Enhance Auditor Independence Research Articles

A Reexamination of Audit Fees for Initial Audit Engagements in the Post-SOX Period

SUMMARY:On August 16, 2011, the Public Company Accounting Oversight Board (PCAOB) issued a concept release seeking comments on ways to enhance auditor independence. The Board notes that higher failure rates in new audit engagements might be linked to unrealistic pricing. The Board's concern is that a new auditor might be more susceptible to management pressure if initial-year audit fees are set artificially low. Prior to the Sarbanes-Oxley Act (SOX) of 2002, empirical evidence shows that auditors discounted their initial-year audit fees. This practice, known as lowballing, was expected to decrease significantly after the enactment of SOX. Indeed, findings in Huang, Raghunandan, and Rama (2009) seem to confirm that Big 4 auditors charged a fee premium on new auditor-client relationships in 2006. However, it is not clear if more recent post-SOX initial-year audits are free of lowballing. We investigate whether lowballing exists in new auditor-client relationships in an “extended” post-SOX environment for the years 2007 to 2010. Our results suggest that both Big 4 and non-Big 4 accounting firms discounted their initial-year audit fees during our sample period (2007–2010). These findings should be of interest to the PCAOB as it searches for ways to bolster auditor independence.Data Availability: Available from public sources.

How Do Regulatory Reforms to Enhance Auditor Independence Work in Practice?

Please note: The publisher is not responsible for the content or functionality of any supporting information supplied by the authors. Any queries (other than missing content) should be directed to the corresponding author for the article.

Auditors and Corporate Governance: Evidence from the Public Sector

SummaryCorporate auditors review and evaluate financial statements. Audit quality depends on auditor expertise and independence. To enhance auditor independence the selection process and auditor rotation requirements have been debated intensively. The available empirical evidence is not conclusive and suffers from serious endogeneity problems. I propose learning from the public sector where auditors play a similar role and present empirical evidence on the impact of auditor expertise, term length and rotation requirements on government performance at the US state level. I find evidence indicating that greater auditor expertise and rotation requirements have a positive effect on state credit ratings.

Audit Committee: Does it Signify as an Independent Watchdog Over and Above External Auditors

The purpose of the study is to understand the significance of audit as independent watchdog, and their dichotomy with external auditors and. We seek to address the issue, to what extent audit committee as another watchdog is critical in enhancing the accuracy of financial reports and complement the role of external auditors. We adopt an investigative approach to understand the role responsibility, liability of both these watchdogs in relations to auditing, internal control and financial reporting to the shareholder and investors of the company. We find that both external auditor and audit committee are important determinants of corporate governance frameworks for shareholder and investor protection. The role, responsibility and liability of an external auditor are clearly articulated, while audit committee as a watchdog performs the oversight function rather auditing the accounts. We also find no consensus on audit committee liability in case of audit failure and their ability to enhance auditor independence. The study implicates that it the auditor, who are the first line of defense for shareholders, with audit committee just playing the complementing role. It will be better for regulators to give more powers to auditors with an increased liability to prevent any auditing or corporate failure. Efforts are required to ensure audit committee independence in assuring auditor independence.

Abnormal Audit Fee and Audit Quality

SUMMARY This study tests the hypotheses that below-normal audit fees signal important nuances in the balance of bargaining power between the auditor and the client, and that such power may ultimately influence audit quality. We find that audit quality, proxied by absolute discretionary accruals and meeting or beating analysts' earnings forecasts, declines as negative abnormal audit fees increase in magnitude, with the effect amplified as proxies for client bargaining power increase. We find that this effect is dampened in years following the Sarbanes-Oxley Act (SOX), suggesting that SOX was effective in enhancing auditor independence.

Do Joint Audits Improve or Impair Audit Quality?

Conventional wisdom holds that joint audits would improve audit quality by enhancing audit evidence precision, because “Two heads are better than one,” and by enhancing auditor independence, because it is more expensive for a company to “bribe” two audit firms than one. Our paper challenges this wisdom. We show that joint audits by one big firm and one small firm may impair audit quality, because, in that situation, joint audits (1) induce a free-riding problem between audit firms, lowering audit evidence precision, and (2) create an opportunity for internal opinion shopping, compromising auditor independence. We further derive a set of empirically testable predictions comparing audit evidence precision, auditor independence, and audit fees under joint and single audits. This paper, the first theoretical study of joint audits, contributes to a better understanding of the economic consequences of joint audits on audit quality.

Comments by the Auditing Standards Committee of the Auditing Section of the American Accounting Association on PCAOB Rulemaking Docket Matter No. 37: PCAOB Release No. 2011-006, Concept Release on Auditor Independence and Audit Firm Rotation

SUMMARY In August 2011, the Public Company Accounting Oversight Board (PCAOB or Board) issued a concept release to solicit public comment on the potential direction of a proposed standard-setting project on means to enhance auditor independence, objectivity, and professional skepticism. The Concept Release sought comments on and explores in detail the possibility of mandatory audit firm rotation. The PCAOB provided for a 121-day exposure period (from August 16 to December 14, 2011) for interested parties to examine and provide comments on the concept release. The Auditing Standards Committee of the Auditing Section of the American Accounting Association provided the comments in the letter below (dated December 13, 2011) to the PCAOB on PCAOB Rulemaking Docket Matter No. 37: PCAOB Release No. 2011-006, Concept Release on Auditor Independence and Audit Firm Rotation. Data Availability: Information about and access to the release are available at: http://pcaobus.org/Rules/Rulemaking/Docket037/Release_2011-006.pdf

Policies To Promote Auditor Independence: More Evidence On The Perception Gap

The extensive body of literature and research concerning auditor independence, the so-called cornerstone of the profession, has centered mainly on alleged threats to perceived independence or threats to actual independence. The objective of this study was to investigate accountants and financial statement users reactions to policies designed to enhance auditor independence. Multidimensional scaling techniques were used to measure the similarity or dissimilarity of the views of four separate groups: Big Eight auditors; non-Big Eight CPAs, bank loan officers, and certified financial analysis. Results showed that the four groups differed significantly in the extent of their support of fourteen policies discussed in the Cohen Communication Report as means to enhance auditor independence. The Cohen Commissions position on these policies was found to appear to be more aligned with financial statement users.

Does Audit Partner Rotation Enhance Audit Quality? Evidence from Japan

I examine that relationship between audit partner rotation and audit quality using 4,232 Japanese listed companies from 2003 to 2006. Firstly, I find that audit-partner rotation over seven years and lead audit-partner rotation over five years have a negative relationship with abnormal accruals on the condition that the tenure of the other audit-engagement partner is seven years or less. Secondly, I find that the impact of rotation of the lead audit partner is a little higher than that of the audit partner. Thirdly, I find that the impact of rotation of (lead) audit partners in non-Big 4 situations is higher than in Big 4 contexts. And fourthly, in the non-Big 4 sample, there are systematic differences between complete rotation of audit partners (lead audit partners), which pushes earnings downward and partial rotation of audit partners (lead audit partners), which pushes earnings upward. These results suggest that complete rotation of audit-engagement partners over seven years (lead audit partners over five years) enhances auditor independence; as a result, it brings conservative accounting policy.

Legal systems and auditor independence

This paper examines whether an appropriate legal system, which is a combination of a legal regime and a damage apportionment rule, effectively enhances auditor independence. Economic and psychological hypotheses derived from a one-period game model in which the auditor may commit either a technical audit failure (resulting from the auditor’s inability to detect true output given a lack of audit effort) or an independence audit failure (resulting from the auditor’s intentional misreporting on false output) are tested. Three major findings are documented. First, auditor independence affects firm investment, which in turn affects audit effort. Under this strategic dependence, no single legal system can provoke audit effort, improve auditor independence, and encourage firm investment simultaneously. To enhance auditor independence and motivate investment, a legal system consisting of both a strict regime and a proportionate rule is preferred. Second, the strict regime induces more auditor independence than the negligence regime, while the proportionate rule induces higher audit effort than the joint-and-several rule. Finally, auditors’ moral reasoning and penalty for misreporting are both positively associated with their independence. In addition, the effect of moral reasoning on auditor independence diminishes as the level of penalty increases. These two results hold only when the legal systems that auditors face are considered.

Audit tenure and the equity risk premium: evidence from Jordan

PurposeThe purpose of this paper is to investigate the relation between audit firm tenure and the perceived audit quality measured by the client‐specific equity risk premium. The study population consists of all the manufacturing and service firms traded in Amman Bourse during the period 2002‐2005.Design/methodology/approachThe Boone et al. model – with some modifications – was used for testing the hypotheses.FindingsThe results show that the relation between audit firm tenure and equity risk premium is positive, the equity risk premium increases with tenure as a result of reduced audit quality. These results were consistent with some previous studies, which showed that long relationships between an audit firm and a client are associated with lower perceived audit quality and, as a result, higher equity risk premium.Practical implicationsThe audit firm should be rotated in order to enhance auditor independence and audit quality, and increase investors' confidence in reported earnings. Additionally, investors are encouraged to give higher attention to the tenure of the audit firm when evaluating the quality of the financial reports of the companies they are planning to invest in.Originality/valueThis is the first paper to provide evidence from a developing country about an important issue – audit quality – which is expected to support and sustain improvement of audit quality, and therefore, financial reporting quality.

Auditor Independence and the Cost of Capital Before and After Sarbanes–Oxley: The Case of Newly Issued Public Debt

An important aim of the Sarbanes–Oxley Act (SOX) was to reduce the cost of capital by enhancing auditor independence. However, prior literature has argued that SOX has been ineffective in meeting this objective. We contribute to this debate by first providing evidence suggesting that auditor independence has increased following SOX. Though we posit an inverse relationship between auditor independence and cost of capital, it is an open question whether this relationship has become stronger or weaker following SOX. An examination of this relationship reveals that auditor independence is more strongly related to bond rating and bond yield premium in the post-SOX period relative to the period before SOX. This evidence suggests greater price sensitivity of corporate debt to the level of auditor independence following SOX. We also show that controlling for the effect of auditor independence and other factors, cost of debt decreased following SOX.

Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan*

We examine the effectiveness of mandatory audit-partner rotation in promoting audit quality using audit data in Taiwan where a five-year audit-partner rotation became de facto mandatory in 2004. Using both absolute and signed abnormal accruals and abnormal working capital accruals as proxies for audit quality, we find some evidence that audit quality of companies subject to mandatory audit-partner rotation in 2004 is higher than audit quality of companies not subject to rotation in 2004. However, audit quality of companies subject to mandatory rotation in 2004 is lower than audit quality of these same companies in 2003 under the old audit partners. Furthermore, audit quality of companies subject to mandatory rotation in 2004 is indistinguishable from audit quality of companies whose audit partners were voluntarily rotated before 2003. Therefore, the effect of mandatory audit-partner rotation on audit quality, in terms of auditors constraining management's extreme income-increasing or extreme income-decreasing accruals, is mixed. In contrast, using earnings response coefficients as a proxy for investor perceptions of audit quality, we consistently find that investors perceive mandatory audit-partner rotation as enhancing audit quality, suggesting that mandatory audit-partner rotation enhances auditor independence in appearance.

Does Mandatory Audit Firm Rotation Enhance Auditor Independence? Evidence from Spain

SUMMARY: In this study, we document evidence on the impact of mandatory rotation of audit firms on auditor independence using Spanish archival data. Rotation of audit firms every nine years was mandatory in Spain from 1988–1995. Although the rule was never enforced, the Spanish context provides a unique setting to examine the effects that mandatory audit firm rotation has on auditor behavior. We examine audit reports for a sample of financially stressed companies from 1991–2000 to compare audit reporting behavior in a regime with rotation (mandatory rotation period: 1991–1994) and one without rotation (post-mandatory rotation period: 1995–2000). We test two competing hypotheses concerning the impact of mandatory rotation on the likelihood of auditors' issuing going-concern modified audit opinions. We find no evidence to suggest that a mandatory rotation requirement is associated with a higher likelihood of issuing going-concern opinions. Our results suggest that auditors' incentives to protect their reputation have a positive impact on the likelihood of issuing going-concern opinions, while auditors' incentives to retain existing clients did not impact on their decisions in both the mandatory rotation and post-mandatory rotation periods. Overall, our results provide empirical support for the arguments put forward by opponents of mandatory rotation.

The association between audit committee and board of director effectiveness and changes in the nonaudit fee ratio

Investors and the US SEC are interested in the impact of nonaudit fees on the economic bonding between auditors and their clients and in the role of audit committees in monitoring this economic bonding. The results of this study show a negative association between audit committee effectiveness and changes in the nonaudit to audit fee ratio, suggesting that effective audit committees generally minimize the nonaudit fee ratio in order to enhance auditor independence. In addition, the results of this study suggest that effective Board of Directors also limit increases in the nonaudit fee ratio, possibly due to their own concerns over auditor independence.

Auditor independence revisited: The effects of SOX on auditor independence

Following a wave of accounting scandals, the Sarbanes–Oxley Act (SOX) was enacted on 30th July, 2002. The objective of the Act was to provide investors with better protection by establishing a new oversight board, improving corporate governance and internal controls, enhancing financial disclosure, and strengthening auditor independence.In this paper, we question the extent to which SOX actually improved auditor independence. We seek to shed some light on auditor independence-related issues by asking: What has the academy learned about SOX's impact on auditor independence in the five years since its enactment? Have researchers even examined key ramifications of SOX's requirements? If not, what areas need scrutiny? These are the issues considered here. In essence, we examine whether there is a gap between what regulators want to see addressed and what researchers have actually looked at with regard to auditor independence in the post-Sarbanes–Oxley period. The Securities and Exchange Commission (SEC) requirement to enhance auditor independence has been far reaching. It involves providing guidelines on matters relating to the provision of nonaudit services, partner rotation, audit engagement teams, auditor compensation and the role of the audit committees. Therefore, we expected to find a large number of academic research papers on this topic. Surprisingly, the number of such papers is very small, with the results inconclusive. Overall, the academy falls short of providing detailed guidance to the SEC and other regulators on the effectiveness of their guidelines in enhancing auditors’ independence. We hope that, after reading our paper, regulators and academicians will agree with us that much more research is needed before assessing the impact of SOX. A recent FEI survey shows that 78 per cent of financial executives agree that the cost of implementing SOX exceed its benefits. We hope financial executives, whether they hold this view or not, may also find an interest in reading our paper.Given strong trends toward globalisation of business and the concomitant easing of cross-border stock exchange listing requirements, we also suggest to regulators that insights into the structure of US auditing may be gleaned by examining apparently successful auditing innovations overseas.

The Effects of Mandatory Earnings Forecasts and Auditor's Legal Regimes on Manager's and Auditors' Behavior - Theory and Experimental Evidence

This study reports the results of an experiment designed to examine whether a regulation system that consists of a mandatory earnings forecast imposing on the manager together with a strict legal regime imposing on the auditor may effectively motivate manager's and auditor's desirable behavior. The experimental results show that the proposed regulation system forms a dynamic interactive process in which a strict legal regime enhances auditor independence, which in turn forces the manager to report realized earnings truthfully. Since the manager is mandated to make earnings forecast and there are costs associated with forecast errors, the manager has to undertake more investment to increase the probability of generating high realized earnings, which in turn improves forecast accuracy despite the fact that audit effort also decreases. In addition, I investigate and show that the mandatory forecast mechanism gives rise to a forecast accuracy concern (i.e., the consistency between forecasted earnings and audited earnings), which significantly encourages the manager to undertake more investment under the condition that the manager cannot manage earnings. This forecast accuracy concern not only enhances earnings forecast accuracy, but also prevents inappropriate use of investor funds. The implications and contributions of these results are discussed.

Auditor Independence and the Cost of Capital Before and after Sarbanes-Oxley: The Case of Newly Issued Public Debt

An important aim of the Sarbanes-Oxley Act (SOX) was to reduce cost of capital by enhancing auditor independence. However, prior literature has argued that SOX has been ineffective in meeting this objective. We contribute to this debate by first providing evidence suggesting that auditor independence has increased following SOX. Though we posit an inverse relationship between auditor independence and cost of capital, it is an open question whether this relationship has become stronger or weaker following SOX. An examination of this relationship reveals that auditor independence is more strongly related to bond rating and bond yield premium in the post-SOX period relative to the period before SOX. This evidence supports the argument that SOX has created benefits that resulted in lower cost of borrowing.

Legal Regimes, Damage Apportionment Rules, and Auditor Independence - Theory and Experimental Evidence

This paper reports the results of four laboratory experiments designed to examine whether an appropriate legal system, which is a combination of legal regime (strict vs. negligence) and damage apportionment rule (joint-and-several vs. proportionate), may serve as an effective mechanism to enhance auditor independence. I adopt the laboratory experiments to test a series of hypotheses derived from a one-period game theoretic model in which the auditor may commit either a technical or an independence audit failure. Several important findings are documented. First, the experimental results confirm the analytical model's prediction that there is a trade-off among auditor's effort, audit failure, and firm's new investments. This trade-off implies that no single legal system can induce higher audit quality, reduce technical audit failure, improve auditor independence, and encourage firm's investment simultaneously. For regulatory purpose, a strict legal regime together with a proportionate damage rule can effectively decrease technical audit failure, improve auditor independence, and encourage firm's investment despite the fact hat audit quality also decreases. This trade-off also accentuates the importance of incorporating auditor's independence strategy into the examination of auditor's legal liability. Second, the auditors' independence is impaired less often than the model prediction because they recognize the compromise of independence to be unethical. In addition, the auditors exert more high effort under the proportionate rule than under the joint-and-several rule because they perceive the former to be relatively fair in the occurrence of a technical audit failure. Finally, an emphasis on damage apportionment rule is by itself not enough to improve auditor independence and motivate firm's investment. A replacement of the negligence regime by a strict regime seems to be more useful than a replacement of the joint-and-several rule by a proportionate rule in achieving these goals.

An Empirical Investigation of Audit Fees, Nonaudit Fees, and Audit Committees*

AbstractThis study examines the association between audit committee characteristics and the ratio of nonaudit service (NAS) fees to audit fees, using data gathered under the Securities and Exchange Commission's (SEC's) fee disclosure rules. Issues related to NAS fees have been of concern to practitioners, regulators, and academics for a number of years. Prior research suggests that audit committees possessing certain characteristics are important participants in the process of managing the client‐auditor relationship. We hypothesize that audit committees that are independent and active financial monitors have incentives to limit NAS fees (relative to audit fees) paid to incumbent auditors, in an effort to enhance auditor independence in either appearance or fact. Our analysis using a sample of 538 firms indicates that audit committees comprised solely of independent directors meeting at least four times annually are significantly and negatively associated with the NAS fee ratio. This evidence is consistent with audit committee members perceiving a high level of NAS fees in a negative light and taking actions to decrease the NAS fee ratio.