Auditor independence, ‘low balling’, and disclosure regulation
TL;DR: In this paper, the authors investigated the allegations of the Commission on Auditors' Responsibilities and the Securities and Exchange Commission that "low-balling" on initial audit engagements impairs auditor independence.
Abstract: This paper investigates the allegations of the Commission on Auditors' Responsibilities and the Securities and Exchange Commission that ‘low balling’ on initial audit engagements impairs auditor independence. We demonstrate that, contrary to these claims, ‘low balling’ does not impair independence; rather it is a competitive response to the expectation of future quasi-rents to incumbent auditors (due, e.g., to technological advantages of incumbency). ‘Low balling’ in the initial period is the process by which auditors compete for these advantages. Critically, initial fee reductions are sunk in future periods and therefore do not impair auditor independence. The implications for current regulation governing changes of auditor (Accounting Series Release No. 165 et al.) and audit fees (Accounting Series Release No. 250) are also discussed.
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TL;DR: In this paper, the authors argue that audit quality is not independent of audit firm size, even when auditors initially possess identical technological capabilities, and when incumbent auditors earn client-specific quasi-rents, auditors with a greater number of clients have more to lose by failing to report a discovered breach in a particular client's records.
Abstract: Regulators and small audit firms allege that audit firm size does not affect audit quality and therefore should be irrelevant in the selection of an auditor. Contrary to this view, the current paper argues that audit quality is not independent of audit firm size, even when auditors initially possesses identical technological capabilities. In particular, when incumbent auditors earn client-specific quasi-rents, auditors with a greater number of clients have ‘more to lose’ by failing to report a discovered breach in a particular client's records. This collateral aspect increases the audit quality supplied by larger audit firms. The implications for some recent recommendations of the AICPA Special Committee on Small and Medium Sized Firms are developed.
4,969 citations
TL;DR: This paper pointed out that the "quality" of earnings is a function of the firm's fundamental performance and suggested that the contribution of a firms fundamental performance to its earnings quality is suggested as one area for future work.
Abstract: Researchers have used various measures as indications of "earnings quality" including persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases. For each measure, we discuss causes of variation in the measure as well as consequences. We reach no single conclusion on what earnings quality is because "quality" is contingent on the decision context. We also point out that the "quality" of earnings is a function of the firm's fundamental performance. The contribution of a firm's fundamental performance to its earnings quality is suggested as one area for future work.
2,633 citations
Cites background or methods from "Auditor independence, ‘low balling’..."
...This outcome appears to result from both greater expertise (effectiveness) and stronger incentives to constrain misreporting (DeAngelo, 1981)....
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...Audit fees and auditor tenure are predicted to be positively correlated with auditor expertise, and hence with detection ability, but they are also predicted to be negatively associated with auditor independence and hence with decreased reporting incentives (DeAngelo, 1981)....
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...Dechow et al. (1996) find an increase in residual bid ask spread for AAER firms....
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...129 (that excludes depreciation); (iii) the absolute value of the residual from a Dechow and Dichev model; (iv) the standard deviation of the residual from (iii) using the time-series of the firm’s residual (i.e., as in FLOS). Aboody, Hughes, and Liu (2005) find that a mimicking portfolio strategy that buys firms with high AQ beta earns positive abnormal returns earns positive abnormal returns....
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...Large-sample studies suggest mispricing of various accrual metrics and components of accruals: total accruals (Sloan, 1996); discretionary accruals (Xie, 2001); accruals and growth in long-term net operating assets as separate components of Sloan’s total accrual measure (Fairfield, Whisenant, and Yohn, 2003); and special items and accruals (Dechow and Ge, 2006). Dechow, Richardson, and Sloan (2008) show that investors correctly price various cash components of earnings except for the change in the cash balance....
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TL;DR: In this article, the authors examined whether the presence of venture capitalists, as investors in a firm going public, can certify that the offering price of the issue reflects all available and relevant inside information.
Abstract: This paper provides support for the certification role of venture capitalists in initial public offerings. Consistent with the certification hypothesis, a comparison of venture capital backed IPOs with a control sample of nonventure capital backed IPOs from 1983 through 1987 matched as closely as possible by industry and offering size indicates that venture capital backing results in significantly lower initial returns and gross spreads. In effect, the presence of venture capitalists in the issuing firms serves to lower the total costs of going public and to maximize the net proceeds to the offering firm. In addition, we document that venture capitalists retain a significant portion of their holdings in the firm after the IPO. THE ABILITY OF THIRD-PARTY specialists to certify the value of securities issued by relatively unknown firms in capital markets that are characterized by asymmetric information between corporate insiders and public investors has attracted much academic interest in recent years. Several authors, including James (1990), Blackwell, Marr, and Spivey (1990), and Barry, Muscarella, Peavy, and Vetsuypens (1991) have developed and tested models based at least in part on the formal certification hypothesis presented in Booth and Smith (1986). A related body of work, represented by DeAngelo (1981), Beatty and Ritter (1986), Titman and Trueman (1986), Johnson and Miller (1988), Carter (1990), Simon (1990), and Carter and Manaster (1990) has examined how investment bankers and auditors help resolve the asymmetric information inherent in the initial public offering (IPO) process. In this paper we examine whether the presence of venture capitalists, as investors in a firm going public, can certify that the offering price of the issue reflects all available and relevant inside information. We hypothesize that venture capitalists can perform this function; that it will be an economically
2,490 citations
TL;DR: In this paper, the authors point out that the quality of earnings is a function of the firm's fundamental performance and suggest that the contribution of a firms fundamental performance to its earnings quality is suggested as one area for future work.
Abstract: Researchers have used various measures as indications of “earnings quality” including persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases. For each measure, we discuss causes of variation in the measure as well as consequences. We reach no single conclusion on what earnings quality is because “quality” is contingent on the decision context. We also point out that the “quality” of earnings is a function of the firm’s fundamental performance. The contribution of a firm’s fundamental performance to its earnings quality is suggested as one area for future work.
2,140 citations
TL;DR: In this article, the authors define higher audit quality as greater assurance of high financial reporting quality, and they provide a framework for systematically evaluating their unique strengths and weaknesses, including the role of auditor and client competency in driving audit quality.
Abstract: We define higher audit quality as greater assurance of high financial reporting quality. Researchers use many proxies for audit quality, with little guidance on choosing among them. We provide a framework for systematically evaluating their unique strengths and weaknesses. Because it is inextricably intertwined with financial reporting quality, audit quality also depends on firms’ innate characteristics and financial reporting systems. Our review of the models commonly used to disentangle these constructs suggests the need for better conceptual guidance. Finally, we urge more research on the role of auditor and client competency in driving audit quality.
1,553 citations
Cites background from "Auditor independence, ‘low balling’..."
...Most studies define audit quality as some variation of “the market-assessed joint probability that a given auditor will both detect a breach in the client’s accounting system, and report the breach” (e.g., DeAngelo, 1981)....
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...Auditor size, usually measured as Big N membership, is used to proxy for audit quality because large auditors are expected to have stronger incentives and greater competencies to provide high audit quality (DeAngelo, 1981)....
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...The nature of the auditor–client relationship presents a natural threat to auditor independence because auditors have incentives to retain fee-paying clients (Mautz and Sharaf, 1961; DeAngelo, 1981)....
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10,771 citations
TL;DR: In this paper, the potential of post-contractural apportunistic behavior for improving market efficiency through intra-firm rather than interfirm transactions is examined under the assumption that vertical costs will increase less than contracting costs as specialized assets and appropriable quasi rents increase.
Abstract: The potential of post-contractural apportunistic behavior for improving market efficiency through intrafirm rather than interfirm transactions is examined under the assumption that vertical costs will increase less than contracting costs as specialized assets and appropriable quasi rents increase. Vertical integration protects against the risk of contract cancellation and can create market power which is not generally referred to as monopoly. Contracts used as a alternative provide economically enforceable protection against opportunistic behavior. Solutions to opportunistic behavior problems can include joint ownership of common assets and condominium ownership of services. Economies of scale are major factors in some businesses, such as insurance. The complexities of ownership relations makes it difficult to assign higher costs to either the contract or vertical-integration approach. This suggests that economic analysis should be used to identify which is most advantageous for specific kinds of activities.
5,728 citations
TL;DR: The authors found that businessmen often fail to plan exchange relationships completely, and seldom use legal sanctions to adjust these relationships or to settle disputes, and that planning and legal sanctions are often unnecessary and may have undesirable consequences.
Abstract: Preliminary findings indicate that businessmen often fail to plan exchange relationships completely, and seldom use legal sanctions to adjust these relationships or to settle disputes. Planning and legal sanctions are often unnecessary and may have undesirable consequences. Transactions are planned and legal sanctions are used when the gains are thought to outweigh the costs. The power to decide whether the gains from using contract outweigh the costs will be held by individuals having different occupational roles. The occupational role influences the decision that is made.
2,504 citations
"Auditor independence, ‘low balling’..." refers background in this paper
...16See Macaulay (1963) for discussion of the use of explicit and implicit contracts in business relationships....
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1,719 citations