[Show abstract][Hide abstract] ABSTRACT: There have been calls for auditor liability reform in U.S. and international markets. A frequent recommendation is to place a ceiling, or cap, on auditors’ potential liabilities. Despite the interest in liability caps, a lack of publicly available data has precluded researchers from studying these agreements. We examine a unique sample of 111 companies that publicly disclose auditor liability caps during 2005 and 2006, a time period in which there was uncertainty in the regulatory guidance regarding the impact of auditor liability caps on auditor independence. Our analysis addresses two research questions. First, does the presence of auditor liability caps vary depending on client risk characteristics? We find some evidence of heightened risk in companies with liability caps. Relative to a control sample, our liability cap sample is more concentrated in high-litigation risk industries and reports internal control weaknesses with greater frequency. Second, does the presence of an auditor liability cap impact audit fees? Consistent with the insurance hypothesis for audit pricing, we find a negative relation between audit fees and companies with liability caps.
[Show abstract][Hide abstract] ABSTRACT: The auditor change literature has generally concluded that clients from which an audit firm resigns are risky clients, yet little is known about the period after a predecessor auditor has resigned from an engagement. We investigate a sample of resignations to determine why an audit firm chooses to accept the role of successor auditor on a presumably risky engagement and whether this decision is associated with a future adverse outcome. Consistent with prior studies, our results indicate that, relative to Non-Big N firms, Big N firms are more selective in accepting the successor auditor role when the predecessor auditor has resigned. Incremental to these prior studies, we find that Big N firms factor in two variables to help mitigate their potential risk – the timing of the predecessor audit firm’s resignation and their own firm’s expertise. Our analysis of future outcomes indicates that the resigned clients engaged by Non-Big N successor auditors are associated with weaker long-term financial ratios, shorter survival tenures, and a greater proportion of adverse outcomes compared with the resigned clients engaged by Big N successor auditors.
[Show abstract][Hide abstract] ABSTRACT: This paper examines the role of auditee profitability in pricing new audit engagements. Changes in the auditing environment are noted that suggest that auditors are managing their practices differently than they have in prior years. Audit fees are examined to answer two questions: first, whether CPA firms still discount fees for new engagements in the current audit environment; second, whether such fee discounts are dependent upon auditee profitability. The results suggest that auditors still discount new engagements in the 1990s, but that they are less willing to offer discounts when auditees show losses in the year prior to the new audit engagement. Further, this result is stronger for companies that switch from non-Big Six firms to Big Six firms than it is for intra-Big Six switches. These findings suggest that auditors are managing their exposure to audit risk by adjusting audit fees.
[Show abstract][Hide abstract] ABSTRACT: The issuance of clean opinions to failing firms has been interpreted by both the financial press and Congress as evidence of serious problems in the auditing profession. Critics of the audit profession believe that audit failures are caused by a lack of overall audit quality and/or problems related to independence. The purpose of this paper is twofold. First, we provide additional insights into the opinion formulation process by presenting a model that is both simpler than that used in prior research and more consistent with what auditors say they actually do. Based on a sample of 311 bankrupt firms, our results indicate that our simple indicator model significantly outperforms prior models in distinguishing between modified and unmodified reports issued to bankrupt companies. Second, we evaluate the extent to which the data for these bankrupt firms are reasonably predictive of failure. Contrary to public perception, we find that auditors consistently modify the reports of those companies that are most distressed and issue unmodified reports to those companies that are least distressed. In fact, the auditors modified significantly more audit reports than they would have by using a well-accepted bankruptcy prediction model. The vast majority of the firms in our sample, however, simply do not exhibit the characteristics we would expect of severely distressed firms.
[Show abstract][Hide abstract] ABSTRACT: Many observers are dissatisfied with the accounting profession?s ability to warn the public of upcoming bankruptcy filings. The Chairman of the SEC recently reminded auditors that "they are the public?s watchdog in the financial reporting process" and that "we rely on auditors to put something like the Good Housekeeping seal of approval on the information investors receive" (Levitt, 1998). Since regulators and users tend to treat an unmodified audit opinion as a "clean bill of health", they do not expect the business to fail in the near future. Research has shown that more often than not, auditors end up letting users down when it comes to predicting bankruptcy filings with audit opinions. Although auditors assert they are not responsible for predicting future events, it is very clear that their opinion decision is evaluated, at least in part, based on events that occur after the audit report date. The interesting and logical next step is to find out how companies exit bankruptcy. Do they liquidate or reorganize? Successful reorganization may, in the end, exonerate auditors and preserve their role as an early warning device. Is there any evidence to suggest that auditors end up being correct? The opinion prediction model developed in the paper introduces a new bankruptcy resolution variable that proxies for the auditor?s prognosis of the ultimate disposition of the soon-to-be-bankrupt company. Using a sample of bankruptcy filings between 1982 and 1992, we find that auditors do not seem to be able to predict filings or resolution. Instead, the model suggests that auditors are less likely to issue a modified opinion when the financial prospects of the company are not clear and when auditors are faced with incentives to delay or avoid a modified opinion. Our tests of bankruptcy resolution support what auditors have been arguing for years: that they are not clairvoyant with respect to a client?s future. The results of the research are not encouraging for those who rely on audit opinions as an early warning device.
[Show abstract][Hide abstract] ABSTRACT: This paper contributes to the recent international debate over mandatory auditor rotation by providing a conceptual research framework in which to view the tenure-audit quality relation. Audit quality is viewed to be a function of auditor performance. The auditor’s ability and professional conduct are argued to be major factors affecting performance. Economic incentives and market structure have endogenous relationships with both performance and tenure. Research implications of the framework suggest that evaluating the efficacy of mandatory auditor rotation is likely to be a complex process, more involved than a simple association test of the tenure-audit quality relation. The study also proposes several avenues for future examination: (1) evaluation of assumptions implicit in rotation arguments; (2) testing of magnitudes and effect directions; (3) examination of professional oversight controls; and (4) assessment of the costs of compulsory rotation.
Journal of International Accounting, Auditing and Taxation. 01/1999;