequent higher reputation incentives can improve audit quality, partners have a lower incentive to monitor other partners when names are disclosed. This may lead to a fall in audit quality when the rule is implemented. We present several solutions to this problem.

Auditor-Provided Lobbying Service and Audit Quality

Regulators and the public have expressed concerns about accounting firms lobbying politicians and regulators on behalf of their own audit clients because it could pose an advocacy threat to auditor independence. In this study, we examine whether these lobbying activities by accounting firms are associated with their clients’ audit quality. As required disclosures of lobbying activities under the Lobbying Disclosure Act are very limited, we construct a proxy to capture auditor lobbying on behalf of audit clients. Using our proxy for lobbying, we find that perceived audit quality (measured using earnings response coefficients) is negatively related to lobbying. However, we fail to find that actual audit quality is lower for these clients (measured as the propensity to restate earnings, propensity to issue a going-concern opinion, and discretionary accruals). Our findings suggest that investors perceive auditors’ lobbying for clients’ political interests as harmful to audit quality but that these concerns do not appear to materialize in the financial statements. Similar to the literature on other nonaudit services, our evidence suggests that reputation concerns and litigation risk provide enough incentive for auditors to maintain their independence in the presence of an advocacy threat to auditor independence.

Joint Provision of Audit and Non-Audit Services, Audit Pricing and Auditor Independence

The SEC recently amended its auditor independence rule, prohibiting auditors from providing certain non-audit services to their audit clients. The International Federation of Accountants (IFAC) has also released a draft revision to its Code of Ethics, which will have a similar effect. These changes are intended to reduce motivation for auditors to compromise their independence. We present an economic model, based on earlier work by DeAngelo and by Magee and Tseng, to examine the economic impact of the provision of non-audit services on the pricing of audits and on the incentives for auditors to compromise independence. The model extends earlier work in that it (i) allows for both consensus and genuine differences of opinion among auditors about a disputed accounting issue; (ii) permits opinion-shopping by clients; (iii) explicitly considers the legal and disciplinary costs for an auditor both of wrongly agreeing and of wrongly disagreeing with the client; (iv) includes the effect of profits from consulting work which is ‘tied’ to the audit engagement; and (v) examines the situation in which an auditor compels a client to change a treatment with which the auditor privately agrees, in order to avoid the costs for the auditor of defending that treatment publicly.The model enables the calculation of audit prices when the incumbent auditor either agrees or disagrees with the client, facing competing auditors who unanimously agree, unanimously disagree, or have divided opinions; this leads to the wealth change for an auditor who compromises independence. Profits from non-audit services reduce ongoing audit fees, but do not affect any initial fee discount (low-balling). We infer that audit firms which cannot cross-subsidize audit work from consulting profits will suffer a competitive disadvantage in the audit market. Profits from non-audit services do not contribute to auditors’ economic incentives to compromise independence. The main incentive comes from the economic benefit to the client from a preferred treatment, but competition and the threat of legal or disciplinary action usually limits the incentive. However, incentives to compromise may exist even when the client does not benefit, because economic pressure to compromise comes from the regulatory environment as well as from the client. When auditors are unanimous that the client’s treatment is wrong, the incentive to compromise may be unlimited. It thus appears that the new SEC and IFAC rules may lead to an increase in the prices for audit services, while doing little to reduce the economic incentives for auditors to compromise independence.

Audit Committee Incentives and the Resolution of Detected Misstatements

SUMMARYWe investigate the role of audit committee economic incentives in judgments involving the resolution of detected misstatements. The results reveal a positive association between audit committee short-term stock option compensation and the likelihood that managers are allowed to waive income-decreasing misstatements that, if corrected, would have caused the company to miss its analyst forecast. Complementary results reveal a positive association between the audit committee long-term stock option compensation and the likelihood that managers are allowed to waive income-increasing misstatements when the company reports just missing, meeting, or beating its analyst forecast. These findings illustrate agency conflicts that can arise when compensating audit committees with options. We obtain these results while controlling for CEO option compensation and audit committee characteristics, along with indicators of corporate governance, auditor incentives, and company characteristics.Data Availability: Data used in the study are available from public sources

Can Enforcement Actions on Engagement Auditors Improve Audit Quality?

A unique feature of Chinese auditing and one under consideration for adoption in the U.S. is regulatory oversight of individual auditors. This paper analyzes enforcement actions by the China Securities Regulatory Commission (CSRC) against engagement auditors and investigates whether audit quality improves for sanctioned auditors. Our results indicate lower discretionary accruals for client firms following sanctions. Complementing this, and indicative of greater skepticism and independence by sanctioned auditors, we find that the probability of issuing a modified audit opinion increases following sanctions. We conjecture that audit quality increases because sanctions increases the likelihood of job loss and also damages reputations; consistent with this, we find evidence of job loss among some of the sanctioned auditors and of stock market losses for clients audited by sanctioned auditors. These adverse consequences appear to encourage sanctioned auditors to “clean up their act.” Finally, we examine one channel through which sanctions improve audit quality: we find evidence of a longer lag between fiscal year end and the date of the audit report, a metric interpreted in the literature as a measure of auditor effort. Thus, it appears that sanctions, by raising the specter of job and/or reputation loss, compel sanctioned auditors to increase effort in such a way that audit quality rises. Overall, our results indicate that governmental sanctions improve audit quality. This suggests that auditor incentives stemming from oversight mechanisms play a critical role in determining audit quality.

Did PwC lose reputation post audit failure at Satyam Computer Services? Evidence from the Indian audit market

Safeguarding reputation is one major incentive for large auditors to maintain high audit quality. We investigate the phenomenon of reputation by studying the impact of an audit failure on the reputation of a large audit firm in India. Specifically, we analyse the events surrounding the high profile audit failure of Satyam Computer Services and its resultant impact on the audit practice of PricewaterhouseCoopers (PwC) and its affiliates in India. The results of our analysis indicate that following the audit failure there was a high propensity for clients of PwC firms to switch to other firms. We interpret this behaviour as indicative of a loss of reputation for PwC due to the Satyam audit failure.

Does Audit Transparency Improve Audit Quality and Investment Efficiency?

We examine eects of disclosing precisions of audit opinions (i.e., enhancing audit transparency) on auditor quality and investment e¢ ciency in a setting where the useful- ness of an audited …nancial report is jointly determined by the quality of the underlying …nancial reporting (i.e., a mapping from a …rm's fundamentals into an unobservable true accounting signal), misreporting of the true signal by the …rm's manager, and audit quality (i.e., the precision with which audit evidence collected by the auditor correctly captures the underlying true accounting signal and hence uncovers manager- ial misreporting). In our model, the auditor exerts an unobservable eort to in‡uence audit quality and is motivated by liability in the event of an audit failure. We show that while higher transparency enhances the information decision usefulness of audited …nancial reports for investors, it can also adversely aect the auditor's incentives and consequently lower the expected audit quality and investment e¢ ciency. We show that the underlying quality of …nancial reporting is an important determinant for this

Management Influence on Auditor Selection and Subsequent Impairments of Auditor Independence during the Post‐SOX Period

The objective of this study is to examine managerial involvement in auditor selection decisions when audit committees are “directly responsible” for auditor relationships, including selection of the audit firm. The Sarbanes-Oxley Act (SOX) of (2002) requires fully independent audit committees to be “directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm” (Section 301). This statutory requirement is a regulatory attempt to eliminate management influence over the external auditor and align auditor incentives with those of the board and shareholders. While regulators largely assume that audit committees take responsibility for auditor selection in the post-SOX period (Doty 2011), there exists no archival analysis testing this assumption. Therefore, the effectiveness of this regulation (SOX Section 301) remains uncertain. In this paper, we examine (a) whether contrary to the intent of SOX, managers continue to influence auditor selection decisions in the post-SOX period, and (b) whether this influence subsequently impairs auditor independence as presumed in the legislation. With respect to (a), we use the association between management affiliation and auditor hiring as a way in which to identify management influence over auditor selection. Management affiliation is defined as a prior employment relationship of a manager (i.e., CEO, CFO, controller) with a Big 4 auditing firm. While an affiliation between a

Truth-telling by Third-party Auditors and the Response of Polluting Firms: Experimental Evidence from India*

Abstract In many regulated markets, private, third-party auditors are chosen and paid by the firms that they audit, potentially creating a conflict of interest. This article reports on a two-year field experiment in the Indian state of Gujarat that sought to curb such a conflict by altering the market structure for environmental audits of industrial plants to incentivize accurate reporting. There are three main results. First, the status quo system was largely corrupted, with auditors systematically reporting plant emissions just below the standard, although true emissions were typically higher. Second, the treatment caused auditors to report more truthfully and very significantly lowered the fraction of plants that were falsely reported as compliant with pollution standards. Third, treatment plants, in turn, reduced their pollution emissions. The results suggest reformed incentives for third-party auditors can improve their reporting and make regulation more effective.

Financial Statements Insurance

The fact that auditors are paid by the companies they audit creates an inherent conflict of interest. We analyze how the provision of financial statements insurance could eliminate this conflict of interest and properly align the incentives of auditors with those of shareholders. We first show that when the benefits to obtaining funding are sufficiently large, the existing legal and regulatory regime governing financial reporting (and auditing) results in low quality financial statements. Consequently, the financial statements of firms are misleading and firms that yield a low rate-of-return (low fundamental value) are over-funded relative to firms characterized by a high rate-of-return (high fundamental value). We present a mechanism whereby companies would purchase financial statements insurance that provides coverage to investors against losses suffered as a result of misrepresentation in financial reports. The insurance premia that companies pay for the coverage would be publicized. The insurers appoint and pay the auditors who attest to the accuracy of the financial statements of the prospective insurance clients. For a given level of coverage firms announcing lower premia would distinguish themselves in the eyes of the investors as companies with higher quality financial statements relative to those with higher premia. Every company would be eager to pay lower premia (for a given level of coverage) resulting in a flight to high audit quality. As a result, when financial statements insurance is available and the insurer hires the auditor, capital is provided to the most efficient firms.

Competitive Procurement of Auditing Services with Limited Information

We analyse the auditing procurement process when the client is initially uncertain about her/her auditing needs and when she/he cannot discern the level of assurance provided by the auditor. The client's limited information can lead to under-auditing and substantial rent for auditors, despite the presence of ex ante competition among auditors. The information asymmetry can also make it difficult for new auditors with superior auditing technologies to displace incumbent auditors. In addition, the asymmetry can limit the incentives of auditors to improve their technologies.

Departing and Incoming Auditor Incentives, and Auditor-Client Misalignment under Mandatory Auditor Rotation: Evidence from Korea

In this paper we provide evidence on specific factors that could affect audit quality under mandatory rotation, using data from Korea where mandatory auditor rotation was put into effect in 2006. We find no evidence supporting the “Brillo pad effect” (the argument that departing auditors have incentives to clean up the balance sheet) or the “new broom effect” (the argument that new auditors can find problems that long-standing auditors tend to overlook). On the contrary, departing auditors spend fewer hours just before rotation, consistent with a lack of incentives to maintain quality given the impending rotation. Compared to clients in other mandatory rotations, the clients rotating away from industry specialist auditors have higher audit hours and higher absolute discretionary accruals post-rotation, suggesting there are adverse effects from breaking such auditor-client pairings. Finally we find that Big 4 auditors’ market share continues to increase after mandatory rotation is imposed. Our findings therefore fail to support mandatory rotation.

Identifying Unintentional Error in Restatement Disclosures

Regulatory oversight bodies and audit researchers are interested in restatements as a reliable indicator of audit quality. This paper describes the construction and validation of a new proxy for restatements that correct unintentional error. This proxy classifies less than one third of restatements as correcting unintentional error, in contrast to current proxies that classify over half of all restatements as correcting error. I find, for years with auditor’s Sarbanes-Oxley Act Section 404 (SOX 404) opinions, that restatements that correct unintentional error are associated with less net income smoothing, less earnings persistence, and less positive accruals than other restatements. Automated text searches of restatement announcements, for language asserting or implying lack of management intent, are used to identify restatements that correct unintentional error. This more refined proxy will contribute to future research by enhancing the power of tests used to study associations between unintentional error and the expertise and incentives of CFOs, audit committees, and auditors.

Truth-Telling by Third-Party Auditors and the Response of Polluting Firms: Experimental Evidence from India

In many regulated markets, private, third-party auditors are chosen and paid by the firms that they audit, potentially creating a conflict of interest. This paper reports on a two-year field experiment in the Indian state of Gujarat that sought to curb such a conflict by altering the market structure for environmental audits of industrial plants to incentivize accurate reporting. There are three main results. First, the status quo system was largely corrupted; with auditors systematically reporting plant emissions just below the standard, although true emissions were typically higher. Second, the treatment caused auditors to report more truthfully and very significantly lowered the fraction of plants that were falsely reported as compliant with pollution standards. Third, treatment plants, in turn, reduced their pollution emissions. The results suggest reformed incentives for third-party auditors can improve their reporting and make regulation more effective.

Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees

ABSTRACT This study investigates how manager and auditor incentives, along with audit committee characteristics, are associated with materiality judgments about detected misstatements. Using data on detected misstatements that occurred between 2003 and 2006, we find auditors' incentives to protect their reputations weaken the effect of managerial incentives associated with the pressure created by analyst following; auditors are less likely to allow managers to waive material misstatements as audit fees increase. Regarding audit committee characteristics, results reveal that audit committees with greater financial expertise are less likely to allow managers to waive material misstatements compared to audit committees with less expertise. Data Availability: Data used in the study are available from public sources.

Do abnormal accruals affect the life expectancy of audit engagements?

We examine the cross-sectional determinants of audit engagement length, paying particular attention to abnormal accruals as a potential driver. We are interested in how the potentially incongruent incentives of managers and auditors can cause frictions, and in turn affect the audit engagement’s life expectancy. We estimate a hazard model in the form of a multi-period logit model, allowing us to estimate (the inverse of) the life expectancy of audit engagements. We find that audit engagement life expectancy at any age decreases when firms make relatively large positive or large negative abnormal accruals. One interpretation of these results is that large positive (negative) abnormal accruals make the auditor (client) more likely to terminate the engagement. Conversely, smaller abnormal accruals reflect a compromise which extends the life of the engagement. Our results are robust to several alternative specifications and controls. However, because there is no complete theoretical model that explains audit engagement length, our results should be interpreted with caution.