Dennis J. Chambers

Future Nonaudit Service Fees and Audit Quality

Prior to the Sarbanes�Oxley Act of 2002, audit partners experienced economic pressure to grow revenue from the sale of nonaudit services to their audit clients. To an auditor who is highly rewarded for revenue generation and growth, nonaudit services may represent a particularly strengthened economic bond with the client. Prior research shows that, in general, nonaudit service fees received in the current period do not impair audit quality. We examine a different setting. We propose that auditor independence can become impaired, and audit quality compromised, when clients that currently purchase relatively low amounts of nonaudit services, increase their purchases of nonaudit services from the auditor in the subsequent period. We test our prediction in the context of earnings management as a proxy for audit quality, measured by (a) performance-adjusted discretionary accruals and (b) classification shifting of core expenses. Our results indicate that prior to the Sarbanes-Oxley Act, rewards to the auditor in the form of future additional nonaudit service fees from current-year high fee-growth-opportunity clients adversely affects audit quality. This effect is particularly strong among companies with powerful incentives to manage earnings. Our findings indicate that regulators should consider the multiperiod nature of the client�auditor relationship when contemplating policies that restrict nonaudit services, as well as the overall environment in which audit partners operate. This might include partner compensation arrangements that put pressure on audit partners to focus on increasing revenue at the expense of audit quality.

Evidence on the Usefulness of Capital Expenditures as an Alternative Measure of Depreciation

Investment professionals often suggest that accounting earnings is a more useful indicator of share value if adjusted by substituting current capital expenditures for reported depreciation. We investigate the usefulness of this alternative depreciation measure by comparing the ability of reported earnings and adjusted earnings to explain the cross-sectional distribution of stock prices for a large sample of manufacturing firms. We find that adjusted earnings explains a much smaller fraction of the variation in share prices than earnings based on reported depreciation, and provide evidence on the reasons for this difference.

Audit Quality and Accrual Persistence: Evidence from the Pre- and Post-Sarbanes-Oxley Periods

Purpose - The purpose of this paper is two-fold: first, to examine whether the quality of accruals, as measured by accrual persistence, improved in the post-Sarbanes-Oxley (SOX) period, and second, to examine the degree to which SOX-related improvement in accrual persistence varies across companies depending on the degree of their auditors independence. Design/methodology/approach - The paper compares accrual persistence in the pre- and post-SOX periods to test the first question. Then, partitioning on relative client importance as a measure of auditor independence, the paper compares the SOX-based improvement for clients of low and high independence audit firms. Findings - The study first demonstrates that accrual persistence increased significantly in the post-SOX period. The study also finds evidence that in the post-SOX period, the subsample of companies audited by Big-N auditors with lower-independence experienced the greatest improvement in accrual persistence. Originality/value - This is the first paper to evaluate SOX-related improvements in the quality of earnings as measured by accrual persistence. Prior studies test abnormal accruals and other earnings management metrics, however, persistence is a more general test of financial statement quality. This study also is the first to compare SOX-related improvements for clients of firms with differing levels of independence.

Audit Quality and Accrual Reliability: Evidence from the Pre- and Post-Sarbanes-Oxley Periods

This study examines three research questions. First, did accrual reliability improve in the post-SOX period? Second, do companies receiving higher-quality audits report accruals that are more reliable? Third, did the degree of SOX-related improvement in accrual reliability vary across companies with disparate audit quality? We first demonstrate that accrual reliability increased significantly in the post-SOX period. We next define three metrics for audit quality: audit firm industry specialization, audit-firm independence, and client-specific audit-firm litigation/reputation risk. We find evidence that accrual reliability is positively associated with each of our audit quality metrics. Finally, we find evidence that in the post-SOX period, subsamples of companies experienced more improvement in accrual reliability than others. Specifically, companies audited by non-specialist auditors, those audited by lower-independence auditors, and those that represent higher litigation/reputation risk to their auditor experienced the greatest improvement in accrual reliability in the post-SOX period.

Discussion of "Is Research and Development Mispriced or Properly Risk Adjusted?"

Mustafa Ciftci, Baruch Lev, and Suresh Radhakrishnan (2011) provide an interesting and innovative look at the question of mispricing and compensation for bearing risk related to research and development (R&D) intensity. They introduce a number of significant contributions to this literature. They partition their sample based on R&D strategy, and test for both business and information risk. They find differences in the returns for bearing business and information risk across their strategy sample partitions. They also find evidence that firms following an innovative R&D strategy are underpriced by the market.