Minlei Ye

Equity Incentives and Earnings Management Evidence from the Banking Industry

We examine the relationship between equity incentives and earnings management in the banking industry. By focusing on this regulated industry and using industry-specific earnings management proxies, we provide evidence on the impact of regulation on earnings management arising from chief executive officers’ equity incentives. We find that bank managers with high equity incentives are more likely to manage earnings, but only when capital ratios are closer to the minimums required by regulators. This finding indicates that, in the banking industry, potential regulatory intervention induces, rather than mitigates, earnings management arising from equity incentives.

The Economics of Setting Auditing Standards

This paper develops a theory of the negotiating positions, or preferences over auditing standards, of the interest groups that may set such standards. Specifically, we consider how the preferences of auditors as standard setters may differ from the preferences of investors. We represent auditing standards by two properties: toughness and vagueness. Toughness is the level of audit effort required by the standards. Vagueness is the uncertainty of audit effort levels that could be considered by different parties as “in compliance” with the standards. Our model predicts that auditors and investors would consider both toughness and vagueness in influencing or setting auditing standards, since preferences over vagueness depend on the level of toughness. We model the market as composed of auditors with different wealth levels and investors with various investment projects and optimal standards will vary across these parties. We show that as a result of such tensions, auditing standards with a degree of vagueness are preferred. By analyzing the economic incentives of different potential standard setters, we help explain how auditing standards have developed in the real world and lay out the foundation for future research on the standards.

Do Joint Audits Improve or Impair Audit Quality

Conventional wisdom holds that joint audits would improve audit quality by enhancing audit evidence precision because “Two heads are better than one.” Our paper challenges this wisdom. We show that joint audits by one big firm and one small firm may impair audit quality, because, in that situation, joint audits induce a free‐riding problem between audit firms and reduce audit evidence precision. We further derive a set of empirically testable predictions comparing audit evidence precision and audit fees under joint and single audits. This paper, the first theoretical study of joint audits, contributes to a better understanding of the economic consequences of joint audits on audit quality.

The Joint Effects of Multiple Legal System Characteristics on Auditing Standards and Auditor Behavior

We derive the optimal toughness of auditing standards under different legal regimes, which are characterized by differences in the uncertainty concerning the outcome of legal proceedings (termed vagueness of legal systems) and differences in the size of damage awards. We find that optimal audit quality that maximizes investors’ welfare requires different auditing standards when legal systems have different characteristics. This finding provides implications for the adoption of International Standards on Auditing (ISAs). Countries, such as the U.S., where auditor legal liability is significantly more onerous than the global norm are not likely to adopt ISAs, since these standards may not induce auditors to provide the optimal level of audit quality. Conversely, the adoption of ISA’s by countries, such as China, where the legal system makes the recovery of damages from auditors quite difficult, is not by itself likely to result in a high level of audit quality.

Transaction Costs and Competition among Audit Firms in Local Markets

We develop a measure to capture an audit firms competitive position in a local audit market based on the transaction costs of changing audit firms included in DeAngelos (1981) multi-period audit pricing model. Our competition measure reflects the size difference between the largest audit firm in a market specified by client industry at the city level and the other audit firms operating in that market. We find that audit fees of a client decrease as this size difference increases. This result suggests that smaller audit firms charge lower audit fees because of their competitive disadvantage to the local largest firm.