Scott Duellman

Evidence on the Role of Accounting Conservatism in Monitoring Managers' Investment Decisions

Watts (2003), among others, argues that conservatism helps in corporate governance by mitigating agency problems associated with managers’ investment decisions. We hypothesize that if conservatism reduces managers’ ex ante incentives to take on negative NPV projects and improves the ex post monitoring of investments, firms with more conservative accounting ought to have higher future profitability and lower likelihood (and magnitude) of future special items charges. Consistent with this expectation, we find that firms with more conservative accounting have (i) higher future cash flows and gross margins, and (ii) lower likelihood and magnitude of special items charges than firms with less conservative accounting.

A New Approach to Estimating the Relation between Audit Fees and Financial Misconduct

Corporate fraud imposes a large social cost, estimated at 22 cents per dollar invested in the fraud firm, yet misreporting firms have a low likelihood of being detected (Dyck, Morse and Zingales, 2013). Auditors, who are expected to be at the forefront of fraud detection, lag behind other stakeholders in uncovering misstatements. We investigate auditors’ poor record in detecting fraud using a new measure of financial statement manipulation that, unlike previous measures, is an ex-ante measure of misstatement and is not commingled with a firm’s business and economic risks. We posit that auditors balance their client retention motive with reputational costs when auditing a firm. Since investors can infer audit effort from the publicly disclosed audit fee, the reputational impact of misstatements may be contingent on the perceived effort. Thus, despite having reputational incentives to prevent misstatements, the expected rents to the auditor of retaining a potentially misstating client may outweigh the reputational cost when the audit fee is low. Consistent with the retention effect, we find a negative relation between the likelihood of material misstatement and audit fees. This effect is economically significant as a one standard deviation increase in misstatement risk associates with an 8.5% fee reduction. In additional testing, we find no evidence that auditors signal investors to the reduced financial statement quality through alternate channels. Furthermore, although a strong audit committee is related to fewer misstatements, it does not mitigate the negative relation between material misstatements and audit fees.Research on the association between abnormal audit fees (measuring audit effort) and financial misconduct has produced mixed results. The use of actual misstatements in this research creates small-sample inferences, introduces systematic selection bias, and reduces the scope of sample coverage. In this study we use a metric based on Benford’s Law to analyze the impact of abnormal audit fees on the likelihood of misconduct. This measure is parsimonious, avoids selection bias, and can be computed for a large sample of public firms. Consistent with theory, we find that greater audit effort reduces the likelihood of misconduct and auditor resignations are more likely for clients with higher misconduct likelihood. Our findings are not driven by audit firm size, client size, the governance structure of the client, or economic bonding explanations. The effect is not subsumed when controlling for alternative misconduct measurement metrics and is robust across multiple tests to address endogeneity.

Expertise Rents from Insider Trading for Financial Experts on Audit Committees

Sarbanes Oxley Act (SOX) Section 407 requires firms to disclose if there is a financial expert serving on their audit committees. The extant literature has largely documented SOX 407 benefits, ranging from controlling earning management to reducing internal control weaknesses. Our paper investigates whether there is a cost associated with SOX 407. Using a sample of executive and director transactions from 2003 to 2007, we test whether financial experts obtain information rents or expertise rents on stock purchases. Information rent is earned due to access to superior information, whereas expertise rent is earned due to superior processing skill of the same information. We first find that audit committee members obtain significantly higher abnormal returns than other independent board members. This suggests that audit committee members, including both financial and non-financial experts, earn information rent due to their access to privileged information in audit committees. We then find that financial experts on audit committees obtain higher abnormal returns than non-financial experts on audit committees. Because financial experts and non-financial experts have access to the same information in audit committees, our finding suggests that audit committee financial experts earn additional rents due to their financial expertise. The existence of such expertise rents indicates that there is a cost associated with SOX 407.

Audit Fees and Misstatements: A Fresh Look from an Ex-Ante Perspective

Corporate fraud imposes a large social cost, estimated at 22 cents per dollar invested in the fraud firm, yet misreporting firms have a low likelihood of being detected (Dyck, Morse and Zingales, 2013). Auditors, who are expected to be at the forefront of fraud detection, lag behind other stakeholders in uncovering misstatements. We investigate auditors’ poor record in detecting fraud using a new measure of financial statement manipulation that, unlike previous measures, is an ex-ante measure of misstatement and is not commingled with a firm’s business and economic risks. We posit that auditors balance their client retention motive with reputational costs when auditing a firm. Since investors can infer audit effort from the publicly disclosed audit fee, the reputational impact of misstatements may be contingent on the perceived effort. Thus, despite having reputational incentives to prevent misstatements, the expected rents to the auditor of retaining a potentially misstating client may outweigh the reputational cost when the audit fee is low. Consistent with the retention effect, we find a negative relation between the likelihood of material misstatement and audit fees. This effect is economically significant as a one standard deviation increase in misstatement risk associates with an 8.5% fee reduction. In additional testing, we find no evidence that auditors signal investors to the reduced financial statement quality through alternate channels. Furthermore, although a strong audit committee is related to fewer misstatements, it does not mitigate the negative relation between material misstatements and audit fees.Research on the association between abnormal audit fees (measuring audit effort) and financial misconduct has produced mixed results. The use of actual misstatements in this research creates small-sample inferences, introduces systematic selection bias, and reduces the scope of sample coverage. In this study we use a metric based on Benford’s Law to analyze the impact of abnormal audit fees on the likelihood of misconduct. This measure is parsimonious, avoids selection bias, and can be computed for a large sample of public firms. Consistent with theory, we find that greater audit effort reduces the likelihood of misconduct and auditor resignations are more likely for clients with higher misconduct likelihood. Our findings are not driven by audit firm size, client size, the governance structure of the client, or economic bonding explanations. The effect is not subsumed when controlling for alternative misconduct measurement metrics and is robust across multiple tests to address endogeneity.

Client Retention or Reputation? An Analysis of Audit Fees and Material Misstatements

Corporate fraud imposes a large social cost, estimated at 22 cents per dollar invested in the fraud firm, yet misreporting firms have a low likelihood of being detected (Dyck, Morse and Zingales, 2013). Auditors, who are expected to be at the forefront of fraud detection, lag behind other stakeholders in uncovering misstatements. We investigate auditors’ poor record in detecting fraud using a new measure of financial statement manipulation that, unlike previous measures, is an ex-ante measure of misstatement and is not commingled with a firm’s business and economic risks. We posit that auditors balance their client retention motive with reputational costs when auditing a firm. Since investors can infer audit effort from the publicly disclosed audit fee, the reputational impact of misstatements may be contingent on the perceived effort. Thus, despite having reputational incentives to prevent misstatements, the expected rents to the auditor of retaining a potentially misstating client may outweigh the reputational cost when the audit fee is low. Consistent with the retention effect, we find a negative relation between the likelihood of material misstatement and audit fees. This effect is economically significant as a one standard deviation increase in misstatement risk associates with an 8.5% fee reduction. In additional testing, we find no evidence that auditors signal investors to the reduced financial statement quality through alternate channels. Furthermore, although a strong audit committee is related to fewer misstatements, it does not mitigate the negative relation between material misstatements and audit fees.Research on the association between abnormal audit fees (measuring audit effort) and financial misconduct has produced mixed results. The use of actual misstatements in this research creates small-sample inferences, introduces systematic selection bias, and reduces the scope of sample coverage. In this study we use a metric based on Benford’s Law to analyze the impact of abnormal audit fees on the likelihood of misconduct. This measure is parsimonious, avoids selection bias, and can be computed for a large sample of public firms. Consistent with theory, we find that greater audit effort reduces the likelihood of misconduct and auditor resignations are more likely for clients with higher misconduct likelihood. Our findings are not driven by audit firm size, client size, the governance structure of the client, or economic bonding explanations. The effect is not subsumed when controlling for alternative misconduct measurement metrics and is robust across multiple tests to address endogeneity.