Rani Hoitash

Auditor fees and audit quality

Purpose - The paper aims to examine the relation between fees paid to auditors and audit quality during the period of 2000-2003. Design/methodology/approach - The paper constructs a measure of auditor profitability that is used as a proxy for auditor independence. The methodology is grounded in the notion that auditor independence is influenced by effort and risk-adjusted fees, rather than the level of fees received from clients. Since, risk and effort are unobservable, the paper uses proxies based on client size, complexity and risk to estimate abnormal fees. Abnormal fees are derived using a fee estimation model drawn from prior literature. The paper employs two metrics to assess audit quality – the standard deviation of residuals from regressions relating current accruals to cash flows and the absolute value of performance-adjusted discretionary accruals. Findings - The paper documents a statistically significant negative association between total fees and both audit quality proxies over all years. These findings are robust to a variety of additional tests and several alternative design specifications. The results (pre- and post-SOX) are consistent with economic bonding being a determinant of auditor behavior rather than auditor reputational concerns. Research limitations/implications - The possibility that the empirical tests do not completely capture the impact of unobserved risk cannot be ruled out, though the paper attempts to do so by employing alternative specifications and sensitivity tests. Practical implications - Policy makers should note that current restrictions on the provision of non-audit services may not sufficiently resolve the issue of economic bonding and its impact on auditor independence. Originality/value - In contrast to previous studies whose results are ambiguous, the paper finds a statistically significant positive association between several measures of total fees (it uses size-adjusted and abnormal fees) and two metrics of accruals quality in all years (2000-2003), consistent with economic bonding being a determinant of auditor behavior rather then auditor reputation concerns.

Evidence from the United States on the Effect of Auditor Involvement in Assessing Internal Control over Financial Reporting

Securities regulators around the world are considering the costs and benefits of alternative policies for providing information to financial markets on corporate internal control. These policy options differ on the level of auditor involvement, among other dimensions. We examine the association of relative auditor involvement and auditor characteristics with Section 302 internal control disclosures made by US ‘non-accelerated filers’ from 2003 to 2005. We find more material weaknesses disclosed in the fourth quarter, when there is relatively more auditor involvement, relative to the first three quarters. Clients of larger audit firms have higher disclosure rates (although they are probably less risky due to more stringent client acceptance standards), but this difference is due to fourth quarter disclosures. Audit firms with Section 404 experience also have greater material weakness disclosure, implying process improvement associated with knowledge sharing across engagements. Collectively, our results shed light on ways to increase the effectiveness of internal control regulation.

Do Accountants Make Better Chief Financial Officers

We examine whether chief financial officers (CFOs) with accounting backgrounds (accountant CFOs) are associated with more conservative corporate outcomes. We find that, in high-growth industries, firms with accountant CFOs invest less in research and development and capital expenditures and are less likely to engage in external financing. In low-growth industries, we find that firms with accountant CFOs exhibit greater cost efficiency. Our results are consistent with risk aversion on the part of accountant CFOs. We further document that accountant CFOs are negatively associated with firm value in high-growth industries and positively associated with firm value in low-growth industries.

Sustaining the Financial Value of Global CSR: Reconciling Corporate and Stakeholder Interests in a Less Regulated Environment

In this article we examine the association between corporate social responsibility (CSR) and firm value. This line of research is important since firms continue to invest in CSR even though past studies reveal a limited linkage between financial value and CSR. However, the business case for CSR or “doing good while making a profit,” appears to be advancing within the business ethics literature as a preferred conception of CSR. We conjecture that the greater unification and refinement of both profit maximization and stakeholder interests through corporate acts, not statements alone, will sustain the financial value of CSR in a less regulated global business environment. We study the triangle of what companies say, what companies do, and firm financial performance. We analyze Fortune 250 firms and find a positive association between what companies do based on KLD Research and Analytics, Inc. (KLD) ratings, and what companies state about ethics in their CSR statements. We then employ regression analysis and find that companies’ socially responsible acts are positively associated with overall firm value and financial performance. Yet we do not find a statistically significant association between what companies say regarding ethics in their CSR statements and their financial outcomes. These results suggest that firm value and financial performance is associated with what companies do and not what they say. Our results seem to be driven by multinational corporations (MNCs) and not by non‐MNCs. This is possibly because MNCs generally operate in a less regulated global business environment that often necessitates strong ethical corporate leadership to further stakeholder interests. Overall, these results help reconcile corporate and stakeholder objectives since evidence of a link between financial performance and doing good sustains global CSR.

SOX 404, Auditor Effort, and the Prevention of Financial Report Misstatements

Prior research shows that the Sarbanes Oxley (SOX) Section 404(b) integrated audit is associated with lower incidence of misstatements. We predict that the knowledge gained from internal control testing under 404(b) should improve the auditor’s ability to detect misstatements relative to other internal control regimes that do not require control testing, and that this benefit will vary with the incremental effort applied to the engagement. Our baseline tests show that the association between incremental audit effort (proxied by abnormal audit fees) and misstatement reduction is greater under SOX 404(b) vs. other regimes (including SOX 404(a)). These findings imply that the value of incremental audit effort is not uniform, but is greater when control testing is required and sufficient resources are available to thoroughly understand client controls. We further examine the conditions under which knowledge gained from auditor control testing is more valuable. We find that the benefits from control testing do not vary across internal control regimes under AS2 vs. AS5, and are more pronounced for engagements with shorter auditor tenure, non-Big 4 auditors, firms disclosing material weakness in internal controls, and firms misstating core accounts.

Auditor Fair Value Expertise

Under the premise that auditors develop specialized knowledge, we propose that auditors can gain expertise in auditing fair value (FV) estimates. PCAOB inspections repeatedly indicate deficiencies in audits of FV estimates, resulting in efforts by regulators to improve the related guidance and auditing standards (PCAOB 2017). Nevertheless, regulators cannot fully resolve the complexity and inherent subjectivity in auditing fair value estimates, and thus, other solutions may be needed. We surmise that domain-specific auditor FV expertise, gained from work experience during the audit of FV measurements, can contribute to higher audit quality. Utilizing FV-related restatements and comment letters, we find that expertise in auditing level 3 FV estimates at the office level is associated with greater FV audit quality. Level 2 FV expertise or national level FV expertise are not associated with higher FV audit quality. Following the receipt of a comment letter, we further find that auditor FV expertise is associated with lower comment letters’ remediation costs and higher FV disclosure quality. Finally, we find that the value relevance of level 3 FV disclosures increases with the extent of auditor FV expertise. Collectively, our results highlight that auditor fair value expertise contributes to the credibility and usefulness of FV disclosures.

Auditor Response to Clients' Reputational Risk

In this study, we use new data to examine client reputation risk as a component of auditor risk assessment and response. The RepRisk database captures negative media coverage of companies’ environmental, social, and governance practices in a quantified measure of client reputational risk. Due to its focus on non-financial risk, this measure is uniquely able to disentangle auditor reputation considerations from the risk of material misstatement. We predict that auditors consider client reputational risk in the risk assessment phase of the audit. Specifically, client reputation risk may impact auditor business risk, where an auditor suffers reputation losses from their association with a client with impaired reputation. We find that client reputational risk has a positive impact on audit fees and the likelihood of auditor changes. Thus, our findings suggest that auditors monitor negative media coverage of their clients and incorporate it into pricing and retention decisions. We conduct supplemental analyses suggesting that our evidence is consistent with an auditor business risk explanation incremental to responses explained by risk of material misstatement and increased effort.