Inder K. Khurana

Audit‐Firm Tenure and the Quality of Financial Reports*

This study examines whether the length of the relationship between a company and an audit firm (audit†firm tenure) is associated with financial†reporting quality. Using two proxies for financial†reporting quality and a sample of Big 6 clients matched on industry and size, we find that relative to medium audit†firm tenures of four to eight years, short audit†firm tenures of two to three years are associated with lower†quality financial reports. In contrast, we find no evidence of reduced financial†reporting quality for longer audit†firm tenures of nine or more years. Overall, our results provide empirical evidence pertinent to the recurring debate regarding mandatory audit†firm rotation — a debate that has, to date, relied on anecdotal evidence and isolated cases.

The role of accounting and auditing in corporate governance and the development of financial markets around the world

Abstract For a sample of 31 countries, we document that financial disclosures are more transparent and national accounting standards require timelier (accrual based) reporting in countries with stronger investor protection. These countries also spend more on auditing enforcement and the Big Five accounting firms audit proportionately more companies in these countries. These results indicate that higher quality accounting standards and the enforcement of such standards through higher quality auditing are more likely to exist in corporate governance in countries with strong investor protection. Higher quality accounting and auditing are also positively associated with financial market development in countries whose legal systems are conducive to the protection of investors. However, we are unable to find systematic evidence that higher quality accounting and auditing alone—independent of a countrys underlying investor protection regime—affects the development of financial markets.

Relative value relevance of historical cost vs. fair value: Evidence from bank holding companies

Abstract This study complements the growing literature on the value relevance of fair value by examining the validity of the hypothesis that fair value is more informative than historical cost as a financial reporting standard for financial instruments. Using the fair value disclosures made under Statement of Financial Accounting Standards (SFAS) No. 107 and SFAS No. 115 by bank holding companies (BHCs) over the 1995–98 period, we compare the relative explanatory power of fair value and historical cost in explaining equity values. For our entire sample, we are unable to detect a discernible difference in the informativeness of fair value measures collectively relative to historical cost measures. However, for small BHCs and those with no analysts following, we find that historical cost measures of loans and deposits are more informative than fair values. Anecdotal evidence indicates that loans and deposits are not actively traded and often involve more subjectivity with respect to the methods and assumptions used in estimating their fair values. In contrast, fair value of available-for-sale securities, which are more actively traded in well-established markets, explains equity values more than historical cost. Taken together, our results are consistent with the notion that fair value is more (less) value relevant when objective market-determined fair value measures are (not) available. More importantly, our results suggest that simply requiring fair value as the reported measure for financial instruments may not improve the quality of information for all BHCs unless appropriate estimation methods or guidance for financial instruments that are not traded in active markets can be established.

Do Investors Care about the Auditor's Economic Dependence on the Client?*

In this study, we investigate whether investor perceptions of the financial reporting credibility of Big Five audits is related to the auditors economic dependence on the client as measured by nonaudit as well as total (audit and nonaudit) fees paid to the incumbent auditor. We utilize the client-specific ex ante cost of equity capital as a proxy for investor perceptions of financial reporting credibility, and examine auditor fees both as a proportion of the revenues of the audit firm and the revenues of the audit firms practice office through which the audit was conducted. Our findings suggest that both nonaudit as well as total fees are perceived negatively by investors, i.e., the higher the fees paid to the auditor, the greater the implied threat to auditor independence, and the lower the financial reporting credibility of a Big Five audit. Further, our findings appear to be largely unrelated to corporate governance, i.e., investors do not perceive the auditor as compensating for weak governance. Separately, recent anecdotal evidence suggests that declining revenues from nonaudit services - as a result of recent regulatory restrictions - are being offset by substantial increases in audit fees. Other things being equal, rising audit fees imply higher profit margins for audit services indicating that the audit function may no longer be a loss-leader. Thus, to the extent that investors perceive total fees negatively, recent regulatory initiatives to limit nonaudit fees may not have adequately addressed the perceived, if not the actual, threat to auditor independence posed by fees.

Firm Growth and Disclosure: An Empirical Analysis

Extant theoretical research posits that information asymmetry and agency issues affect the cost of external financing and hence impact the ability of firms to finance their growth opportunities. In contrast, the literature on disclosure policy posits that expanded and credible disclosure lowers the cost of external financing and improves a firms ability to pursue potentially profitable projects. An empirical implication is that disclosure can help firms grow by relaxing external financing constraints, thereby allowing capital to flow to positive net present value projects. This paper empirically evaluates this prediction using firm-level data over an 11-year period. As anticipated by theory, we find a positive relation between firm disclosure policy and the externally financed growth rate, after controlling for other influences.

Audit Firm Tenure and the Equity Risk Premium

Although investor perceptions of audit quality play a critical role in maintaining systemic confidence in the integrity of financial accounting reports (Levitt [2000]), prior research on the effects of auditor tenure from an investor perspective is relatively sparse. In this study, we investigate whether investors price audit firm tenure for Big Five audits by examining the relation between tenure and the ex ante equity risk premium, that is, the excess of the company-specific ex ante cost of equity capital over the risk-free interest rate. Based on prior research, whereas the “auditor learning” argument predicts that audit quality will change in only one direction (i.e., improve) with tenure, the “auditor-client closeness” argument suggests that audit quality may decrease beyond some (albeit unspecified) length of tenure because of impaired auditor independence and objectivity. Consistent with prior theoretical arguments, we find some evidence of a nonlinear relation between audit firm tenure and the ex ante equity risk premium, that is, we find that the equity risk premium decreases in the early years of tenure but increases with additional years of tenure. These findings persist after we control for well-known risk factors and company characteristics that have been shown in prior research to be related to the cost of equity capital. The implications of our findings are discussed.

The Role of Firm-Specific Incentives and Country Factors in Explaining Voluntary IAS Adoptions: Evidence from Private Firms

Abstract This paper investigates voluntary adoptions of International Accounting Standards (IAS) by private enterprises, and builds on prior research which posits that higher quality financial reports through IAS adoption can reduce information asymmetry and facilitate contracting with external parties. Specifically, we pursue the following questions. First, do firm-specific incentives matter in the IAS adoption decision after controlling for country-level institutional factors? Second, does the relative importance of firm vs. country factors vary across institutional settings? Using a sample of 3,722 small and medium-sized private enterprises from 56 countries, we report two primary findings. First, both firm and country factors matter in the voluntary IAS adoption decision. Second, when we focus on sub-samples of countries partitioned by the level of economic development, we find that firm factors dominate country factors in more developed countries, while in less developed countries, country factors dominate firm factors in explaining IAS adoptions. This result is consistent with the argument in Doidge et al. (Journal of Financial Economics, 86(1), pp. 1–39, 2007) that firm incentives are more important in explaining governance choices (including accounting) in more developed countries where the benefits from better governance are more likely to exceed the attendant costs. Collectively, our results suggest that less developed countries can enhance the benefits from IAS adoptions by developing institutions which facilitate private contracting.

Does Corporate Transparency Contribute to Efficient Resource Allocation

This paper examines whether a countrys corporate transparency environment, which includes the quality of accounting information, contributes to efficient resource allocation. Based on a cross-country study of 37 manufacturing industries in 37 countries, we provide three pieces of related evidence. First, we find the contemporaneous correlations in industry growth rates across country pairs are higher when there is a greater level of corporate transparency in the country pairs, after controlling for country-level economic and financial development. Second, we find the influence of transparency on these correlations is stronger when country pairs are at similar levels of economic development (GDP). Finally, when we control for the level of transparency explained by a countrys institutions in place, we find that residual transparency (unexplained by country-level factors) is associated with industry-specific growth rates. Taken together, the results are consistent with corporate transparency facilitating the allocation of resources across industry sectors.

Are Fundamentals Priced in the Bond Market

To date, the discussion of the Lev and Thiagarajan (1993) fundamentals in the prior literature has been exclusively in the context of the stock market. Our study is the first to examine the value relevance of these fundamentals for default risk. By focusing on the market for new bond issues, we examine the value relevance of the fundamental score using expected rather than realized returns. Also, by focusing on the bond market we provide a different perspective than that brought by prior studies relying solely on stock prices. We find the fundamentals to be priced in the market for new bond issues as indicators of expected future earnings and to be value relevant in enabling the market to discern differences in bond credit quality over and above the published bond ratings.

Institutional Shareholders' Investment Horizons and Tax Avoidance

We investigate whether the level of ownership by institutional shareholders with a long-term horizon is associated with firms’ tax avoidance activities. In theory, tax avoidance increases firm value through tax savings; however, institutions with long-term investment horizons are likely to discourage tax avoidance activities if such activities encourage managerial opportunism and reduce transparency. Using a sample of firms with institutional ownership data from 1995-2008, we find less tax avoidance in firms held by long-term institutional shareholders. Probing further, we find these results are generally driven by poorly-governed firms. Overall, our results highlight the role of certain types of institutional shareholders in affecting a firm’s tax avoidance behavior.