K. K. Raman

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.

Off-Balance Sheet R&D Assets and Market Liquidity

In this study, we document the information asymmetry effects associated with off-balance sheet (unrecorded) R&D assets using a market microstructure methodology. Collectively, the evidence suggests that a potential harm (lower market liquidity) is associated with the current accounting treatment of R&D spending.

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.

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.

An Empirical Investigation of the Market for 'Single Audit' Services

Audits conducted under the 1984 Single Audit Act go beyond the traditional financial statement audit by placing substantial additional emphasis on the review and evaluation of internal controls and testing of compliance with laws and regulations. The General Accounting Office (GAO), congressional committees, and the American Institute of CPAs (AICPA) have expressed concern about the possible effects of the single audit on audit fees, the quality of single audits, and the effects of alleged low balling. This article provides evidence bearing on these issues, based on data for a national sample of cities.

The Housing Value-Relevance of Governmental Accounting Information

In this paper, we examine the value-relevance of local government accounting measures of financial condition from the perspective of the citizenry. The Governmental Accounting Standards Board (GASB) has identified citizens as a primary user group for governmental accounting information, albeit from an electoral perspective. However, citizens can express their preferences not only through voting (voice) but also through mobility (exit) (Hirschman, 1970, p. 4). In metropolitan areas, citizens typically have a choice of residential location among a number of different local governments. Since homeowner equity represents a substantial portion of all personal wealth, housing values are of significant interest to citizens. We identify local government financial condition as a relevant locational attribute in valuing housing. Although individual citizens generally do not read government financial reports, others (such as members of professional groups) may serve as information search agents for and on behalf of the citizenry (GASB, 1997, para. 165). We investigate whether extant local government accounting data (as measures of financial condition) are priced in metropolitan housing markets and whether the association between accounting information and housing values is stronger for local governments with a relatively higher property tax burden. The policy implications of our study are also addressed.

The Effect of Voluntary GAAP Compliance and Financial Disclosure on Governmental Borrowing Costs

State and local governments are not subject to Securities and Exchange Commission (SEC) regulations requiring compliance with generally accepted accounting principles (GAAP). It was only in 1980 that Standard & Poors issued a policy statement indicating a failure to conform with GAAP would be considered a negative factor in establishing municipal bond ratings. Until May 1986, governmental GAAP was not even enforceable under Rule 203 of the AICPA code of ethics. While some state governments regulate the accounting practices of their local governments, the states themselves are exempt from all accounting regulations. In this unregulated environment, differential levels of financial disclosure by the states are observed. Differential disclosure is presumably the outcome of an economic decision based on the conventional equalization of the marginal costs and benefits of GAAP compliance. In this paper, we try to estimate the magnitude of one potential benefit accruing from differential GAAP compliance—the interest cost savings on general obligation bonds. Our study suggests the bond markets are “informationally efficient” in the sense that bond prices incorporate the effects of differential GAAP compliance.

State regulation of accounting practices and municipal borrowing costs

This article examines the association between state regulation of accounting practices and municipal borrowing costs. The results demonstrate that stringent accounting regulations do have an effect on borrowing costs after abstracting the effect of other explanatory variables. The direction of the observed effect is difficult to assess due to presence of multicollinearity in the model. However, lower borrowing costs are suggested by the analysis.

Tax Effort as an Indicator of Fiscal Stress

The most visible credit market measure of the fiscal health of a municipality is the credit rating. In this article we ask whether the credit rating fully incorporates the fiscal stresses faced by municipal governments. We utilize state “tax effort” as a measure of the fiscal stress faced by a municipality. The findings suggest that municipalities located in states characterized by poor fiscal health pay higher than average interest costs on their bond issues (holding credit rating constant). State “tax effort” seems to reflect elements of fiscal stress that are not adequately taken into account through the rating process.

Are Big Four Audits in ASEAN Countries of Higher Quality than Non-Big Four Audits?

Abstract We investigate whether reputation concerns provide sufficient incentive for Big Four auditors to provide higher quality audits in ASEAN countries where litigation exposure is low or nonexistent. We proxy audit quality based on the quality of reported earnings (earnings conservatism) to examine whether Big Four auditors provided higher quality audits (relative to non-Big Four auditors) during 1990–96. To neutralise the potential confounding effects of cross-border differences, we investigate the relative quality of Big Four vs. non-Big Four audits within each country separately so that each country serves as its own control. Our results suggest that although both Big Four and non-Big Four auditees report conservative earnings in all countries, only in the US do Big Four auditees report more conservative earnings than non-Big Four auditees. Thus, although the World Bank and UNCTAD (1999) did not express concerns about Big Four audit quality in emerging markets until 1999, the evidence suggests that the Big Four were not providing higher quality audits in ASEAN countries even prior to the 1997 Asian financial crisis. Our findings are interesting in the context of the ongoing globalisation of capital markets in which cross-border investors in emerging markets, separated from corporate management not only geographically but often culturally and linguistically, are presumed to rely on a brand name Big Four audit to provide enhanced assurance on financial statements.