Ariel J. Markelevich

Auditor fees and audit quality

Purpose - The paper aims to examine the relation between fees paid to auditors and audit quality during the period of 2000-2003. Design/methodology/approach - The paper constructs a measure of auditor profitability that is used as a proxy for auditor independence. The methodology is grounded in the notion that auditor independence is influenced by effort and risk-adjusted fees, rather than the level of fees received from clients. Since, risk and effort are unobservable, the paper uses proxies based on client size, complexity and risk to estimate abnormal fees. Abnormal fees are derived using a fee estimation model drawn from prior literature. The paper employs two metrics to assess audit quality – the standard deviation of residuals from regressions relating current accruals to cash flows and the absolute value of performance-adjusted discretionary accruals. Findings - The paper documents a statistically significant negative association between total fees and both audit quality proxies over all years. These findings are robust to a variety of additional tests and several alternative design specifications. The results (pre- and post-SOX) are consistent with economic bonding being a determinant of auditor behavior rather than auditor reputational concerns. Research limitations/implications - The possibility that the empirical tests do not completely capture the impact of unobserved risk cannot be ruled out, though the paper attempts to do so by employing alternative specifications and sensitivity tests. Practical implications - Policy makers should note that current restrictions on the provision of non-audit services may not sufficiently resolve the issue of economic bonding and its impact on auditor independence. Originality/value - In contrast to previous studies whose results are ambiguous, the paper finds a statistically significant positive association between several measures of total fees (it uses size-adjusted and abnormal fees) and two metrics of accruals quality in all years (2000-2003), consistent with economic bonding being a determinant of auditor behavior rather then auditor reputation concerns.

Auditor Fees and Fraud Firms

The issue of whether auditor fees affect auditor independence has been extensively debated by regulators, investors, investment professionals, auditors, and researchers. The revised Securities and Exchange Commission (SEC) requirements that resulted from the implementation of the Sarbanes‐Oxley Act (2002) limit nonaudit services (NAS) and mandate NAS fee disclosure. The SECs requirements are based on the argument that auditor independence could be impaired—and hence audit quality may be reduced—when auditors become economically dependent on their clients or audit their own work. Economic bonding leads to reduced independence, which can lead to reduced audit quality. We study a sample of firms sanctioned by the SEC for fraudulent financial reporting in Accounting and Auditing Enforcement Releases (SEC‐sanctioned fraud firms) and examine whether there is a relationship between auditor fee variables and the likelihood of being sanctioned by the SEC for fraud. We use SEC sanction as a measure of audit quality that has not previously been used in the auditor fee literature and is more precise than some of the other proxies used for flawed financial/auditor reporting. We find, in univariate tests, that fraud firms paid significantly higher (total, audit, and NAS) fees. However, in multivariate tests, when controlling for other fraud determinants and endogeneity among the fraud, NAS, and audit fee variables, we find that while NAS fees and total fees are positively and significantly related to the likelihood of being sanctioned by the SEC for fraud, audit fees are not. These findings suggest that higher NAS fees may cause economic bonding, thereby leading to reduced audit quality. Our findings of significantly higher NAS fees and total fees in fraud firms hold after controlling for latent size effects and other rigorous testing. These results contribute to the literature that examines the SECs concerns regarding NAS and can be used by policy makers for additional consideration.

Sustaining the Financial Value of Global CSR: Reconciling Corporate and Stakeholder Interests in a Less Regulated Environment

In this article we examine the association between corporate social responsibility (CSR) and firm value. This line of research is important since firms continue to invest in CSR even though past studies reveal a limited linkage between financial value and CSR. However, the business case for CSR or “doing good while making a profit,” appears to be advancing within the business ethics literature as a preferred conception of CSR. We conjecture that the greater unification and refinement of both profit maximization and stakeholder interests through corporate acts, not statements alone, will sustain the financial value of CSR in a less regulated global business environment. We study the triangle of what companies say, what companies do, and firm financial performance. We analyze Fortune 250 firms and find a positive association between what companies do based on KLD Research and Analytics, Inc. (KLD) ratings, and what companies state about ethics in their CSR statements. We then employ regression analysis and find that companies’ socially responsible acts are positively associated with overall firm value and financial performance. Yet we do not find a statistically significant association between what companies say regarding ethics in their CSR statements and their financial outcomes. These results suggest that firm value and financial performance is associated with what companies do and not what they say. Our results seem to be driven by multinational corporations (MNCs) and not by non‐MNCs. This is possibly because MNCs generally operate in a less regulated global business environment that often necessitates strong ethical corporate leadership to further stakeholder interests. Overall, these results help reconcile corporate and stakeholder objectives since evidence of a link between financial performance and doing good sustains global CSR.

Accounting for derivative instruments and hedging activities (SFAS No. 133)

Purpose – The purpose of this paper is to examine the impact of firms using derivatives applying Statement of Financial Accounting Standards (SFAS) No. 133. It aims to measure the magnitude of cumulative effects of changes in accounting principle from the income statement in the year of adoption, market reaction to earnings announcements, and key financial ratios effects.Design/methodology/approach – Search of the Compustat Industrial database for firms reporting a cumulative effect of a change in accounting principle in their annual income statements for fiscal years ending after 15 June, 2000. We then examine the impact of firms using derivatives applying SFAS No. 133.Findings – The sampled firms reported an absolute cumulative effect on income of

An Analysis of the Israeli XBRL Adoption Experience

6.8 billion, 65 per cent of which was negative. Significant negative unexpected returns were observed around earnings announcement dates. Abnormal returns correlated with the cumulative effect, rather than with change in earnings per share from operations, sh...

Accounting for Derivative Instruments and Hedging Activities (SFAS No. 133): Implications for Profitability Measures and Stock Prices

eXtensible Business Reporting Language (XBRL) is a language for the electronic communication of business and financial data which is revolutionizing business reporting around the world. It is a tool to bridge potential language barriers and unify financial reporting. This has appeal to foreign investors among others, who can rely on information in XBRL-tagged financial reports to make investment decisions without having to translate financial statements from local language. In 2008, Israel required most public companies to adopt International Financial Reporting Standards (IFRS) for financial reporting and all public companies to use XBRL-tagged reporting format, as part of an aggressive effort to make its capital markets more transparent and attractive for foreign investors. In this paper we study all Israeli public companies and analyze their XBRL-tagged financial statements that are available on MAGNA, the Israel Securities Authority’s electronic system. We describe the unique process by which the XBRL-based data was collected and reported. In addition we examine these companies’ original full body Hebrew-based financial statements. We document deficiencies in the XBRL-tagged filings, and inconsistencies between them and the Hebrew-based annual reports. Further, we conduct numerous interviews with professionals in the American and Israeli financial communities to gain additional insight on the conversion. This unique analysis allows us to better understand the benefits and challenges of the adoption of XBRL, particularly when coupled with the adoption of IFRS.

Academic - Business Collaboration: A Market Failure

Purpose - The purpose of this paper is to examine the impact of firms using derivatives applying Statement of Financial Accounting Standards (SFAS) No. 133. It aims to measure the magnitude of cumulative effects of changes in accounting principle from the income statement in the year of adoption, market reaction to earnings announcements, and key financial ratios effects. Design/methodology/approach - Search of the Compustat Industrial database for firms reporting a cumulative effect of a change in accounting principle in their annual income statements for fiscal years ending after 15 June, 2000. We then examine the impact of firms using derivatives applying SFAS No. 133. Findings - The sampled firms reported an absolute cumulative effect on income of

Information content of IFRS versus domestic accounting standards: evidence from mandatory IFRS adoption in Israel

6.8 billion, 65 per cent of which was negative. Significant negative unexpected returns were observed around earnings announcement dates. Abnormal returns correlated with the cumulative effect, rather than with change in earnings per share from operations, showing that the surprise related to the accounting change. Ratio analyzes and regressions results show sampled firms with material unrealized gains and losses related to hedging with derivative instruments. Earnings-related ratios, return on assets (ROA), return on equity (ROE) and measures of other comprehensive income decreased significantly from 2000 to 2001 after experiencing prior period significant increases. Practical implications - The results presented in the paper should lead to further research on the effect on new authoritative standards on the financial reporting process. Originality/value - Rather than judge SFAS No. 133s relative merits and shortcomings, the Standards actual (rather than predicted) effects were analyzed. Focus was on the magnitude of the impact of SFAS No. 133 and the effect on key financial ratios. The impact of adopting the Standard was analyzed and it was found that it violated a basic tenet of financial accounting pronouncements: a “value neutral” basis was examined.

Introducing XBRL through a financial statement analysis project

In this paper we consider the reasons for and the costs of limited collaboration between academic researchers and private sector firms. We focus, in particular, on one type of knowledge transfer between the two realms, namely, academic consulting to the private sector. We argue that academics do not understand the value their expertise, methodological approach and soft skills can have for industry. We also argue that industry actors are not fully aware that rigorous, evidence-based advice can be obtained from academics and that, in some cases, advice from academics will either exceed or compare favorably with services obtained from leading consulting companies. The paper is organized as follows: part I surveys the different forms that collaboration between academia and industry can take. Part II examines the empirical data on how much collaboration is actually happening. Part III explores the reasons for the broad disconnect between industry and academia. Parts IV and V argue that the lack of such collaboration results in missed opportunities for both academics and industry and thus constitutes a market failure. Part VI raises suggestions for increasing collaboration.

Earnings quality following corporate acquisitions

Beginning in 2008, most Israeli public companies were required to adopt international financial reporting standards (IFRS). Previously, Israel followed its own set of financial reporting standards - Israeli generally accepted accounting principles (GAAP). This paper examines the impact of the conversion from Israeli GAAP to IFRS on the reporting of financial performance of over six hundred Israeli public companies. Results of this study contribute to the discussion on the impact of mandatory IFRS adoption and have potential implications for other countries currently considering conversion from legacy GAAP to IFRS. In Israels case, the conversion, done to facilitate foreign investment in Israeli companies, had little or no impact on financial results or value relevance of accounting information.