This study examines whether the length of the relationship between a company and an audit firm (audit-firm tenure) is associated with financial-reporting quality. Using two proxies for financial-reporting quality and a sample of Big 6 clients matched on industry and size, we find that relative to medium audit-firm tenures of four to eight years, short audit-firm tenures of two to three years are associated with lower-quality financial reports. In contrast, we find no evidence of reduced financial-reporting quality for longer audit-firm tenures of nine or more years. Overall, our results provide empirical evidence pertinent to the recurring debate regarding mandatory audit-firm rotation — a debate that has, to date, relied on anecdotal evidence and isolated cases.

Audit‐Firm Tenure and the Quality of Financial Reports*

Do fees for non-audit services compromise auditor's independence and result in reduced quality of financial reporting? The Sarbanes-Oxley Act of 2002 presumes that some fees do and bans these services for audit clients. Also, some registrants voluntarily restrict their audit firms from providing legally permitted non-audit services. Assuming that restatements of previously issued financial statements reflect low-quality financial reporting, we investigate detailed fees for restating registrants for 1995 to 2000 and for similar nonrestating registrants. We do not find a statistically significant positive association between fees for either financial information systems design and implementation or internal audit services and restatements, but we do find some such association for unspecified non-audit services and restatements. We find a significant negative association between tax services fees and restatements, consistent with net benefits from acquiring tax services from a registrant's audit firm. The significant associations are driven primarily by larger registrants.

Auditor Independence, Non‐Audit Services, and Restatements: Was the U.S. Government Right?

We investigate the conventional wisdom that competition among interested parties attempting to influence a decision maker by providing verifiable information brings out all the relevant information. We find that, if the decision maker is strategically sophisticated and well informed about the relevant variables and about the preferences of the interested party or parties, competition may be unnecessary; while if the decision maker is unsophisticated or not well informed, competition is not generally sufficient. However, if the interested parties' interests are sufficiently opposed, or if the decision maker is seeking to advance the parties' decision maker's need for prior knowledge about the relevant variables and for strategic sophistication. In other settings, only the combination of competition among information providers and a sophisticated skepticism is sufficient to allow defective decision making.

Relying on the Information of Interested Parties

Rotation of audit partners is one of the main policy initiatives that has been implemented in many jurisdictions around the world to deal with concerns about audit quality. The basis of any requirement limiting the tenure of audit partners is that there is a reduction in audit quality associated with long periods of tenure. Using data from Australia, where the audit partner can be identified and for a period where partner rotation was not mandatory, we examine the association between audit quality and long audit partner tenure. The three measures of audit quality examined are the auditor's propensity to issue a going‐concern audit opinion for distressed companies, the direction and amount of abnormal working capital accruals, and just beating (missing) earnings benchmarks. For long tenure observations we find a lower propensity to issue a going‐concern opinion and some evidence of just beating (missing) earnings benchmarks, consistent with deterioration in audit quality associated with long audit partner ...

Audit Partner Tenure and Audit Quality

This paper uses recent experimental studies of financial accounting to illustrate our view of how such experiments can be conducted successfully. Rather than provide an exhaustive review of the literature, we focus on how particular examples illustrate successful use of experiments to determine how, when and (ultimately) why important features of financial accounting settings influence behavior. We first describe how changes in views of market efficiency, reliance on the experimentalist’s comparative advantage, new theories, and a focus on key institutional features have allowed researchers to overcome the criticisms of earlier financial accounting experiments. We then describe how specific streams of experimental financial accounting research have addressed questions about financial communication between managers, auditors, information intermediaries, and investors, and indicate how future research can extend those streams. We focus particularly on (1) how managers and auditors report information; (2) how users of financial information interpret those reports; (3) how individual decisions affect market behavior; and (4) how strategic interactions between information reporters and users can affect market outcomes. Our examples include and integrate experiments that fall into both the “behavioral” and “experimental economics” literatures in accounting. Finally, we discuss how experiments can be designed to be both effective and efficient.

https://educipta.com/wp-content/uploads/2014/09/Experimental-Research-in-Financial-Accounting.pdf

Experimental research in financial accounting

The Robustness of Bubbles and Crashes in Experimental Stock Markets

We provide results from an experiment designed to assess whether mandatory rotation and/or retention of auditors increases auditors' independence by reducing their willingness to issue reports biased in favor of management. Auditors' reporting is compared across the following four regimes: one that does not require either rotation or retention, a second that requires retention only, a third that requires rotation only, and a fourth that requires both rotation and retention. We find that the rotation requirements in the third and fourth regimes decreased auditor-subjects' willingness to issue biased reports, relative to the two regimes in which rotation was not imposed. In these other two regimes, however, many manager-subjects voluntarily retained the same auditor-subjects over multi-periods. While the long running interactions between manager- and auditor-subjects resulted in more favorable reports by auditor-subjects (a lower level of independence), the established relationships also induced manager-subjects to make higher investments.

An Experimental Investigation of Retention and Rotation Requirements

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

/pdf/independence-in-appearance-and-in-fact-an-experimental-4u33chuojo.pdf

Independence in Appearance and in Fact: An Experimental Investigation*

INTRODUCTION Accounting scholars have long been challenged to demonstrate the relevance and timeliness of their research to the issues faced by accounting policymakers. Among others, Schipper (1994), Swieringa (1998), and Barth et al. (2001) provide examples of the progress made by empirical-archival studies in addressing this challenge. Notwithstanding this progress, the ability of empirical-archival accounting research to offer policy-directed insights is inherently limited, for two reasons. First, real-world data can only inform us of reactions to policies that already exist, whereas the policymaker's perspective demands ex ante insights of likely reactions to policies that could exist. Second, the variation among firms in accounting practices coincides with a multitude of other factors that vary at the same time, making it difficult to isolate the incremental effect of accounting alternatives. Given these limitations, several observers, such as Maines (1994), Beresford and Johnson (1995), and Swieringa (1996), sugges t a role for true experiments--designed studies in which participants make decisions under experimenter-controlled conditions--in addressing accounting policy questions. Only in a true experiment can we vary an existing or proposed policy alternative of interest and measure its incremental influence on decision makers, holding all other influences constant. This commentary explores this idea in greater depth, especially with respect to the different strengths and weaknesses of individual judgment and decision-making studies, often termed behavioral research, and multiperson interactive studies with competitive incentives, often termed experimental economics, for producing useful policy insights. (1) Our premise is that, viewed as a whole, these two styles of experimentation help to mitigate the concern that experiments are of limited value to policy debates because they lack realism (Abdel-khalik 1994). Behavioral studies of individual judgment and decision making often lack the realism of explicit performance incentives and the multiperiod, multiperson nature of economic competition. For different reasons, experimental economic studies also lack realism, because they often involve student subjects performing stylized tasks that are abstracted from the real-world environment. When viewed as a whole, however, these two approaches complement each other, addressin g the other's weaknesses and offering unique strengths. We provide some historical perspective below, followed by examples from each approach that illustrate our premise. For the sake of brevity, we focus our examples on financial-accounting policy questions, although we could offer similar observations for policy questions involving auditing, management accounting, and taxation. We then comment on the strategic implications of accounting policy questions, distinguishing between experiments that manipulate policy alternatives and those that treat accounting choices as strategic decisions by opportunistic managers. Our concluding comments return to our overall premise and suggest ways to integrate the benefits of different experimental styles. SOME HISTORY Although marked by recent interest, the use of experiments to address accounting policy questions dates back several decades. Swieringa and Weick (1982) review several experimental studies of accounting policy questions conducted in the 1960s and early 1970s. The popularity of such experiments ebbed significantly by the mid-1970s, concurrent with the critical view of this literature that emerged by that time (Gonedes 1972; Gonedes and Dopuch 1974). Criticism reflected a two-pronged attack, noting both the lack of theory in the experimental literature of the day and the inconsistency of this literature with the prevailing belief in informational market efficiency. The following passage from Gonedes and Dopuch (1974, 106) is telling: Since laboratory studies concentrate on individual behavior rather than competitive market phenomena, their relevance to the issues at hand seems nonexistent. …

Using Laboratory Experiments to Evaluate Accounting Policy Issues

I report the results of an experiment designed to investigate the influence of noncredible communications and group affiliation on the formation of self-serving bias in an auditing trust game. I find that manager-subjects use noncredible communications (i.e., a message communicating their intent to commit low fraud levels without actually having to implement this fraud level) to induce a self-serving bias on the part of auditor-subjects. However, the self-serving bias is neutralized when auditor-subjects belong to groups that create social pressure to conform to group norms. My finding that group affiliation can undo self-serving bias calls into question the Bazerman et al. (1997) conclusion that auditors cannot be independent because of self-serving biases.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID275821_code010716670.pdf?abstractid=275821&mirid=2

Ronald R. King

Papers

The Robustness of Bubbles and Crashes in Experimental Stock Markets

An Experimental Investigation of Retention and Rotation Requirements

Independence in Appearance and in Fact: An Experimental Investigation*

Using Laboratory Experiments to Evaluate Accounting Policy Issues

An Experimental Investigation of Self-Serving Biases in an Auditing Trust Game: The Effect of Group Affiliation