Jeff L. Payne

The Effect of a Bidding Restriction on the Audit Services Market

Central to debates about the audit services market is the effect of competition on auditor performance. The economic performance of auditors has been examined in studies of pricing, labor allocation, and concentration statistics. The purpose of this study is to document the price and quality effects of an unusual state-mandated market restriction that required nonprice competition and prohibited price competition among auditors. We adopt an industrial organization perspective, with particular emphasis on capture theory. Specifically, we analyze Section 473.317, Florida Statutes (Rule 21A24.03, Florida Administrative Code), which mandated that proposals to perform an audit not include fee information1 and specified the procedure to be used to select an external auditor. Basically, an auditee was required to rank prospective auditors in order of nonprice preference and

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.

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.

The Torpedo Effect: Myth or Reality?

General evidence indicates that managers manage earnings at three common earnings thresholds: analyst forecasts, prior period earnings, and zero earnings. We examine one market-based motivation suggested for this behavior. If managers perceive the market penalty for barely missing an earnings threshold to be disproportionately high (i.e., a torpedo effect), they may use discretion to manage earnings upward to meet the earnings threshold. This market-based incentive would explain the evidence in favor of earnings management at earnings thresholds. To test the existence of a torpedo effect, we employ a comprehensive model that measures the market’s reaction to reported earnings that barely miss earnings thresholds. This model controls for the level of unexpected earnings and several other firm characteristics known to affect the relation between returns and earnings. Overall, we conclude that there is little evidence of a torpedo effect. This conclusion holds for both low-growth and high-growth firms and is unaffected by the firm’s history of meeting the threshold. Our paper dispels some commonly held beliefs about the market’s response to earnings thresholds.

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.

Earnings Management: Do Firms Play “Follow the Leader”?†

In this study we examine whether the reported performance of one firm affects the discretionary reporting behavior of another firm. We do this by identifying the leader within each industry, defined as the first large announcing firm. We find that the discretionary performance of followers (those firms announcing after the leader) relates positively to the leaders reported performance. Specifically, when the leader misses analysts’ expectations, followers report lower discretionary accruals, have fewer income-decreasing special items, and are less likely to meet analysts’ expectations. In contrast, when leaders report good news, followers report higher discretionary accruals and are more likely to meet expectations (although we do not find evidence of a positive association between leaders’ good news and followers’ income-decreasing special items). Overall, the results are consistent with managers of followers perceiving that earnings news of the leader will affect investors’ and others’ performance expectations for their firms.

AN EXPERIMENTAL EXAMINATION OF THE PEER REVIEW PROCESS

Abstract The recent financial failure of several multi-billion dollar publicly traded companies has dramatically increased financial statement users concerns about the quality of financial reporting. In response, President Bush recently signed the Sarbanes-Oxley Act, which significantly increases regulatory oversight of the financial reporting and auditing processes. A section of the Act creates an inspection process for firms that provide audits to publicly traded companies. This research provides an examination of the timing of the current peer review and recently enacted inspection processes. The stated goal of these review processes is to increase the value of accounting services by improving quality. Utilizing the laboratory markets methodology, this paper examines the influence of a peer review type process on the provision of audit quality, specifically examining the periodicity of review process. The results indicate a timely review process increases audit quality.