Brian W. Mayhew

Do Nonaudit Services Compromise Auditor Independence? Further Evidence

This paper challenges the findings of Frankel et al. (2002) (FJN). The results of our discretionary accruals tests differ from FJNs when we adjust discretionary current accruals for firm performance. In our earnings benchmark tests, in contrast to FJN we find no statistically significant association between firms meeting analyst forecasts and auditor fees. Our market reaction tests also provide different results than those reported by FJN. Overall, our study indicates that FJNs results are sensitive to research design choices, and we find no systematic evidence supporting their claim that auditors violate their independence as a result of clients purchasing relatively more nonaudit services.

The Impact of Ethics Education on Reporting Behavior

We examine the impact of an ethics education program on reporting behavior using two groups of students: fourth year Masters of Accounting students who just completed a newly instituted ethics education program, and fifth year students in the same program who did not receive the ethics program. In an experiment providing both the opportunity and motivation to misreport for more money, we design two social condition treatments – anonymity and public disclosure – to examine whether or to what extent ethical values are internalized by students. We find that when participants are anonymous, misreporting rates are nearly the same regardless of ethics program participation. However, when their reporting behavior is made public to the cohort, participants who completed the ethics program misreported at significantly lower rates than those who did not receive the ethics program. The results suggest that ethics education does not necessarily result in internalized ethical values, but it can impact ethical behavior.

The Impact of Authority on Reporting Behavior, Rationalization and Affect

We examine reporting choices, rationalizations and emotional responses when an authority figure directs participants to misreport the results of their performance for financial gain. Our research is motivated by the assertions of several individuals involved in major accounting scandals that an authority figure instructed them to perpetrate fraudulent financial reporting. We employ a laboratory experiment where a “boss” instructs participants to misreport for financial benefit. We find that, when instructed to misreport: (1) more participants misreport, (2) they rationalize their behavior primarily by displacing responsibility, and (3) they do not feel as badly as they do when they misreport on their own volition. We find that displacing responsibility mediates the relation between being told to misreport and the act of misreporting, resulting in lower levels of negative affect. Our research addresses calls to better understand the role of rationalizations in fraudulent reporting (Hermanson 2009) and lays the groundwork necessary to explore interventions that reduce fraudulent financial reporting (AICPA 2002, Wells 2004).

Examining the Role of Auditor Quality and Retained Ownership in IPO Markets: Experimental Evidence*

We use experimental markets to test the Datar, Feltham, and Hughes (DFH) 1991 model of entrepreneur choice of auditor and retained ownership in initial public offerings (IPOs). DFH predict that entrepreneurs use retained ownership to signal IPO value and substitute high-quality auditors for retained ownership to signal value as the risk of the IPO increases. Given the mixed support for DFH from archival research, we conduct experimental markets that directly operationalize the models decision variables, which permits a direct test of whether the model is descriptively valid. In addition, our market setting provides a strong test of this theory by including an alternative Nash equilibrium also present in field settings, one in which only auditor quality is used by entrepreneurs to signal IPO value. Our results suggest that DFH predict entrepreneur behavior in baseline markets where both computerized investors and auditors are programmed to price consistently with the DFH equilibrium. However, the DFH model does not describe behavior when “robot” investors are replaced with human investors in the market. The results suggest that entrepreneurs and investors strategically interact in a manner that leads them away from the DFH equilibrium and toward the alternative Nash equilibrium behavior of entrepreneurs with high-value assets hiring high-quality auditors irrespective of IPO risk. Our results imply that the DFH model has limited descriptive validity, document the importance of strategic behavior on market equilibrium formation, and suggest that the mixed results found in prior DFH-based field studies may reflect the models low descriptive validity.

The Effect of Accounting Uncertainty and Auditor Reputation on Auditor Independence

This paper reports the results of experimental economic markets designed to examine whether an auditors objectivity (independence) is impacted by uncertainty regarding the appropriate accounting treatment for a client. In particular, we are interested in whether the auditor exploits this uncertainty by agreeing with her clients preferred accounting treatment even when her evidence suggests an alternative treatment is more likely to be correct. We examine the effect of accounting uncertainty in a setting where the auditor not only wants to satisfy her client but also wants to maintain a reputation for audit objectivity in the market. The results provide strong evidence that the level of accounting uncertainty impacts auditor independence. Specifically, when accounting uncertainty did not exist, auditors maintained their independence by truthfully reporting the observed value. Auditors appeared to remain independent due to concerns about their reputations with managers and investors. However, when accounting uncertainty existed, auditors impaired their independence by misreporting the observed value in favor of the manager. Our results specify some initial boundary conditions for the impact of auditor reputation and investor pricing on auditor independence, and suggest that regulators should focus on enhancing auditor incentives to maintain independence when faced with accounting uncertainty. It appears that regulators do not need to be as concerned about independence violations when accounting pronouncements provide unambiguous guidance. An auditors concern about her reputation provides adequate incentive to prevent independence impairment when she is certain about the appropriate accounting treatment. Our results also suggest future research should assess the ability of other audit market forces to reduce the propensity of auditors to violate independence when faced with accounting uncertainty.

The Impact of Market Structure on Audit Price and Quality

We examine the association between U.S. audit market structure and both audit price and quality. The significant consolidation of the largest audit firms and its effect on market structure has raised international concern among policy makers. We address this concern by examining the association between equality of Big4 market shares at the U.S. national-industry level and both audit fees and audit quality. Our results suggest that greater national-industry Big4 market equality is associated with lower audit fees and higher audit quality measured by client restatements. We extend the analysis to the city level and find equality associated with higher fees but little association with quality. We incorporate market concentration as another measure of market structure and find equality better captures the association between market structure and audit fees. National-industry equality also continues to be positively associated with quality despite a significant association between city level concentration and quality. Our results suggest that the equality of audit firm market shares is associated with important market outcomes even in the highly concentrated audit market, and that alternative levels of market aggregation such as the national-industry and city levels provide different insights into the effects of market structure.

The Pricing of Assurance Services in Secondary Equity Offerings

This paper examines the pricing of assurance services in secondary equity offerings (SEOs). Our empirical model extends initial public offering (IPO) fee specifications to include variables that are unique to, or more relevant for, secondary offerings. We document an inverse relationship between SEO fees and a clients ability to delay its secondary offering, suggesting that auditors do not charge as much for SEOs made by relatively mature firms. The relationship reverses, however, when the client is required to use more comprehensive types of filings (i.e., when assurance effort is higher). We also show that fees are higher when the SEO comes to market during the clients annual audit period. This finding is consistent with the shifting of year-end audit fees to SEO engagements in an effort to boost earnings for both clients and auditors (at the expense of shareholders). We cannot, however, unambiguously conclude that fee shifting exists, as the observed fee premium could be explained by other factors.

Behavioral research in auditing: Past, present, and future research

The purpose of this paper is to provide insight regarding past, present, and future research in behavioral auditing to Ph.D. students and other researchers seeking to identify productive opportunities for future research. Our analysis is informed by recent publication trends and interviews with twenty-one active researchers likely to shape behavioral auditing research in the next decade. The results demonstrate a shift in research interest toward topics including auditor independence, corporate governance, emerging audit approaches, and new assurance services. This shift highlights a growing popularity of research motivated by emerging practice trends and issues receiving attention by the SEC, AICPA, and ASB. Our interviewees stressed the importance of integrating multiple methodologies in future research. Overall, our results demonstrate that behavioral auditing research remains an active and successful area of literature.

Entrepreneur Choice of Auditor and Retained Ownership in IPO Markets: Experimental Evidence

We use experimental economic markets to test the Datar, Feltham and Hughes (DFH) (1991) model of entrepreneur choice of auditor and retained ownership in initial public offering markets. The mixed evidence provided by prior research using archival data motivated our experimental approach. Experimental markets inherently exhibit considerably more control over the models decision variables than do archival studies. This enables us to test whether the model adequately describes human behavior and examine the effect of an important decision variable cited by prior research. Our results provide considerable support for the DFH model of entrepreneur behavior in treatments where investors are programmed to price consistent with the DFH equilibrium. We also found support in similar treatments for a modified DFH model that included the impact of client risk on auditor fees. However, the model was far less predictive of entrepreneur behavior in markets with human investors instead of programmed investors. The results suggest that human entrepreneurs and investors adapt to the choices each made within a particular market, such that less than half of the markets conformed to DFHs predictions while the rest followed an alternative equilibrium where only the entrepreneurs choice of auditor signaled firm value. Our results suggest that in signaling models like DFH, theorists should consider market environments and interactions that can lead to one equilibrium versus another.

The Impact of Consulting Services on Audit Quality: An Experimental Approach

We use experimental markets to examine whether providing consulting services to a non‐audit client impacts audit quality. Our paper directly addresses concerns raised by the Public Company Accounting Oversight Board that the largest public accounting firms’ growth in their consulting practices threatens audit quality. We conduct an experiment proposed using a registration‐based editorial process. We compare a baseline where the auditor does not provide consulting services to conditions where auditors provide consulting to audit clients or where auditors only provide consulting services to non‐audit clients. Our unique design provides evidence on whether providing consulting to non‐audit clients strengthens the salience of a client‐cooperative social norm that reduces audit quality. We do not find differences in audit quality by condition in our planned analysis, however we find greater variation in audit quality in the conditions where auditors provide consulting services compared to the baseline. In unplanned analyses, our results suggest providing consulting services increases auditor cooperation with managers, increasing audit quality when managers prefer high audit quality and decreasing audit quality when managers prefer low audit quality.