FIFTEENTH

Office of Accounting Research Department of Accountancy University of Illinois at Urbana-Champaign October 17-19, 2002

Mark E. Peecher, Editor

S Y M P O S I U M O N

AU D I T I N G

RESEARCH

A publication of the Office of Accounting Research University of Illinois at Urbana-Champaign

FIFTEENTH

Office of Accounting Research Department of Accountancy University of Illinois at Urbana-Champaign October 17-19, 2002

Sponsored by KPMG, LLP

S Y M P O S I U M O N

AU D I T I N G

RESEARCH

Contents Preface Tribute to Robert Kuhn Mautz (1915-2002) Hollis Ashbaugh, Ryan LaFond, and Brian W. Mayhew Do Non-audit Services Compromise Auditor Independence? Further Evidence...... 1 Discussion by: William R. Kinney, Jr.................................................................................. 5 Amy K. Choy and Ronald R. King An Experimental Investigation of Audit Decision Making: An Evaluation Using System-Mediated Mental Model Theory ................................................................. 13 Discussion by: William L. Felix, Jr.................................................................................... 19 Marty Butler, Andrew J. Leone, and Michael Willenborg An Empirical Analysis of Auditor Reporting and its Association with Abnormal Accruals ................................................................................................................... 23 Discussion by: Richard G. Sloan........................................................................................ 27 Randy P. Beatty, Philip R. Drake, and Chris E. Hogan The Impact of the 1995 Private Securities Litigation Reform Act on Litigation Risk and Auditor Compensation in the IPO Market ................................................ 31 Discussion by: James C. McKeown................................................................................... 35 Rajiv D. Banker, Hsihui Chang, and Yi-Ching Kao Factors Affecting Staff Allocations, Costs and Prices for Audit Engagements ....... 43 Discussion by: Mike Stein ................................................................................................. 47 Authors’ reply............................................................................................ 53

T. Jeffrey Wilks and Mark F. Zimbelman The Effects of a Fraud-Triangle Decomposition of Fraud Risk Assessments on Auditors’ Sensitivity to Incentive and Opportunity Cues ........................................ 57 Discussion by: Richard M. Tubbs...................................................................................... 61

Preface This volume contains proceedings from the 15th Symposium on Auditing Research held near the University of Illinois at Urbana-Champaign campus during October 17-19, 2002. As with prior symposia, invitees included approximately 50 persons, including accountancy professors and practitioners as well as University of Illinois faculty and Ph.D. students. The cost associated with bringing participants together was underwritten by KPMG, LLP, via its on-going generous support of the symposium series. Consistent with tradition, many persons freely gave their time and energy to produce a high-quality symposium. Reviewers provided constructive comments, authors and discussants made lucid presentations, and participants posed thoughtful and insightful questions. These proceedings summarize authors’ presentations and discussants’ critiques of research papers accepted for the symposium. The proceedings begin with a tribute to the late R. K. Mautz (1915-2002) followed by summaries of papers. Fred Neumann and Jim Cook generously collaborated on authoring this tribute. Fred conducted most of the research and Jim delivered it so that Symposium participants could reflect on R. K. Mautz’ tireless and timeless contributions. We join KPMG, LLP and all of our colleagues to invite you to submit your papers to the Sixteenth Symposium of Auditing Research to be held during the fall of 2004. Further details will appear in a future edition of The Auditor’s Report. Mark E. Peecher, University of Illinois at Urbana-Champaign, Editor

Audit Research Symposium Planning Committee, 2002 A. Rashad Abdel-khalik Paul Beck Kathryn Kadous Mark E. Peecher, Chair Ira Solomon

Robert Kuhn Mautz (1915-2002) A Life Well Lived Frederick Neumann, University of Illinois at Urbana-Champaign James C. Cook, Ernst & Young LLP1

midst all the angry words and laments this last summer about the breakdown of accounting you may have missed the sad news about someone who contributed significantly to the building up of that profession. His name was

Robert Kuhn Mautz. He was a teacher, a scholar, a practitioner, and a person, par excellence. While he is probably best known for his work in auditing, there is hardly an area of accounting to which he did not contribute significantly. It is not surprising then that he is in the Accounting Hall of Fame and is one of the few academics to have received from the American Institute of Certified Public Accountants their Gold Medal of Honor for Distinguished Service. He was a Canadian by birth, having first seen the light of day in Fort William Ontario, back in 1915. That would make him 87, this past April 12. He was the last remaining and youngest of seven children. Probably to escape the Canadian cold, his parents soon moved to Grand Forks, North Dakota. He used to enjoy regaling us with tales of his growing up on the windswept plains, and delivering newspapers, on foot, in blinding snowstorms and double-digit negative temperatures. No, Illinois winters were no threat to him or to his wife Ruth, whom he met and married there in North Dakota. They were to have three children, 14 grandchildren and 5 great-grandchildren, all of whom survive. Grand Forks was the location of the University of North Dakota, which provided him with his undergraduate education. Mautz was to say, "If the school hadn't been there I probably wouldn't have got to college at all." He worked to fund his way through 1 We were asked by Ira Solomon to deliver a tribute to Robert K. Mautz; Fred as a former academic colleague, Jim as a former student and fellow practitioner. In the summer of 1970, Jim was a student at the University of Illinois (Urbana-Champaign) enrolled in Accountancy 371, the first auditing course. A young man named Carl Mautz was also in the class, and his father was the professor. Reflecting the professionalism and high integrity of Robert Mautz, save for the common surname, this family relationship was undetectable in class. Over that summer, Jim developed a deep respect for Professor Mautz that motivated him to follow Mautz’ career thereafter. This paper reflects personal observations of both Fred and Jim and the results of research conducted by Fred.

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ii Tribute to Robert Kuhn Mautz (1915-2002)

college during the dark years of the Great Depression, including an all-night job as a hotel bellboy. His pragmatic explanation for having picked business as his major was, "I had to be practical. We were still in the depression, and this looked like the best way to get a job." Jobs were indeed scarce when he graduated in 1937 and a teacher, who thought he was too young to begin work anyway, suggested graduate study. He chose the University of Illinois, partly because of its reputation and partly because it was the home state of his parents, both of whom had come originally from Pana, Illinois, just south of Decatur. He received a half-time assistantship and earned his master's degree in 1938, passed the CPA examination in 1940, and completed his Ph.D. in 1942. The next six years he spent in Chicago, in public accounting working for both Haskins & Sells and then for Alexander Grant, to receive both big-firm and smaller-firm experience. There was, however, a brief interlude of a couple of years that he spent in the Navy, during World War II. He was a bomb disposal officer, serving in London and on the continent. Perhaps some of his attention to detail and his fearlessness can be traced to that experience. He returned to the University of Illinois in 1948 to join the faculty for nearly a quarter of a century (despite several attractive offers from other prominent schools) and eventually to become the Weldon Powell Professor of Accountancy. One way in which accounting academicians are tracked is by looking at their record of publications. For over 80 years, the primary source for that record has been the Accountants' Index. An annual publication of the American Institute of Certified Public Accountants, it lists the titles and authors of all the books and articles in leading journals in the field for the preceding year. Originally, in speaking with Ira Solomon about preparing this memorial, we inquired if a student could go over to the library and list all the entries in the Accountants' Index under the name Robert K. Mautz. That arrangement did not work out and we are glad it didn't because of what we then found. Bob Mautz had at least one entry for every volume of the Index from the 1940-43 issue (the Index went to annual editions in 1950) through 1991. Then he missed a few years before a final entry under his name in 1994. His first article actually appeared in 1941, so that makes an unbroken record of listings of over 50 years. We know of no one else with a comparable performance. He was the author or co-author of more than a dozen books and monographs as well as in excess of 100 articles and published proceedings. Occasionally, we would find only one entry and think this must have been an off year, but then we would see some more entries under the designation R.K. Mautz. Some, of course, were co-authored, as he was very generous in allowing others to work with him, but most of his works were single-authored pieces. It was not easy working for him, however, as his first draft material was often more polished than the final of several revisions by his co-authors. While here, he did his work on a

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standard four-course load (per semester) and took his first sabbatical in the fall of 1969, twenty-one years into his teaching career. His first recorded publication was an article in The Accounting Review. In fact, eight of his first eleven articles were in The Accounting Review, one of the most highly regarded academic journals in the field. There are not many scholars who can claim as many articles in that journal, even during their entire lifetime. Over the years, he probably published more articles in The Accounting Review than in any other journal with the exception of The Journal of Accountancy, the primary publication of the American Institute of Certified Public Accountants (AICPA) and The Financial Executive (formerly The Controller), the primary journal of the Financial Executives' Institute (FEI). He was eventually to serve as editor of The Accounting Review for a term before becoming president of the American Accounting Association. In fact, he is the only academician that we know of who has served as editor of two of the three major publications of the American Accounting Association, as he was also the initial editor of Accounting Horizons. The latter was a journal that was designed to bridge the academic and the professional interests in accounting, a daunting challenge— the kind he liked most. By his editing and his editorials, he set the tone not only for this innovative journal, but also for several professional concerns of the day. You would expect that as a student of A. C. Littleton's, he would have a life-long interest in financial accounting. He did and several of his early articles dealt with contemporary issues in this area. Improved disclosure was one of them. Later, he was to chair a committee and author two studies in the area for the FEI entitled, Effects of Circumstances on the Application of Accounting Principles and Financial Disclosure in a Competitive Economy. In the sixties, he became involved in the "postulates of accounting" discussion and shortly thereafter in the "uniformity vs. flexibility" dispute over financial reporting. He also weighed in on accounting for inflation. It was at this same time that he also made an early call for more research in accounting, particularly of the empirical variety. In the auditing area, he was an early advocate of internal control, writing and publishing several articles over the years on its importance to both business and auditing. In the late 1970s, the FEI commissioned him to produce two major studies in this area, after the passage of the Foreign Corrupt Practices Act. Ethics was also a topic of early and life-long concern. Audit planning and a pioneering consideration of evidence issues were both foci of his writing over the years, as well. As he was an educator at heart, you would expect, from him, articles on teaching and curricula matters-and there were several. The relations between academia and the practicing profession were also a continuing matter that claimed his attention.

iv Tribute to Robert Kuhn Mautz (1915-2002)

Occasionally, he would even dare to attempt to explain one side to the other. His understanding of the respective groups, his ability to capture the issues in language each side could comprehend, and the respect each group had for him made such efforts successful and very useful. As early as 1974, he considered the idea of the rotation of auditors and, later, the responsibility of concurring partner review. On more than one occasion, he would step back and try to put a picture in a larger frame. It is not surprising then, to see several of his pieces reprinted in whole or in part in other journals or collections. Unlike many scholars, he did some of his best-known work later in his life, with several articles and monographs on key professional issues. His work for the FEI on diversified companies in 1967 and 1968 provided the basis for the final resolution to conglomerate and segment reporting. It was to be the first of several studies he would do for that organization. His seminal work on Corporate Audit Committees brought that concept to the fore and established much about their potential role and implementation. His work was cited by the SEC and the New York Stock Exchange when shortly thereafter, they decided to require all listed companies to have an audit committee. In the late 1970s he did an extensive study of the field of internal auditing on behalf of the international Institute of Internal Auditors (IIA). His extensive report not only surveyed the field and current issues confronting it, but also made recommendations about future opportunities for development. That report would provide guidance for the IIA for years to come. The report earned him a position on the Board of Trustees of their Research Foundation. His interest in governmental and not-for-profit accounting had also been growing during this period. Some of this work was based on initiatives of the General Accounting Office, which subsequently presented him their Award for Public Service. He became an early advocate for a governmental accounting standards board and was a major force in welding together the many groups interested in the issue, by creating the Government Accounting Standards Board Organizing Committee (GASBOC). The final report of that committee was the catalyst for the successful creation of today's Governmental Accounting Standards Board. He also assisted the Department of the Treasury in its attempt to develop consolidated statements for the federal government. Expression of his views on issues was not limited just to publications as he was invited to speak at several symposia and conferences, including this one, early on. At times, one semester's list of speaking engagements took a whole page—single-spaced. His committee work was prodigious and it was not his style to be just an honorary member either. For example, in 1963, the AICPA appointed him to a 13-man advisory committee to conduct a two-year study of what a CPA should know at

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the start of a career—the "Common Body of Knowledge" study. He also served a term on the Committee on Auditing Procedure (the predecessor of today's Auditing Standards Board) and was elected to the AlCPA's governing Council, the first professor to be so honored. He subsequently served as a member of that Institute's Board of Directors and was a member of the board of trustees of their Accounting Research Association and also of the AICPA Foundation. In addition, he chaired their SEC Disclosure Study Special Committee in the mid-70s. While on campus, he did more than his share of committee work at the department, college, and university level. He not only advocated the creation of the Federal Government's Cost Accounting Standards Board, but he also served as one of the charter members of this Congressionally-chartered organization. He was a prime advocate for high standards in its research efforts, its due process, its fairness and the quality of its pronouncements. He also spent several years as a member of the profession's Public Oversight Board as its only academic member. He was a leader in the creation of the Financial Accounting Standards Board and served as a member of its Financial Accounting Standards Advisory Council. He also was an active member of the first FAF structure study and assisted the Board in its Conceptual Framework project. He was an advisor to the Board on some projects and participated in many of its public hearings. Another area of publication for him, perhaps connected more with teaching was textbooks. In the early 1950s, he and the then head of the Department of Accountancy, C. A. Moyer, came out with their first textbook for intermediate accounting. This was eventually to evolve into today's text by Kieso and Wygandt, two of their students. We say "evolve," as the original volume was less than an inch thick and today's version is more than two, going on three. In 1954, he published the first edition of his Fundamentals of Auditing, which he revised a decade later. Even the original contained several of the ideas that were more fully developed in his Philosophy of Auditing that he subsequently authored with his student Hussein Sharaf in 1961. It remains the leading work on audit theory, even today, forty years later. Many of those ideas were incorporated in his 1964 revision of the textbook, the final edition. His conceptual approach was a landmark in the field, but a book before its time. In those days, other texts implied that one audit approach fitted all clients, with numbered steps for each account regardless of the client's size, industry, or other characteristics. Professor Mautz also wrote requested chapters for several handbooks and various anthologies, edited by others. Teaching may be the least noticed but probably is his most significant area of impact. The effect an instructor has on his students is one of those intangibles only the students and their future careers can answer. You can be sure, however, that none of Bob Mautz's students were involved in any of the accounting problems you have

vi Tribute to Robert Kuhn Mautz (1915-2002)

been currently reading about. I have already mentioned his life-long concern about ethics and it came through loud and clear in his classes. More than that, however, he wanted to be sure that his students thoroughly understood what they were studying, especially with regard to auditing. He had worked out a rationale that both provided a logical explanation for the auditor's efforts and an approach on which students could build in the future. As one student wrote to him later on, "in addition to the content of your class, I learned an attitude and an approach to organization that has stood me in good stead many times." He was more of a "why" teacher than a "how" teacher, though he did not neglect the latter. He produced one of the first audit cases. Whether teaching at the undergraduate or graduate level, he used a modified Socratic method and got students actively involved in discussions, long before it became the "in" thing to do. He brought current events into the classroom and his comments were eagerly anticipated by the students because he was on the front line for several of them. He was designated the first AICPA Distinguished Visiting Professor when he was invited to spend a year at the University of Minnesota. It is not surprising that the American Accounting Association presented him with their Outstanding Educator Award. For years he counseled and trained several of the leading Ph.D. students in the country, some of whom have gone on to be leading educators, others partners in CPA firms, and still others as executives in the business world, here and abroad. He was to supervise 36 dissertations during his 24-year stay here at Illinois. For all students and faculty, he was a role model through his exemplary teaching, research, service, and lifestyle. Bill Kinney once wrote to me, "I am one of the many who has not attended a single class of Bob's, yet I am certainly his student." While he was still on the faculty here, Professor Mautz did some work for Richard Baker, then the managing partner of the accounting firm of Ernst & Ernst in Cleveland. Mr. Baker was so impressed with the results that in 1972, he invited Bob Mautz to become a partner in the firm. It was an offer that would have been difficult to refuse. Mike Grobstein, an Illini and retired Ernst & Young Vice Chair, worked with Bob during that time, and recently noted that Bob was “a great academic and an outstanding practitioner.” Bob worked in the home office of Ernst & Ernst for seven years, until he reached their retirement age. Ray Groves, retired E&Y Chairman, said “Bob was the conscience of a conservative who provided thought leadership and balance in a time of growth.” Instead of returning to Champaign upon his retirement, Bob joined the University of Michigan, which already had several Illini on the faculty. There, he both taught and headed up their new William A. Paton Center of Accounting Research before becoming Head of their Department of Accounting.

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Upon retirement from the University of Michigan, he moved out to Salt Lake City, Utah, the home of the Church of Jesus Christ of Latter-day Saints. Bob Mautz and his wife had converted to that faith in 1951 and he actively served that church throughout the remainder of his life. He continued serving the Mormon Church while in Salt Lake City, as a member of their Auditing Department and as Executive Secretary to the Audit Committee of the Deseret Management Corporation. His beloved wife Ruth died two years ago and he lived the last 14 months of his life with his youngest son, Carl, in Virginia. Reflecting recently about Bob Mautz’ numerous roles over the course of his professional life, retired Ernst & Young Vice Chair Bob Neary noted that “Bob Mautz had more retirements than anybody I know!” In writing about him as a faculty member, a University of Illinois release had this to say,

In any profession, one will find three types of educated men [and women] at work, the practitioners, the teachers, and the philosophers. No essential division exists between them; the crossovers and combinations are common. Whatever the vineyard, a few will prove adept in all its labors—in applying skills, in equipping others to participate, and in pondering the nature of the work they do and its position in the general scheme. Among those few is Robert K. Mautz.

This luminous life—Robert K. Mautz's entire, creative life—well-lived, with a dedicated work-ethic and a genuine commitment to his students, his colleagues, the profession, his family, and his church, is a legacy he unwittingly and unselfishly has left as a sizable endowment and a model for all of us and future generations.

Do Non-Audit Services Compromise Auditor Independence? Further Evidence

Hollis Ashbaugh, University of Wisconsin – Madison Ryan LaFond, University of Wisconsin – Madison Brian W. Mayhew, University of Wisconsin – Madison

egulators, financial statement users, and researchers are concerned that auditors compromise their independence by allowing high fee clients more financial statement discretion relative to low fee clients (Levitt 2000).

Frankel, Johnson and Nelson (2002) (hereafter FJN) use the association between auditor fees and two measures of biased financial reporting - firms’ discretionary accruals and the likelihood of firms meeting earnings benchmarks - to draw inferences on auditor independence. They report evidence that suggests that auditor independence is compromised when clients pay high non-audit fees relative to total fees. The media (e.g., The Wall Street Journal and CFO. com) gave the FJN evidence extensive coverage. We investigate three elements of FJN’s research design to assess the validity of FJN’s inferences regarding auditor independence. The first element that we investigate is the audit fee metric that FJN use to capture the economic dependence of the audit firm on its client. FJN use the ratio of non-audit fees to total fees, i.e., a fee ratio, as their primary measure of dependence. FJN’s motivation for using the fee ratio is based on the U.S. Securities and Exchange Commission’s (SEC) concern about the growth of non-audit fees relative to audit fees during the 1990s. The SEC’s argument that the growth in the provision of non-audit services compromises audit firm independence is based on the premise that the provision of non-audit services increases the fees paid to the audit firm thereby increasing the economic dependence of the audit firm on the client. Prior research supports the SEC’s argument that it is the strength of the economic bond between the audit firm and its client that reduces auditor independence (DeAngelo 1981b, Beck et al. 1988, Magee and Tseng 1991). The fee ratio, however, does not necessarily capture the economic importance of the client to the audit firm. To illustrate the problem, we note sample firms that have fee ratios that exceed the median fee ratio for our sample, but have total fees that appear economically insignificant to the audit firm. For example, two firms in our sample have a fee ratio of 73%, but one reports total fees of $71,000 and the other reports total fees of $5.7 million. Based on their fee ratios, both firms are considered threats to independence in FJN’s design, whereas only the latter is economically significant

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2 Hollis Ashbaugh, Ryan LaFond, and Brian W. Mayhew

to the auditor. We posit that the total fee rather than the fee ratio is the more appropriate measure of the auditor’s economic dependence on a client. The second element that we investigate is whether FJN’s results are sensitive to the measurement of discretionary accruals. Recent research suggests that the discretionary accrual measure used by FJN systematically is biased because the measure does not account for the impact of performance on accruals (Kothari, et al. 2001). We calculate two measures of discretionary accruals that account for the impact of firm performance in the estimation of discretionary accruals. The first method measures performance-adjusted discretionary current accruals as the difference between a firm’s discretionary current accruals measured by the cross-sectional modified Jones model and the median firm’s discretionary current accruals from an industry and performance matched portfolio where performance is proxied by prior year’s return-on-asset. The second approach includes the prior year’s return-on-asset in the regression model used to estimate current non-discretionary accruals. The last element we examine related to FJN’s research design is driven by prior research suggesting that the Big 5 and non-Big 5 firms serve different clienteles (Craswell et al. 1995, Francis and Wilson 1988), and prior research documenting that reported discretionary accruals differ between Big 5 clients and non-Big 5 clients (Francis et al. 1999). We investigate whether FJN's results hold after partitioning the sample into Big 5 versus non-Big 5 clients. We start our empirical analyses by replicating FJN’s discretionary accrual test. Similar to FJN, we document a positive association between the absolute value of firms’ discretionary accruals and fee ratio. However, we find no association between firms’ total fees and FJN’s measurement of discretionary accruals. These findings suggest that the fee ratio versus the total fee captures different information related to the economic dependence of audit firms on their clients. We repeat the discretionary accrual analysis using our alternative performance adjusted discretionary current accrual measures. Regardless of the discretionary accrual measure employed, we find a positive association between fee ratio and the absolute value of discretionary current accruals. However, in contrast to FJN, when we partition sample firms based on whether they report income-increasing or income-decreasing performance-adjusted discretionary current accruals, we find no association between the fee ratio and income-increasing discretionary accruals. Rather, our results indicate that the association between the fee ratio and the absolute value of discretionary accruals is driven by income-decreasing discretionary accruals. While income-decreasing accruals can be interpreted as a form of biased financial reporting, income-decreasing accruals also reflect a conservative application of generally accepted accounting principles (GAAP). Typically regulators and financial statement users are more concerned with the opportunistic

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application of GAAP than the conservative application of GAAP, with the opportunistic application of GAAP more likely signaling problems with auditor independence (Becker et al. 1998). In contrast to the results based on the fee ratio, we find no statistically significant association between total fees and income-increasing or income-decreasing accruals. We find, however, a marginally significant positive association between positive discretionary accruals and non-audit fees. Although, after analyzing Big 5 clients separately from non-Big 5 clients, we find no significant association between non-audit fees and income-increasing accruals. We also find that Big 5 clients drive the negative association between the fee ratio and income-decreasing discretionary current accruals. These results support prior research suggesting that Big 5 clients report more conservatively than non-Big 5 clients (Francis et al. 1999). In addition to their discretionary accruals analysis, FJN use the relation between the fee ratio and two earnings benchmarks – small earnings increases and meeting analyst forecasts - to draw inferences on audit firm independence. The assumption behind these tests is that a positive association between the fee ratio and the likelihood of meeting an earnings benchmark is an indication that auditor objectivity has been compromised as a result of supplying a relatively greater proportion of non-audit services to total services. We investigate the same earnings benchmarks as FJN. However, unlike FJN, we find no statistically significant association between either the fee ratio or total fees, and firms meeting earnings benchmarks. Our findings are consistent with the findings of Francis and Ke (2001) who investigate the association between fees and earnings benchmarks. Based on the use of discretionary accruals and earnings benchmarks as proxies for biased financial reporting, we find no systematic evidence supporting the claim that auditors violate their independence as the result of clients paying high fees or having high fee ratios. References: Beck, P. J., T. J. Frecka, and I. Solomon. 1988. An empirical analysis of the relationship between MAS involvement and auditor tenure: Implications for auditor independence. Journal of Accounting Literature 7: 65-84. Becker, C. L., M. L. DeFond, J. Jiambalvo, and K. R. Subramanyam. 1998. The effect of audit quality on earnings management. Contemporary Accounting Research 14: 1-24.

4 Hollis Ashbaugh, Ryan LaFond, and Brian W. Mayhew

Craswell, A., J. Francis, and S. Taylor. 1995. Auditor brand name reputations and industry specializations. Journal of Accounting and Economics 20 (December): 297-322. DeAngelo, L. 1981b. Auditor size and audit quality. Journal of Accounting and Economics (December): 183-200. Francis, J., and E. Wilson. 1988. Auditor changes: A joint test of theories relating to agency costs and auditor differentiation. The Accounting Review 63 (October): 663-682. Francis, J. R., E. L. Maydew, and H. C. Sparks. 1999. The role of big 6 auditors in the credible reporting of accruals. Auditing: A Journal of Practice & Theory 18: 17-34. Francis, J. R. and B. Ke. Do non-audit services compromise auditor independence? University of Missouri and The Pennsylvania State University working paper. November 2001. Frankel, R. M., M. F. Johnson, and K. K. Nelson. 2002. Auditor independence and earnings quality. Working paper, Stanford (January 2002). Kothari, S. P., A. J. Leone, and C. E. Wasley. 2001. Performance matched discretionary accrual measures. Working paper, University of Rochester. Levitt, A. Speech given at New York University Center for Law and Business. May 10, 2000. Magee, R., and Tseng. 1990. Audit pricing and independence. The Accounting Review 65 (April): 315-336.

Do Non-audit Services Comprise Auditor Independence? Further Evidence: Discussion William R. Kinney, Jr., University of Texas at Austin

shbaugh, LaFond, and Mayhew (ALM) present a thoughtful and timely replication and reformulation of the audit firm fee research of Frankel, Johnson, and Nelson (FJN) (2002). In effect, ALM asks “do FJN properly

measure and interpret the association between audit firms’ non-audit services (NAS) fees from their audit clients and lax GAAP enforcement?” The answer is important because FJN is believed by some to support actions of the SEC and Congress to ban audit firms from offering some professional services. Using essentially the same 2000 proxy statement fee data as FJN, ALM first replicate FJN’s results using the ratio of NAS fees to total audit firm fees. Then they use the scholarly literature to suggest refined formulations of FJN’s independent and dependent variables to assess the association, generalizeability and interpretation of FJN’s conclusions. ALM come to different statistical and substantive conclusions, and provide insights into the possible causes of FJN’s results. In this discussion, I will begin with background on an intermediate construct (auditor independence) and its regulation, and then review recent research on NAS fees and auditor independence. Next, I discuss ALM’s research design and results and then I draw some brief conclusions. I. Background: Auditor Independence and Its Regulation Some presume that auditor independence is compromised by NAS fees to the audit firm, and that compromised independence leads to lax enforcement of GAAP. But what is meant by “auditor independence?” Auditor independence is rarely defined and much confusion results from the use of “negatives” to operationalize the concept. Auditor independence is typically operationalized through proscriptions of relationships and activities. For example, the auditor is judged not to be independent of an audit client if the auditor or the auditor’s associates own stock in the client, make business decisions for the client, or keep the books for or provide certain other services to an audit client (the list of proscribed services was extended by the Sarbanes-Oxley Act of 2002). Only the “certain services” part is at issue in FJN and ALM. The left side of Figure 1 summarizes the negative approach to auditor independence.

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6 William R. Kinney, Jr.

Securities and Exchange Commission. Final Rule: Revision of the Commission’s Auditor Independence Requirements (17 CFR Parts 210 and 240) (November 21, 2000).

F i g u r e 1 : A p p r o a c h e s t o a u d i t o r i n d e p e n d e n c e

• N e g a t i v e - a u d i t o r n o t i n d e p e n d e n t i f

– o w n s s t o c k– m a k e s d e c i s i o n s– k e e p s t h e b o o k s– d o e s i n t e r n a l

a u d i t i n g o r F I S D I o r c e r t a i n c o n s u l t i n g

• P o s i t i v e - a u d i t o r i s i n d e p e n d e n t i f h e o r s h e h a s

– h i g h i n t e g r i t y a n d o b j e c t i v i t y

– n o s u b s t a n t i a l i n t e r e s t i n t h e i n f o r m a t i o n o t h e r t h a n i t s q u a l i t y

Under a negative approach to auditor independence, the auditor is assumed to be independent regarding professional services if he or she (and the auditor’s firm) do not offer the proscribed services. As far as we know, none of the auditors in the FJN or ALM sample offered any professional services proscribed at the time of the audit. Thus, the concept “auditor independence impairment” is something more than mere negatives. A positive approach to auditor independence might define the auditor as independent if he or she has unquestioned objectivity regarding measurements of an audit client and high integrity, such that the auditor would conduct an appropriate audit and report any false, biased, or misleading measurements by an audit client. Objectivity and integrity are, of course, not directly observable and thus cannot be easily operationalized. An alternative is to define an auditor as independent if he or she had no substantial interest in the information in question other than its “quality,” where information quality includes its reliability. The right side of Figure 1 summarizes a positive approach to auditor independence. The positive approach seems more akin to the behavior being considered by both FJN and ALM in that both posit that the auditor will be lax in detecting departures from GAAP or lax in requiring correction of lax application of GAAP by clients upon whom the auditor depends for current income. FJN focus on the ratio of NAS fees to total fees from a client as the appropriate metric for dependence (or non-independence), while ALM focus on total fees. To illustrate and contrast some of the ALM and FJN research assumptions, one should consider two questions about auditor independence.

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1. Assuming Andersen LLP was not independent of Enron management, then was it due to Andersen’s:

a. audit fee of $25,000,000 dollars? b. non-audit fees of $27,000,000 dollars? c. total fees of $52,000,000? d. ratio of NAS to total fees of .52? e. failure to override the potential interest of David Duncan, the engagement

partner, in Enron’s information other than its quality? ALM implicitly assume that the correct answer is c. – total fees of $52,000,000, while FJN assume that it is d. – the ratio of NAS to total fees of .52. Those taking a positive approach might conclude that a. and b. caused Duncan to lose objectivity with respect to Enron’s information, and that e. allowed lax GAAP application by Enron’s management. Yet, e. is not covered by present ethics proscriptions of the AICPA, SEC, or the Sarbanes-Oxley Act. 2. Would the auditor’s independence be compromised if he or she performed the

following service for an audit client: a. installed a point-of-sale computer system? b. consulted on a world-wide tax optimization plan? c. consulted on accounting for a major transaction being planned based on

alternative transaction design features? d. audited details of transaction processing for use by management? All four services are non-audit services that would contribute to a higher NAS fee ratio, as well as to total fees of the audit firm, and some would argue that one or more services may provide a substantial interest in the financial statement information other than its quality. However, the federal government through the SEC and the Congress (in the Sarbanes-Oxley Act of 2002) proscribe a. and d., but allow b. and c. II. Prior Research on Audit Firm Fees Other scholarly archival studies have used different operationalizations of the dependence problem, but have come to similar conclusions as ALM. As of October 2000, there are at least six other studies of auditor independence in the U.S., with five using the proxy statement disclosures mandated by the SEC. FJN was the first, and to date, the only study that yields statistically significant positive association of non-audit fee metrics with proxies for lax GAAP enforcement, and the only one to use the NAS fee ratio as the primary independent variable. AFN and Kinney and Libby (2002) point out conceptual arguments against the fee ratio measure of the

8 William R. Kinney, Jr.

theoretical construct for lack of independence and all six studies use different forms of the dependent variable measuring lax application of GAAP. Chung and Kallapur (2002) use fee metrics at the audit firm office level to measure possible dependence of smaller operating units on client NAS fees. Francis and Ke (2002) replicate and extend FJN using quarterly earnings as the response variable, and Antle, Gordon, Narayanamoorthy, and Zhou (2002) use systems of equations to isolate the effects of possible dependence. None finds consistently significant positive associations related to NAS fees. DeFond, Raghunandan, and Subramanyan (2002) use audit opinion modifications for going concern status as the dependent variable, but also find no statistically significant differences. The SEC requires registrants to disclose their audit firm’s fees in three categories: (1) audit services (narrowly defined), (2) financial information systems design and implementation services, and (3) “all other” services (SEC 2000). The latter category combines audit-related, internal audit outsourcing, tax, and other services that an audit firm might provide – that is, the “all other” category combines services that are proscribed by Sarbanes-Oxley (internal audit and some consulting services) with those that are not (audit-related, tax, and some consulting services). Thus, the basic data on the independent variable (audit firm fees) is measured with error if one is trying to assess the effect of “egregious” services – services banned or believed to compromise auditor independence. Kinney, Palmrose, and Scholz (2002) use confidential fee data from 1995-2000 and a four-way cut “all other” fees to relate audit firm fees to restatement of financial statements. Their fee data separates the “all other” category of proxy definitions into audit-related fees, internal audit fees, tax services fees, and other fees. They find no consistent positive association between audit firm fees and restatements, but they do find a negative association between tax services fees and restatements. The latter suggests that there may be net beneficial effects of some types of NAS by a registrant’s auditor. Overall, scholarly archival research on the effect of NAS fees on auditor independence suffers from conceptual weaknesses in the definition of independence, the operationalization of the definitions through rules, and the lack of proper data for resolving legitimate questions. AFN has no greater exposure to these problems than the other studies, but the weaknesses point out the need for care in interpreting the archival results and the need for application of other research methods that reduce these weaknesses.

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III. Ashbaugh, LaFond, and Mayhew Research Design and Results As discussed in section I., ALM and FJN differ in their measurements of auditor dependence on a client (the independent variable) and the measure of laxity in enforcing GAAP (the dependent variable). Specifically, FJN assume that the relevant operational measure of auditor dependence on an audit client is the ratio of the NAS fee to total fees, and measure the effect of that dependence using various measures of discretionary accruals, achieving “benchmark” targets based on earnings, and the change in stock price for registrants around the announcement date for fees in the proxy statements. They control for client size, leverage, type of auditor (Big Five vs. non-Big Five), litigation, institutional holdings of registrant stock, mergers, losses, accruals, and cash flows from operations. The design for FJN is shown in Figure 2, panel a.

F i g u r e 2 – R e s e a r c h d e s i g n sp a n e l a : F J N ( 2 0 0 2 )

A u d i t o r l a x i ne n f o r c i n g G A A P

N A S f e e r a t i oD i s c r A c c r u a l sB e n c h m a r k sP r i c e c h a n g e

A u d i t o r d e p e n d e n c e

o n c l i e n t

s i z e , l e v , B i g 5 , l i t , I h o l d , m e r g e , l o s s , A c c , C F O

C o n c e p t u a l

O p e r a t i o n a l

C o n t r o l

I n d e p e n d e n t D e p e n d e n t

p a n e l b : A L M ( 2 0 0 2 )

A u d i t o r l a x i ne n f o r c i n g G A A P

T o ta l f e e sP A C D A / R E C D A

B e n c h m a r k ( s ) P r i c e d r o p

A u d i t o r d e p e n d e n c e

o n c l i e n t

s i z e , l e v , B i g 5 , l i t , I h o l d , m e r g e , l o s s , l a g 1 C A

C o n c e p t u a l

O p e r a t i o n a l

C o n t r o l

I n d e p e n d e n t D e p e n d e n t

10 William R. Kinney, Jr.

In contrast, ALM operationalize auditor dependence on a client by measuring total fees paid to the audit firm. For the dependent variable(s), they use performance- adjusted discretionary accruals (PACDA) and return-adjusted discretionary accruals (RECDA), the benchmarks of FJN, and the price change of registrants around the announcement date as do FJN. The performance-adjusted measures incorporate client firm performance as a factor affecting expected accruals as suggested by other scholarly studies. ALM also control for size, leverage, auditor type, litigation, institutional holdings, mergers, loss, as do FJN, but they specifically exclude accrual-based measures because of the close relation of accrual-based measures to the dependent variable measure and substitute a lagged current accrual measure. These differences in the dependent accrual measures and the model enhancements comprise the basis for ALM’s arguments for their measurement “superiority” over FJN. Figure 2, panel b. depicts ALM's design. Depending on one’s views of the most appropriate operationalization of auditor dependence (e.g., whether the independent variable should be the total fee or ratio of fees) and functional form, one might prefer ALM’s formulation of the estimation over FJN’s. Most, I believe, would side with ALM a priori. Total fees captures the total resource flow from a client to the audit firm, rather than the proportion from non-audit sources. Thus, for example, total fees represent the resources lost if the client is lost, while the ratio measures only proportionate loss due to NAS. Similarly, incorporating the effect of performance on expected accruals is well-accepted in the literature as is exclusion of similar variables from both sides of a regression equation. But do the research choices (or refinements) of ALM make a difference in the estimation results. Let’s summarize the results of ALM’s empirical work. First, they replicate FJN’s basic analyses using the NAS fee ratio, and find that using data from their sample yields the same statistical results as FJN. Second, they substitute their total fees measure for the fee ratio, and find that this alternative independent variable measure is not significantly associated with FJN’s “compromised independence” measure based on accruals. Third, when they substitute PACDA and RECDA for FJN’s accrual measures, they find that FJN’s NAS fee ratio results are due to firms experiencing net income declines. Also, they find that total fees are not associated with PACDA. However, Big Five vs. non-Big Five results are different for PACDA, particularly with regard to the incidence of income-decreasing discretionary accruals. Thus, FJN’s NAS fee ratio-based conclusions appear driven by clientele differences for this partition of the overall data set. ALM do not emphasize their results for the benchmark achievement dependent variables or stock price reaction to proxy announcement of the fee data. However,

Fifteenth Symposium on Auditing Research 11

their results differ from FJN’s. For the benchmark tests, ALM find no consistent association with analyst forecast benchmark achievement for total fees or their ratio although there are some seemingly minor sample and model differences between FJN and ALM. As to the price declines surrounding registrants’ announcements of audit firm fees in proxy statements, the present version of ALM is very brief and sketchy. Apparently, they replicate FJN’s analyses and find a statistically significant negative coefficient related to at least some audit firm fee metrics. However, they also find an implicit average price effect size that is very small. They attribute the statistical significance to the effect of the large sample size rather than an economically important effect. That is, the large sample size makes even inconsequential price declines appear statistically significant. In my view, discussion of ALM’s price response tests should be expanded to illuminate the arguments and should include a formal calculation of effect size to aid understanding of the consequence of FJN as well as the present work. For example, an indication of relative implicit effect size estimates following Cohen (1988) might be included. IV. Conclusions There are many ways of characterizing the overall results of ALM. The minimum that can be said is that FJN’s results and interpretation of their results are sensitive to research design choices. Many research choices must be made in analyzing the available data, and the statistical results and their interpretation vary substantially depending on the research choices. Choice of theoretical underpinnings is important because there are substantial legal, regulatory, and economic implications of one’s choices when interpreting the results. This means that one’s interpretation will depend upon how much one believes in the design choices. Many will side with ALM a priori. In particular, many will conclude that total fees are a better measure of the economic dependence of the auditor on a client than the NAS fee ratio, and ALM’s performance-adjusted measures are superior to the simpler measures used by FJN and the latter’s method of accounting for performance. For those with this view, ALM’s results suggest that there is no consistent evidence supporting lax GAAP enforcement related to NAS fees paid to a registrant’s audit firm. A second conclusion from ALM is that audit firm size may be an issue. This is in regard to the non-Big Five results for earnings declines. Finally, in my view, the present paper would be substantially strengthened if it would elaborate on the market price decline tests that they conducted, including quantification of the “effect size.”

12 William R. Kinney, Jr.

Overall, ALM is in line with the other five studies of U.S. audit firm fee data in failing to reject the (null) hypothesis of pervasive statistically significant positive association between fee measures and lax GAAP application. References: Antle, R., E. Gordon, G. Narayanamoorthy, and L. Zhou. “The Joint Determination of Audit Fees, Non-Audit Fees, and Abnormal Accruals.” Working paper, Yale University (June 2002). Ashbaugh. H., R. Z. LaFond, and B. Mayhew. “Do Non-Audit Services Compromise Auditor Independence? Further Evidence.” Working Paper, University of Wisconsin at Madison (April 18, 2002). Chung. H. and S. Kallapur. “Client Importance, Non-Audit Services, and Abnormal Accruals.” Working Paper, Purdue University (May 2002). Cohen, J. Statistical power analysis for the behavioral sciences (2nd edition). Hillsdale, NJ: Erlbaum (1988). DeFond, M., K. Raghunandan, and K. Subramanyam. “Do Non-Audit Service Fees Impair Auditor Independence? Evidence from Going Concern Audit Opinions.” Working paper, University of Southern California (January 2002). Francis, J. and B. Ke. “Do Non-Audit Services Compromise Auditor Independence?” Working paper, University of Missouri (2002). Frankel, R., M. Johnson, and K. Nelson. “The Relation Between Auditors’ Fees for Non-Audit Services and Earnings Management.” Forthcoming 2002 in The Accounting Review Earnings Quality Conference Special Issue. Kinney, W. and R. Libby. “Discussion Comments on ‘The Relation Between Auditors’ Fees for Non-Audit Services and Earnings Quality.’” Forthcoming 2002 in The Accounting Review Earnings Quality Conference Special Issue. Kinney, W., Z. Palmrose, and S. Scholz, “Auditor Independence and Non-audit Services: What do Restatements Suggest (Preliminary Analyses)?,” Working paper, University of Texas (2002).

An Experimental Investigation of Audit Decision-Making: An Evaluation Using System-Mediated Mental Model Theory

Amy K. Choy, Washington University Ronald R. King, Washington University

ell et al. (1997) advance the argument that systems audits may be a superior alternative to traditional audits in today’s business environment. Under the systems audit (SA) approach, the auditor takes a “top down-big picture”

orientation by first acquiring general knowledge about the client’s underlying business activities and then using this knowledge as a guide for collecting evidence and drawing inferences (Kinney 2000). The SA approach has evolved, in part, because the business models of clients have become increasingly complex, which in turn has increased the demands on the auditor (Elliott 1994). Under the traditional audit (TA) approach, auditors use more of a “bottom up-data immersion” approach, in which they immerse themselves in the data of accounting transactions and develop perceived relations between transactions and financial statements, but perhaps without specific knowledge of the underlying business processes that generated the transactions. Currently, the largest audit firms are moving toward a greater SA orientation (Eilifsen et al. 2001; Winograd et al. 2000). However, with the occurrence of recent high profile business failures, new audit approaches need to be scrutinized. We have two purposes for this study. The first is to develop a theory that explains and predicts auditors’ ability to make correct inferences under different audit approaches. We refer to our theory as the System-Mediated Mental Model (SMMM) theory, which is discussed below. The goal of this modeling exercise is to provide an explanation of how systems thinking can improve auditor decision-making. This explanation, in turn, strengthens the theoretical underpinnings of different audit approaches so that public-policy appraisals can be based on solid conceptual anchors. The second purpose is to investigate the theory using a laboratory experiment that captures the important aspects in both the “bottom up-data immersion” orientation of the TA approach and the “top down-big picture” orientation of the SA approach. The SMMM theory builds on two related but distinct foundation theories. The first is the mental model theory (MMT), which has its roots in cognitive psychology (Johnson-Laird 1983). MMT predicts that humans make inferences by constructing mental models that are internal (mental) representations of some external state of

B

14 Amy K. Choy and Ronald R. King

affairs. Decision-makers (DMs) who face complex problems and are boundedly rational (i.e., have limited working memory or problem solving skills), may be unable to construct and evaluate multiple mental models to generate an accurate integrated mental model, thereby making certain errors. The second input into the SMMM theory comes from the general system theory (GST) proposed by the biologist Bertalanffy (1968). This theory emphasizes understanding the interactions of activities within an entity (such as the client’s organization) and the interactions between the entity and its environment. The SA approach, as articulated by Bell et al. (1997) is a special application of GST. We use the MMT to focus our understanding of how DMs make inferences and how errors could occur. Although MMT explains how and why DMs make errors in their decisions, the theory offers no alternative for improvement. Conversely, the GST offers an approach for improving individual’s ability to solve complex problems and explains why the approach works. However, GST offers no explanation for how DMs make decisions. By combining the MMT with the GST, we develop the SMMM theory to provide insight to how systems thinking can lead to improved decision-making. The MMT component of the SMMM theory assumes that auditors construct mental models to make inferences and that multiple mental models must be integrated correctly to arrive at one final model needed for making correct inferences. The GST component of the SMMM theory suggests that knowledge of the underlying system can improve an auditor’s ability to make correct inferences. Simply put, the SMMM theory posits that systems knowledge will help DMs integrate multiple mental models more correctly, thus reducing inference errors. In contrast, DMs who fail to develop systems thinking are forced to integrate the mental models using a data immersion perspective. We denote this decision making approach as component-based reasoning and call the theory that explains the decision process the component based mental model (CBMM) theory. A data immersion method requires greater cognitive demands and, with bounded rationality, can result in certain decision errors. Our goal is not to identify how the SA approach produces systems thinking, but rather to investigate how systems knowledge can enhance decision-making. Our hypotheses compare predictions from the theory of unbounded rationality, CBMM and SMMM theories. The unbounded rationality hypotheses predict that subjects will always make correct inferences. If DMs are boundedly rational, however, the CBMM predicts that the DMs will make specific inference errors consistent with not integrating mental models properly. The SMMM theory predicts that DMs will avoid making these predictable errors once they acquire a system-thinking framework for the underlying task.

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We test the SMMM theory with an experiment using student subjects that follows the precepts of experimental economics, including providing subjects with salient and dominant rewards. The task performed by subjects (hereafter referred to as auditors) has two components that are consistent with auditing tasks and that fit within the domain of the SMMM theory. The first component of the task surrogates for planning and execution of the audit (i.e., collecting and analyzing information), and the second component surrogates for issuing a report. In the experiment, it is costly for the auditor to conduct the audit, and to commit reporting errors. We design two experimental audit approaches under two different environments. The first audit approach is a top down-big picture approach (denoted as TOP), designed in the spirit of the SA approach, which helps the DM to develop a systems organizing framework for decision-making. The second audit approach is a bottom up-data immersion approach (denoted as BOT), designed in the spirit of the TA approach, which provides no help to the DM help in developing an organizing framework. The task is designed so the TOP and BOT approaches are equivalent if DMs are unboundedly rational. However, if DMs are boundedly rational, they may be less efficient in their task by collecting non-diagnostic evidence or may lack effectiveness by committing more reporting errors under the BOT approach than under the TOP approach. The SMMM theory predicts that the TOP approach will result in more efficient and effective decisions in complex tasks. The two environments are Static World (SW) and Dynamic World (DW) surrogating for a stable and an evolving business environment, respectively. Our results reject the unbounded rationality hypotheses and are consistent with the predictions of the CBMM theory (for the BOT settings) and the SMMM theory. Specifically, the CBMM theory predicted specific types of inference errors that our subjects did commit without systems knowledge. Consistent with the SMMM theory, the results indicate that systems knowledge reduces the predicted errors committed by the auditors. We also investigate auditors’ willingness to pay to acquire the TOP approach. We find predictable relation between auditors’ reporting accuracy in earlier parts of the experiment and their selections of the TOP approach in later parts of the experiment. Our research complements traditional behavioral auditing research (for reviews, see Gibbins and Swiengera 1995; Libby 1995; Messier 1995; Solomon and Shields 1995) and research addressing systems audits (Ballou et al. 2001; Blokdijk et al. 2001; O’Donnell 2001) by investigating psychology-based theory under controlled experimental economic conditions. We view our research as a first step in a progression from theory development and refinement, to laboratory experimentation, and then to empirical investigation in natural settings.

16 Amy K. Choy and Ronald R. King

There are some noteworthy caveats to our study. First, our operationalization of the audit setting and audit approaches (TA and SA) is very stark relative to natural settings. However, we seek to create a setting and theory that is intentionally simplified to focus on primitive decision-making issues that are general in scope. A second caveat is that we use student subjects in our experiment, rather than audit practitioners. However, our subject pool choice and other experimental choices were chosen to enhance internal validity, which is a fundamental requirement of valid experimentation (Peecher and Solomon 2001). The last caveat is that we do not investigate how DMs might develop an understanding of a system. Rather, we investigate how an organizing framework, such as systems knowledge, can be useful in settings where DMs are prone to making predictable errors. One future research possibility is to refine the theory to evaluate its robustness when applied to other types of problems. A second possibility is to investigate experimentally the implications of adding a strategic, motivated reasoning element to the setting to investigate moderators of biased auditor decision-making. For example, while Kadous et al. 2003 find that asking auditors to identify the highest quality revenue recognition method before deciding whether to accept a client-preferred revenue recognition intensifies the degree to which auditors' directional goals increase the acceptance of the client-preferred method, the identification of the highest quality method itself could be moderated by auditors' understanding of the underlying systems. References: Bell, T., F. Marrs, I. Solomon, and H. Thomas. 1997. Auditing Organizations Through a Strategic-Systems Lens. The KPMG Business Measurement Process. KPMG Peat Marwick LLP. Bertalanffy, L. von. 1968. General Systems Theory. Foundations, Development, Applications. New York, N. Y.: George Braziller. Brown, C., M. Peecher, and I. Solomon. 1999. Auditors’ hypothesis testing in diagnostic inference tasks. Journal of Accounting Research (Vol. 37, No 1, Spring): 1-26. Elliott, R. 1994. “The future of audits. Journal of Accountancy 178 (September): 74-82. Eilifsen, A., W. Knechel, and P. Wallage. 2001. Application of the business risk audit model: A field study. Accounting Horizons (Vol 15, No 3 September): 193-207

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Gibbins, M., and R. J. Swieringa. 1995. Twenty years of judgment research in accounting and auditing. In R. H. Ashton and A. H. Ashton (Eds), Cambridge Series on Judgment and Decision Making: Judgment and Decision-Making Research in Accounting and Auditing. New York: Cambridge University Press: 131-249. Johnson-Laird, P. N. 1983. Mental models. Cambridge, UK: Cambridge University Press. Kadous, K., J. Kennedy, and M. Peecher. 2003. The affect of quality assessment and directional goal commitment on auditors' acceptance of client-preferred accounting methods. The Accounting Review (forthcoming). Kinney, W. 2000. Information Quality Assurance and Internal Control. Irwin McGraw-Hill. Libby, R. 1995. The role of knowledge and memory in audit judgment. In R. H. Ashton and A. H. Ashton (Eds), Cambridge Series on Judgement and Decision Making: Judgment and Decision-Making Research in Accounting and Auditing. New York: Cambridge University Press: 176-206. Messier, W.G. Jr. 1995. Research in and development of audit-decision aids. In R. H. Ashton and A. H. Ashton (Eds), Cambridge Series on Judgement and Decision Making: Judgment and Decision-Making Research in Accounting and Auditing. New York: Cambridge University Press: 207-228. Peecher, M. and I. Solomon. 2001. Theory & experimentation in studies of audit judgments & decisions: Avoiding common research traps. International Journal of Auditing (Vol. 5, November): 193-203. Solomon, I., and M. D. Shields. 1995. Judgment and Decision-Making Research in Auditing. In R. H. Ashton and A. H. Ashton (Eds), Cambridge Series on Judgement and Decision Making: Judgment and Decision-Making Research in Accounting and Auditing. New York: Cambridge University Press: 137-175. Winograd, B, J. Gerson, and B. Berlin. 2000. Audit practices at PricewaterhouseCoopers. Auditing: A Journal of Practice and Theory (Fall): 175-182.

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An Experimental Investigation of Audit Decision-Making: An Evaluation Using System-Mediated Mental Model Theory: Discussion

William L. Felix, Jr., University of Arizona

n this paper, the authors report that they combine a theory of the role of systems knowledge that predicts improved decision making and a well known theory of mental models to build a joint model that will help them predict changes

(improved accuracy) in audit decision making. They term their combined theory System-Mediated Mental Model theory (SMMM). They then indicate that this theory is the basis for the experimental market design for which they report results. The authors indicate that these experimental results support the superiority of the combined knowledge for participants making their experimental decisions. They contrast their new theory to a data driven approach to decision making that they term component based/mental model (CBMM) reasoning. Underlying their modeling arguments is an attempt to model and obtain evidence on whether auditors will perform better using an approach that begins with an overall understanding of the client’s business processes and the interactions of these processes with the environment as opposed to an approach that begins with detailed collection of audit evidence. There are two key linkages in this paper. The first linkage is between the authors’ combined model of decision making and the experiments. The second linkage is between the real world of auditing and both the theory and the experiments presented by the authors. Because accepting the validity of these linkages is critical to accepting the authors’ interpretation of their experiments, I begin this comment with some observations about these linkages. Thereafter, I finish by commenting on the experiment itself. In the description of the SMMM theory, the authors indicate that the contribution of SMMM comes from the ability to predict how decision makers benefit from knowledge of underlying systems. A subtle distinction not addressed in the paper is the difference between the acquisition of knowledge of underlying systems and how that knowledge affects the decision makers’ organization and use of the knowledge in decision making. The latter process is an important mediating influence on how systems knowledge affects decisions. The authors do point out this issue but they defer it to future research. In their development of the SMMM model, the authors report that they draw on a well-known descriptive theory of mental models as a framework for understanding decision making. They combine this mental model theory with a theory claiming

I

20 William L. Felix, Jr.

that systems knowledge improves decision making. A careful reading of the descriptions in the first several pages of the paper leads the reader to the discovery that no explicit model or theory is developed. There is no set of relationships that allow the development of specific, refutable hypotheses. Absent an explicit theory, it is not a surprise that the connection between the theory development and the specific experimental design is imprecise. This lack of a specific connection puts considerable pressure on the reader to evaluate critically the claimed connection of this very general theory with the experiments. In the experiment, a logical relationship (termed a logical expression or LE) is used to relate the state of nature (good or bad) to observable outcomes on four accounts. The experimental participants are given a set of outcomes and asked to infer the logical relationship from the outcomes and thereby assess the state of nature. Essentially, the experiment tests how well knowing the structure of the LE improves the inferences. It is not a great surprise that the experimental results indicate that providing the structure improves the inferences. A fundamental question the reader must consider is how well knowing or inferring this logical relationship relates to the systems knowledge claimed by the authors to significantly improve auditor decision making. Auditing is characterized as either systems based, top down or data driven, bottom up. The importance of starting the audit with a strong knowledge of the client and its business has been acknowledged at least since the 1960’s. It is likely that most auditors obtain and document some evidence of general knowledge of the client’s business. However, it is reasonable to question (1) how well auditors at that time or since have responded to the need for this knowledge or (2) when they obtained such knowledge, how well auditors have used it. As an observer of auditing practice, it appears that repeated waves of “new” approaches to auditing surface every few years. The most recent wave in the mid 1990’s reemphasized the importance of understanding the client’s business. KPMG’s BMP approach is a well-known example.1 BMP requires the audit team to acquire, structure, and document business knowledge using strategic systems analysis. We have little evidence on the extent to which a systems approach or its equivalent was used in practice prior to the most recent wave of changes. In addition, BMP, when properly used, requires the audit team to carefully link the audit team’s assessed business risks to the audit plan. This emphasis on specific links between the business knowledge and the audit plan is relatively new. The reader is not informed as to why knowledge of business systems was chosen for

1 While the authors assert that KPMG’s BMP is a special case of their general systems theory, they could better clarify why this assertion is reasonable.

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emphasis when there are an array of possible contributions to audit decision making from an audit approach such as BMP. As described above, the author’s characterize audits as either top down or bottom up. Top down audits are characterized as beginning with well organized and utilized knowledge of the business systems. Bottom up audits are characterized as beginning with detailed knowledge of business transactions and internal controls. This simplification of audits into two types may be reasonable, but it would be helpful if the authors would point out to the reader what they are doing. Namely, they are simplifying the practicing world for experimental purposes. Is their simplification reasonable? Perhaps, but it is noteworthy that the simplification disallows decision makers who fail to develop systems thinking from supplementing their thinking via off-line storage of knowledge (working papers) or interaction with audit team members (it is possible that a team discussion would help organize implication of the client’s environment). Casual observation of practice across time would suggest that the data driven approach would characterize the knowledge and actions of junior auditors. The broader knowledge of audit management would more closely approach that provided by a systems understanding. It is an interesting question as to what impact BMP and its competitors have had on audit team knowledge, especially for junior auditors. It is possible that a major advantage of a systems approach is to significantly improve the sharing of knowledge of the client across the entire audit team and to provide better documentation, which would improve knowledge transfer to new team members. These alternative sources of improvements in auditing from BMP may be worthy of research. Here again, implicit specific choices were made in the research design without discussion. In summary, then, the paper provides evidence from an experimental economics design that is meant to characterize highly simplified audit settings. The development of theory in the paper is only loosely connected to the experiments, and the experiments’ connection to practice relies on substantial simplifications that may or may not be reasonable.2

2 In a footnote, the authors defend their many simplifications from auditing in their design by stating “…our objective is to incorporate only those frictions that are most germane to testing the theory.” It is easy to agree with this statement in concept, but what does it mean? What are the “frictions” in the real-world auditing decision making scene? And how do we evaluate whether those remaining in the design are those most appropriate to testing the theory? The lack of development again leaves the reader in doubt as to what the authors are referring.

22 William L. Felix, Jr.

Despite questions surrounding key linkages in the paper, the experiments themselves appear to be well designed and executed. The discussion about logical expressions used to represent the “system” in the experiments is clear and easy to understand, and the experimental design and hypotheses logically flow from the “system” development. I view the discussions and the reported results of the experiments using student participants as reasonable evidence on the decision making effectiveness of the participants under the described stylized conditions. A key issue for readers to consider is the linkage from these experiments to the theories and to practice. To this reader, they are not sufficiently clear.

An Empirical Analysis of Auditor Reporting and its Association with Abnormal Accruals Marty Butler, University of Rochester Andrew J. Leone, University of Rochester and University of Michigan

Michael Willenborg, University of Connecticut

everal recent studies have examined the relation between modified opinions and earnings management (e.g., Bartov et al., 2000; Bradshaw et al., 2001). These studies suggest that earnings management, as proxied by large or

positive accounting accruals, leads to modified opinions and thus can be used as a proxy for earnings quality. Our study reexamines the relation between modified audit opinions and abnormal accruals, assessing, in particular, the claim that a modified audit opinion is a reliable signal of earnings management. The audit process and audit standards are such that an opinion modification due to material misstatement or departure from GAAP should be rare.1 When auditors detect material misstatements, they are brought to the attention of management and/or the audit committee who agree to an adjustment. Nonetheless, empirical evidence on the relation between abnormal accruals as a proxy for earnings management and modified opinions is difficult to refute. Previous research documents that firms receiving modified opinions have total and abnormal accruals that are more negative and larger in absolute value than those that do not (e.g., Bartov et al., 2000; Bradshaw et al., 2001; Francis and Krishnan, 1999). We attempt to reconcile this puzzle in the following way. First, we categorize modified opinions by type to identify the reasons opinions are modified. Next, we identify the categories that drive the documented relation between abnormal accruals and modified opinions. Finally, after ruling out several earnings management explanations for the relation, we consider non-earnings management explanations. Specifically, we consider whether extreme poor performance leads to nondiscretionary accruals that are misclassified by accrual models as discretionary.2 Our study makes three contributions. First, we introduce a sampling procedure that enables us to quickly and reliably collect a large number of audit opinions directly

1 We thank Ed Kay, Managing Partner at PricewaterhouseCoopers, Rochester, NY, who described the audit process to us and, in particular, the steps that are taken by auditors when a material misstatement is identified. 2 For example, Kothari et al. (2002) and Dechow et al. (1995) find that abnormal accruals estimated from various accrual models are misspecified for firms with extreme performance.

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24 Marty Butler, Andrew J. Leone and Michael Willenborg

from firms’ EDGAR filings. Second, we provide a comprehensive analysis of the reasons auditors issue modified opinions. This descriptive analysis enables us to identify the type or types of modified audit opinions that drive the results of previous studies, which typically do not distinguish among the various types of modifications. Third, we offer new insights on the relation between audit opinions and accounting accruals that contribute to the extant literature on the association between audit opinions and earnings management. We trace and verify the audit opinion codings on Compustat to source documents on EDGAR. Interestingly, we find that 1,385 (16 percent) of 8,478 opinions that Compustat classifies as modified, are essentially clean opinions. For example, 801 firm-year observations are classified as modified because the auditors noted in the report that they also reviewed a supplementary schedule filed with the 10-K. Based on a content analysis of over 7,000 modified opinions from 1994 to 1999, we identify two factors that account for over 90% of modifications: consistency issues requiring no restatements (e.g., accounting changes) and troubled-company issues (e.g., going-concern uncertainty). In addition, we find that while unqualified opinions with explanatory language are relatively common, qualified opinions are rare. Further, the reasons for qualified opinions appear to be unrelated to earnings management, thus refuting the contention that earnings management “causes” modified opinions. We find that the opinion-accruals relation is driven by “troubled” companies (e.g., with going-concern opinions) because they have extreme negative abnormal accruals. Abnormal accruals are more negative for firms receiving troubled company opinions, regardless of their auditor’s size and despite matching such companies with firms that have comparably poor ROA but clean opinions. In analyzing the specific source of abnormal accruals in troubled companies, we find that these firms have large negative accruals that are principally nondiscretionary. These accruals are most likely classified as “discretionary” because abnormal accrual models are misspecified when firms experience abnormally poor performance. The negative relation is largely explained by two components of accruals—increases in accounts payable and asset impairment charges—each of which is apt to be a nondiscretionary response to severe financial distress. GC firms are often liquidity-constrained and delay payments to creditors to raise cash, with the association between GC opinions and A/P increases being especially pronounced in exceptionally small firms. These firms also recognize what appear to be real (nondiscretionary) economic declines in asset values through asset impairment charges. The asset write-downs are inconsistent with earnings management in that these firms continue to perform poorly for several years after receiving GC opinions. Thus, GC firms naturally have large negative accruals that standard models of earnings management classify as discretionary even if they are nondiscretionary—in

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other words, traditional models of earnings management are likely misspecified for GC firms. We encourage researchers to be cautious when attempting to make inferences about the relation between modified opinions and traditional measures of abnormal accruals. Bartov et al. (2000), for example, assume that firms receive modified opinions because they engage in earnings management. However, as we discuss above, earnings management is rarely the cause of an opinion modification. Further, the relation between modified opinions and the magnitude of signed accruals is negative, driven by firms with GC opinions, and not representative of extreme cases of earnings management. Traditional models of earnings management are misspecified in cases of extreme performance (e.g., distress). Consequently, the models Bartov et al. (2000) recommend as having the most power—cross-sectional Jones and cross-sectional Modified Jones—are the models likely to suffer most from misspecification. Indeed, differences in the power of models they report are likely to be measures of relative misspecification, not power. Bradshaw et al. (2001) provide several alternative explanations for the negative relation between accruals and audit opinions, which they are not able to distinguish with their data. Our findings are consistent with their explanation that the role of auditors is not to issue audit modifications based on an assessment about the quality of earnings as measured by accrual levels. As our description of the audit process and our content analysis imply, auditors are unlikely to issue modified opinions for earnings-management reasons. Last, our finding that the association is impervious to auditor type and that the relation is reliably negative extends Francis and Krishnan’s (1999) study of opinions and accruals, which concludes that larger auditors respond to heightened earnings management risk assessments by adjusting opinion thresholds downward for high-accrual firms. References: Bartov, E., Gul, F., Tsui, J. 2000. Discretionary-accruals models and audit qualifications. Journal of Accounting and Economics 30: 421–452. Butler, M., A. Leone, and M. Willenborg. 2002. An empirical analysis of auditor reporting and its association with abnormal accruals. Working paper. Bradshaw, M., Richardson, S., Sloan, R. 2001. Do analysts and auditors use information in accruals? Journal of Accounting Research 39: 45–74. Dechow, P., Sloan, R., Sweeney, A. 1995. Detecting earnings management. The Accounting Review 70: 193–225.

26 Marty Butler, Andrew J. Leone and Michael Willenborg

Francis, J., Krishnan, J. 1999. Accounting accruals and auditor reporting conservatism. Contemporary Accounting Research: 16, 135–165. Kothari, S. P., Leone, A., Wasley, C. 2001. Performance matched discretionary accrual measures. Unpublished working paper. University of Rochester.

An Empirical Analysis of Auditor Reporting and its Association with Abnormal Accruals: Discussion

Richard G. Sloan, University of Michigan

utler et al provide a careful examination of the relation between modified audit opinions and abnormal accruals. They also provide a convincing explanation for the observed negative association between modified audit

opinions and abnormal accruals. The key limitation of the paper is that it provides no new insights into the role of the audit process in improving financial reporting. I. Introduction Butler, Leone and Willenborg (BLO hereafter) provide a detailed contextual analysis of audit opinions that allows them to conduct a more thorough analysis of the relation between audit opinions and abnormal accruals. Their analysis convincingly demonstrates that the negative relation between modified audit opinions and abnormal accruals is attributable to troubled companies. They also make a convincing case that these negative abnormal accruals are the result of negative nondiscretionary accruals that arise naturally in troubled companies. Their results cast doubt on the conclusions of previous research that has attributed the relation between modified audit opinions and accruals to discretionary accruals and earnings management. The key shortcoming of the paper is that it is silent on the effective-ness of the audit process. Thus, while I do not take issue with the study’s findings, its contribution is limited, because it is silent on the key issue that initially motivated research in this area. I expand on these points below. II. Strengths Attention to Institutional Detail The first key strength of the paper is that the authors conduct a detailed analysis of the factors leading to a modified audit opinion. This study begins with a careful analysis of the relevant securities laws, professional standards and other institutional factors. The authors then conduct a very thorough content analysis on a large sample of modified audit opinions, thus facilitating a detailed classification of audit opinions in their empirical tests. In contrast, past research has tended to operate under the maintained assumption that modified audit opinions result from earnings management and has used narrow classifications of audit opinions available from COMPUSTAT [e.g., Bartov, Gul and Tsui, 2000].

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28 Richard G. Sloan

Robust Result with Convincing Explanation The second key strength of the paper is that it documents a robust empirical regularity and provides a convincing explanation for this regularity. Previous research shows that modified audit opinions do seem to be related to accruals, but that the relation appears to be negative [see Bradshaw, Richardson and Sloan, 2001]. In other words, a modified opinion is more likely when accruals are unusually low. This finding runs counter to the idea that modified opinions flag cases where management has attempted to overstate earnings. By using their detailed audit opinion classification, BLW show that this negative relation is driven by the subset of modified audit opinions relating to troubled companies. These modified opinions consist of going concern uncertainties, bankruptcies and other material business uncertainties. BLW next present evidence that these firms have large negative nondiscretionary accruals arising from liquidity constraints (increases in accounts payable) and asset impairments. The overall picture that emerges is that modified audit opinions are negatively correlated with firm performance, and that it is this underlying firm performance that drives the relation between modified audit opinions and accruals. In other words, firm performance is a correlated omitted variable, and after controlling for this correlated omitted variable, there is no evidence of a relation between audit opinions and abnormal accruals. Thus BLW’s evidence provides a natural explanation for the negative relation between modified audit opinions and abnormal accruals, and also contradicts previous research that has attributed this relation to earnings management [see Bartov, Gul and Tsui, 2000]. III. Key Limitation The conclusion reached by BLW is that there is no evidence of a relation between modified audit opinions and earnings management. In this sense, the paper does a good job of overturning the findings of Bartov et al and corroborating the findings of Bradshaw et al. However, the paper is silent on the key issues that initially prompted research in this area. It sheds no light on the extent to which the audit process mitigates earnings management or improves financial reporting. Despite the detailed institutional and content analysis supporting the paper, it is basically a methodological piece suggesting that previous research on the relation between audit opinions and earnings management is misspecified. The paper is silent on the effectiveness or ineffectiveness of the audit process. What we really need is papers that can comment directly on the effectiveness of the audit process in improving the quality of financial reporting.

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IV. Concluding Comments BLW is a fine paper that makes an important contribution to the literature and has many strong points. In particular, it shows how detailed institutional and content analyses can result in more powerful tests, and it highlights the importance of firm performance as a correlated omitted variable in tests of earnings management based on accruals. However, at the end of the day, it is a methodological piece that is silent on the broader issues of the role of audits in both mitigating earnings management and improving financial reporting. Hopefully, the same techniques that allowed BLW to get this far will also help us to start addressing these more fundamental questions in the future. References: Bartov, E., F. A. Gul and J. S. L. Tsui. 2000. Discretionary-accruals models and audit qualifications. Journal of Accounting and Economics 30, 421-452. Bradshaw, M. T., S. A. Richardson and R. G. Sloan. 2001 Do analysts and auditors use information in accruals? Journal of Accounting Research 39, 45-74. Butler M., A. J. Leone and M. Willenborg. 2002 An empirical analysis of auditor reporting and its association with abnormal accruals. The Fifteenth Symposium on Auditing Research, University of Illinois at Urbana-Champaign, Illinois.

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The Impact of the 1995 Private Securities Litigation Reform Act on Litigation Risk and Auditor Compensation in the IPO Market Randy P. Beatty, University of Southern California

Philip P. Drake, Thunderbird American Graduate School of International Management

Chris E. Hogan, Southern Methodist University

he Private Securities Litigation Reform Act of 1995 (hereafter the 1995 Reform Act) was the first major reform of the Securities Acts of 1933 and 1934. The 1995 Reform Act was the result of extensive lobbying by several

groups, including the Big Six accounting firms. In a 1993 position paper, the Big Six firms claimed that the incidence of and costs related to litigation threatened the profession’s ability to service the public interest (Arthur Andersen & Co. et al. 1993). The accounting firms asserted that most litigation was filed to secure multi-million dollar settlements and not to redress grievous instances of fraud (S. Hrg. 103-431, p. 670). Despite this assertion, the 1995 Reform Act has been scrutinized in the wake of Enron and other recent alleged scandals as lawmakers discuss whether the Act “made it not only possible but likely that something like Enron would occur” (Labaton 2002). The 1995 Reform Act decreased auditor litigation exposure in some respects, but at the same time, increased the auditor’s responsibility to detect and report fraud (King and Schwartz 1997; Goldwasser 1997). The 1995 Reform Act was intended to discourage abusive claims of investors’ losses due to fraudulent misstatements or omissions by issuers of securities, and to provide more protection against securities fraud and increase the flow of forward-looking financial information (Andrews and Simonetti 1996). The major provisions that affect auditors include heightened pleading standards, a change from joint-and-several liability to proportionate liability in most allegations of Rule 10b-5 violations, and the increased responsibility for auditors to detect and report illegal acts (Andrews and Simonetti 1996; Pincus 1996). The heightened pleading standards require plaintiffs to have solid information regarding a violation of securities laws prior to filing a claim. In addition, the 1995 Reform Act provides for a stay of discovery while a motion to dismiss is being considered. These provisions were intended to address the criticism that class action securities cases were being filed following a drop in stock price, without any prior evidence of securities law violations, and then plaintiffs were building their cases solely on information learned during the discovery process. Defendants argued that

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32 Randy P. Beatty, Philip P. Drake and Chris E. Hogan

they would often settle cases simply to avoid the costly process of discovery, even if they were innocent. The goal of this study is to examine the impact of the 1995 Reform Act on litigation against IPO firms, and on auditor compensation. We focus on the IPO market for two main reasons. First, the large accounting firms claim that they are managing their own business risk by avoiding high-risk engagements, including some IPOs (Arthur Andersen & Co. et al. 1992, p. 5). Thus, litigation reform should have a greater impact on litigation risk premiums on high-risk engagements. Second, auditor compensation data on IPO engagements are available in the offering prospectus. Using a sample of IPOs and data on lawsuits filed against IPO firms, we find both univariate and multivariate evidence consistent with a reduction in IPO litigation subsequent to the 1995 Reform Act. We observe a decline of 0.64 percentage points in the unconditional probability of IPO lawsuits for all IPOs from a 5.15 percent probability of being sued during the five-year period 1991-1995 to a 4.51 percent probability during the period from 1996-1999. For the subsample of IPOs used in our auditor compensation regressions, we document a significant decrease in the probability of being sued from 7% to 5%. We control for changes in the IPO market by estimating a model of the probability of an IPO being involved in litigation. This model shows that the likelihood of being sued is increasing in offering size, estimated losses from a drop in stock price, and the standard deviation of post-offering returns, and firms in the high tech industry have a 4.0% greater chance of being sued. The conditional probability of being sued decreases by 4.3% following the 1995 Reform Act. Overall, these results suggest that litigation risk in the IPO market declined in the post-1995 Reform Act period. Assuming there were frivolous lawsuits in the pre-Reform Act period, the reduction in the incidence of litigation following the 1995 Reform Act is consistent with the intent of the law. We estimate models of auditor compensation both in the pre- and post-Reform Act periods, using various proxies for litigation risk and controlling for other factors commonly found to be associated with auditor compensation. The evidence of a decline in litigation rates following the 1995 Reform Act for our subsample of firms with complete data suggests that we would observe a decline in the litigation risk premium component of auditor compensation subsequent to the enactment of the law. The results of the auditor compensation regressions are consistent with either no change, or a decrease in the litigation risk component. If we use the predicted probability of being sued from the litigation prediction model as a measure of risk, we find evidence of a positive and significant litigation risk premium in both the pre- and post-Reform Act periods; however, the risk premium is not significantly different across the two periods. If we use the estimated losses from a stock price drop as a measure of risk, or if we identify high risk clients in the auditor

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compensation regression as those that were actually subsequently sued, we find evidence consistent with a positive and significant litigation risk premium prior to the 1995 Reform Act, but no significant litigation risk premium following the Act. The difference in litigation risk premium is only significantly different across the two time periods when actual litigation rates are used as a measure of risk. Despite finding evidence that the litigation rates have declined following passage of the 1995 Reform Act, we observe only evidence consistent with a decline in the litigation risk premium component of auditor compensation when we use actual litigation rates as a measure of litigation risk. References: Andrews, A.R. and G. Simonetti. 1996. Tort Reform Revolution. Journal of Accountancy. September: 53-55. Arthur Andersen & Co., Coopers & Lybrand, Deloitte & Touche, Ernst & Young, KPMG Peat Marwick, and Price Waterhouse. 1992. The Liability Crisis in the United States: Impact on the Accounting Profession. Goldwasser, D. 1997. The Private Securities Litigation Reform Act of 1995: Impact on Accountants. The CPA Journal (January): 72-75. King, R., and R. Schwartz. 1997. The Private Securities Litigation Reform Act of 1995: A Discussion of Three Provisions. Accounting Horizons 11 (March): 92-106. Labaton, S. 2002. Enron Scandal Shocks Even Those Who Helped It Along. The New York Times on the Web (www.nytimes.com). February 3. S. Hrg. 103-431. 1993. Private Litigation under the Federal Securities Laws. Hearings before the Subcommittee on Securities of the Committee on Banking, Housing, and Urban Affairs, United States Senate (June 17 and July 21). U.S. Government Printing Office, Washington.

34

The Impact of the 1995 Private Securities Litigation Reform Act on Litigation Risk and Auditor Compensation in the IPO Market: Discussion

James C. McKeown, Penn State University

thank the organizers for the opportunity to discuss the paper by Professors Beatty, Drake, and Hogan (BDH). It addresses an interesting question in attempting to determine whether the Private Securities Litigation Reform Act

affected litigation risk or auditor compensation. In concentrating on IPOs, they have access to data appropriate for this task. My discussion will cover Big Five firm market share, litigation rates and relation to market returns, classification of litigation as pre- or post-Act, and the models (both audit fee and litigation risk). I conclude with other suggestions for improving the paper. I. Big Five Market Share BDH reports and discusses an increase in Big 5 market share between the 1991-95 period and the 1996-1999 period. In fact, there is essentially no difference in the Big 5 market share between the two periods, as is shown by a re-examination of Table 1. The primary modification I suggest is to remove the cases for which the auditor is not listed, (i.e., missing auditor data), and then compute the percentage of IPOs audited by Big 5. With this correction, the Big 5 market share is basically flat from 86.37 percent in the 1991-1995 period to 86.47 percent in the 1996-1999 period (see the bottom panel of Table 1 herein).1 II. Litigation Rates and Relation to Market Returns Table 2 in BDH reports litigation rates and returns for the years 1991 through 1999. Looking first at the litigation rates, the paper reports a decline in litigation rate between the two periods, though it is not significant. In fact, even that non-significant difference could be a result of the downward trend of the pre-Act period

1 In addition to this correction, I suggest that the market share percentages be computed using the total number of IPOs audited in each time period. That computation is shown in the top panel of Table 1 of the Discussion. Using that method, the market share increases from 86.44 to 86.46 percent. (The authors’ method was to compute the market share for the individual years, and then average the shares.)

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36 James C. McKeown

or the entire period. Figure 1 shows the actual litigation rates as reported in Table 2 of BDH along with the trend of the rates over the entire nine-year period. If there is an overall trend, then the primary outlier is the higher-than-expected 1998 litigation rate. Another way to view the data is that a substantial downward trend occurred during 1991-1995 (the pre-Act period) with the post-Act period fairly flat except for 1998. In either case, the primary effect on litigation rates clearly appears to precede the Act. Examining returns, we see that dividends are excluded. Inclusion of dividends would make a difference of 0.5 to over 2 percent. Thus, exclusion of dividends does not appear to have much effect on the relationship.2 There are, however, two more important issues concerning the returns:

• They are apparently the returns for the calendar years of IPOs issuance. • They include all NASDAQ securities instead of just the IPOs.

It would seem that the more relevant returns would be the three-year returns within the Act’s statute of limitations. I would further recommend that the equally weighted3 return of the IPOs themselves be used since those are the returns which would be most directly involved in litigation decisions. III. Classification of Litigation as Pre- or Post-Act Litigation is classified based on the IPO issuance year regardless of when the litigation started. We may need a lawyer to handle this one, but I wonder how clean the break is between the pre- and post-Act periods. The Private Securities Litigation Reform Act of 1995 has three major sections (titles). Titles I and II of Act cover basic litigation reform, safe harbor for forward-looking statements (again!), various provisions increasing the barrier to successful suits, and establish proportionate liability. Applicability sections say these titles do not affect private litigation “commenced before and pending on the date of enactment of this Act.” Does this mean that litigation may not be initiated after the Act’s enactment date under the previous law? If so, then litigation initiated in 1996 on a 1994 IPO would be under the Act. In that case, the classification used in the paper is not as clean as it seems. Title III covers fraud detection and disclosure. It states that it is effective for annual reports for any period beginning on or after January 1, 1996 or a year later if the registrant is not required to file quarterly reports. Presumably suits filed under this title could still use previous law for any litigation on 1995 IPOs – and for most 1996

2 Including dividends slightly increases the correlation of returns with unconditional litigation probabilities for the years, to .227 for equally weighted and .105 for value-weighted. 3 I recommend equally weighted to be consistent with the percentage computation which weights the observations equally.

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IPOs since the annual reports included in those IPOs would be before the effective date. Thus, regardless of the title of the Act involved, the pre- or post-Act classification of litigation seems to be more complex than assumed in the paper. IV. Audit Fee Model The paper uses EST_LOSS as the ex post measure to proxy for the auditor’s expectation of loss in value of the offering over a three-year period. This may or may not be a good proxy, but since it represents an expectation, I do not believe it should be truncated at zero. The auditor will have a different view of the probability of loss if a large increase in value is expected as opposed to expecting little change in value. Pred(OffVal) is the predicted value of the offering. The computation of Pred(OffVal) either needs to be described differently or possibly the computation itself needs some work. The computation is described as regressing expected offering value against revenue and book value. It either ignores two factors or assumes that their effect on all IPOs is constant:

• If some of the stock is directly issued instead of existing stock being sold by insiders, the revenue and book value will increase as a result of the IPO -- possibly by a large amount. • Assume one million existing shares with an offering of four million new shares. I would expect the company's value to increase by a bit less than 400% (from growth from one million to five million shares). 4 The pre-IPO revenues and book value would greatly underestimate the value of the company that results from the IPO. • Unless no stock is being retained by insiders, the offer value of the IPO would only represent part of the company -- the part related to the stock being sold. If an IPO was simply selling one-half of the existing stock, the value received for that stock would only be half the value of the company. In this case, the dependent variable in the regression would be understated.

I would think this computation would only work when no new stock is being issued and all the existing stock is being sold.5 Another issue here is the assumption that the relationship between the justified value of offerings and the combination of revenues and book values is stable over time and industry. This relationship very likely varies across both of those dimensions. Both of these problems affect 4 The amount of growth in revenues and book value would probably be less than proportional since part of the offering proceeds from new shares must go to pay IPO costs. 5 To be more general, the computation would work whenever the proportions of new stock being issued and existing stock being sold were constant across the sample – quite unlikely.

38 James C. McKeown

OffValRisk also because Pred(OffVal) is the variable which partitions the expected offering value between the amount which is presumed to be justified by revenue and book value versus the unjustified amount representing higher risk to the auditor. The model includes a litigation probability estimate6 to adjust for risk, but the model assumes there are no differences in audit costs for different industries. This assumption becomes more important when some of the usual factors explaining audit fees are excluded due to data availability problems. BDH mentions restatement of dollar amounts to 1999 dollars. Without further specification, I assume the restatement used something like the Consumer Price Index. That may be appropriate for audit fees and proceeds7, but I doubt that it is appropriate for total assets. The issue here is that asset prices do not move the same way as the CPI. Probably the closest general index for total assets would be something like an Investment Price Index. The CPI increased 22% from 1991 to 1999, while investment price indices were generally flat to falling slightly. In addition, amounts recorded for existing assets do not change under our accounting system.8 These factors likely will have the effect of overstating the asset variable for earlier IPOs, possibly affecting the coefficients estimated for LnAssets in the pre- and post-Act periods. When the audit fee model is estimated separately for the two time periods, the overall significant difference could be caused by any of the coefficients. Thus, it would be more appropriate to test individual coefficients. The description of the method used does not tell whether dummies were present for all other variables when testing the constraint on each one. If there were a reason for all variables’ coefficients to differ between periods, then allowing all but the one being tested to differ would be appropriate. However, it is possible that allowing differing coefficients for variables whose coefficients really are not changing could cause non-significant results for other variables. That is, coefficient changes on other variables could compensate for different values of the tested variable’s coefficient.9

6 Use of estimated probabilities of delisting and litigation in a second-stage equation without adjustment for the fact that these estimates are based on the same sample will likely create some problems. 7 I would also think that restatement by CPI would be appropriate for Est_Loss, Pred(OffVal), and OffValRisk, but it is not clear whether this was done. The text says that all dollar amounts were restated in 1999 dollars before computing Table 4, but the headings of Table 4 and other tables do not mention this. The latter two variables are also not described as being logged, though they probably should be. 8 This effect may be less for IPOs whose assets will frequently be fairly recently purchased. 9 We do not know the correlations between the variables to be able to know likelihood of this problem.

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The authors need to be careful when interpreting their results. They have several risk measures in the models. When one is not significant, it is unwise to say “… suggesting that auditors did not charge a significantly higher fee for the clients identified as high risk in this period” (p. 20). Concluding that the null hypothesis is true when it is not rejected is generally ill-advised, but it is particularly dangerous when there are other variables in the same model representing some measure of risk. All of these variables have positive coefficients, two of which are significant in the Post-Act regression in Table 5. It would be preferable to perform joint tests on the risk variables before making conclusions about the effect of risk on audit fees. V. Litigation Risk Model The litigation probability model assumes that auditors use some ex-post measures. It also assumes that auditors will know the coefficients of the model before being able to observe these IPOs. These assumptions seem to be stretching the auditors’ predictive skills. Of course, the authors could point out that the ProbLit is significant, so the auditors seem able to handle this task. It is, however, only significant in the Post-Act regression, and observing significance under these conditions suggests that there may be correlated omitted variables working here. 10 Clearly the auditors do not have this knowledge, so what are they reacting to? In addition, since the delisting probability will affect the litigation probability, I suggest including it in the litigation risk model but not in the auditor compensation regression, which uses probability of litigation as a risk measure (Table 6 Panel B). VI. Exclusion of Other IPO-Related Variables BDH excludes several variables found to be important in other IPO studies. While parsimonious models have virtue, inclusion or discussion of reasons for exclusion of some of the following variables might help readers understand the variable selection decisions. Previous research reports that retained interest affects IPO value. Also firm commitment, offering in units, auditor type, and price per share all might explain the value, Pred(OffVal), and affect the spread, OffValRisk. Previous research has also found several variables not used here to be related to delisting or bankruptcy. Some of them should be considered for inclusion in the models for probability of delisting or probability of litigation. For the delisting model consider including offering in units and firm age. (Inventory over assets would run into the data availability problem reported.) For either probability model, consider including: interest expense to cash, inventory to cash flow, and long-term debt to cash flow. (Data availability may also be an issue for some of these.)

10 Ten percent significance levels on 700+ observations do not provide much evidence.

40 James C. McKeown

VII. Other Suggestions I also offer the following suggestions:

• Conduct joint tests on all risk measures included in each model as a basis for conclusions related to risk. With a number of proxies for risk, tests of coefficients of individual risk proxies have limited meaning. (This one is repeated from above for emphasis.)

• Consider whether other trends explain observed changes between the two periods. If there are trends affecting some of these variables, the current analysis would treat them as if they were an effect of the Act when the real reason was alternate causes or a more general trend that started before the Act became effective.

The two suggestions above could substantially affect the conclusions drawn in this paper. I hope these suggestions and the other comments are helpful to the authors as they continue work on this interesting project.

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Table 1 Annual IPO Market Share of Big 5 versus Non-Big 5

Total Not

Year Big 5 Non-Big 5

Listed Total 1991 335 42 10 387 1992 492 63 10 565 1993 633 95 20 748 1994 340 71 12 423 1995 457 83 17 557

1996 700 122 4 826 1997 482 93 14 589 1998 311 63 6 380 1999 486 32 14 532

’91-‘95 Total 2257 354 69 2680 Percentage 84.22% 13.21% 2.57% '96-'99 Total 1979 310 38 2327 Percentage 85.05% 13.32% 1.63% Adjust for Missing Data ’91-‘95 86.44% 13.56% '96-'99 86.46% 13.54% Using Authors' Approach (average of annual market shares) ’91-‘95 Avg 451.4 70.8 13.8 Percentage 84.14% 13.28% 2.58% '96-'99 Avg 494.8 77.5 9.5 Percentage 84.94% 13.29% 1.77% Adjust for Missing Data ’91-‘95 86.37% 13.63% '96-'99 86.47% 13.53%

Figure 1Trend of Litigation Proportion

2%

4%

6%

8%

1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Actual Trend

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Factors Affecting Staff Allocations, Costs and Prices for Audit Engagements Rajiv D. Banker, The University of Texas at Dallas Hsihui Chang, The University of Texas at Dallas Yi-Ching Kao, University of Wisconsin-Milwaukee

uppliers of audit services seek to produce the desired service output at minimal cost. Since teams comprised of professionals at different levels produce nearly every audit, the level-specific effort exerted by professionals can be viewed as

a distinguishable audit production input. Cost minimization requires optimal mixes of inputs. The optimal mix (of audit professionals at different levels) for a given audit likely depends on client characteristics because these characteristics affect the relative costs of and substitutability among different input factors. Consequently, we use a translog cost model to estimate how client characteristics affect the audit production decision. We also construct an audit pricing model to estimate the degree to which such characteristics jointly affect the cost and pricing of audits. Since the first formal audit pricing model (Simunic 1980), numerous studies have examined determinants of audit pricing, such as the auditor’s brand name (Craswell et al. 1995; Francis 1984; Francis and Simon 1987; Francis and Stokes 1986; Gist 1992; Johnson et al. 1995; Palmrose 1986a), provision of non-audit services (Palmrose 1986b; Simon 1985; Simunic 1984) and repeat versus initial engagements (Butterworth and Houghton 1995; Simon and Francis 1988; Turpen 1990; Walker and Casterella 2000). While audit pricing models in these studies include client characteristics as a control for input quantity, other studies examine how such characteristics actually influence the required quantity of input. These latter studies quantify audit effort as total hours expended (Davidson and Gist 1996; Palmrose 1989), disaggregated hours by task type (Hackenbrack and Knechel 1997), or by the level of audit professional (Davidson and Gist 1996; O’Keefe et al. 1994). Other than Davis et al.’s (1993) study on the association between audit prices and audit hours weighted by billing rates (for different levels of audit professionals), however, no study has considered the relative prices of and substitutability among audit professionals of different levels as distinguishable inputs. We decompose audit teams into three inputs corresponding to three levels of professionals: managers, seniors and juniors, construct audit cost and price models based on standard economic theory, and empirically test these models using a three-year (1999-2001) panel data set. This data set includes the 102 largest clients from an office of an international public accounting firm. This data set allows us to

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44 Rajiv D. Banker, Hsihui Chang, and Yi-Ching Kao

examine the following research questions: How do client characteristics affect the mix of inputs and overall audit cost? How do cost-implications of client characteristics influence audit pricing? Specifically, we identify a set of client characteristics that likely affect both the initially prevailing and ultimately acceptable levels of audit risk, such as client size, ownership type, organizational complexity, asset composition (e.g., receivables and inventories), profitability, liquidity, and leverage. Since client characteristics influence audit cost (multiplication of wage rate and work hours), and audit cost depends on the mix of inputs, we capture the audit firm’s cost-minimization decision by specifying a translog cost equation. The translog cost equation allows for variable wage rates and substitutability among the three levels of professionals. Next, applying Shephard’s Lemma (Shephard 1970), we derive three optimal cost-share equations (each equation represents the optimal proportion of the overall cost allocated to a given level of professionals). In addition to specifying a cost model, we specify an audit price model to evaluate whether the cost implications of client characteristics also influence the equilibrium audit price. If client characteristics directly alter audit cost and production, they may indirectly lead to a shift in audit supply, yielding different equilibrium price and quantity. Given the large clients and the audit firm in our data, the demand for audit services likely is relatively inelastic with respect to price due to statutory requirements and strong economic incentives. Further, the supply of audit services likely is relatively elastic due to flexible staffing at the margin. Consequently, we expect the auditor to adjust audit fees to fully reflect changes in audit costs. We estimate the system of cost, cost-share, and price equations using seemingly unrelated regression to obtain consistent and efficient estimators (Zellner 1962). We observe a significant and positive association between client size and audit risk indicators (public ownership, organizational complexity, receivables-to-asset ratio, inventory-to-asset ratio, and liquidity). Moreover, we find that some client characteristics (size, public ownership, receivables-to-asset ratio, inventory-to-asset ratio, profitability and recent loss) significantly affect the engagement’s mix of audit professionals. Besides client size and public ownership, most client characteristics similarly influence audit costs and audit price. For these two characteristics, the auditor charges a premium. This premium may reflect exceptional technology for auditing large/public clients or exceptional valuation of audit services by large/public clients (Simunic 1980). Overall, our findings replicate prior studies’ findings, document additional factors that affect the auditor’s (cost-minimizing) production and pricing decisions, and establish new linkages between the cost- and price-side impacts.

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References: Butterworth, S. and Houghton, K. A. 1995. Auditor Switching: The Pricing of Audit Services. Journal of Business Finance & Accounting, 22(3): 323-332. Craswell, A. T., Francis, J. R., and Taylor, S. L. 1995. Auditor Brand Name Reputations and Industry Specializations. Journal of Accounting and Economics, 20: 297-322. Davidson, R. A. and Gist, W. E. 1996. Empirical Evidence on the Functional Relation between Audit Planning and Total Audit Effort. Journal of Accounting Research, 34(1): 111-125. Davis, L. R., Ricchiute, D. N., and Tompeter, G. 1993. Audit Effort, Audit Fees, and the Provision of Nonaudit Services to Audit Clients. The Accounting Review, 68(1): 135-150. Francis, J. R. 1984. The Effect of Audit Firm Size on Audit Prices – A Study of the Australian Market. Journal of Accounting and Economics, 62: 133-151. Francis, J. R. and Stokes, D. J. 1986. Audit Prices, Product Differentiation, and Scale Economics; Further Evidence from the Australian Market. Journal of Accounting Research, 24(2): 383-393. Francis, J. R. and Simon, D. T. 1987. A Test of Audit Pricing in the Small-Client Segment of the U.S. Audit Market. The Accounting Review, 32(1): 145-156. Gist, W. E. 1992. Explaining Variability in External Audit Fees. Accounting and Business Research, 23(8): 79-84. Hackenbrak, K. and Knechel, W. R. 1997. Resource Allocation Decisions in Audit Engagements. Contemporary Accounting Research, 14(3): 481-499. Johnson, E. N., Walker, K. B., and Westergaard, E. 1995. Supplier Concentration and Pricing of Audit Services in New Zealand. Auditing: A Journal of Practice & Theory, 14(2): 74-89. O’Keefe, T. B., Simunic, D. A. and Stein, M. T. 1994. The Production of Audit Services: Evidence from a Major Public Accounting Firm. Journal of Accounting Research, 32(2): 241-261. Palmrose, Z. 1986a. Audit Fees and Auditor Size: Further Evidence. Journal of Accounting Research, 24(1): 97-110.

46 Rajiv D. Banker, Hsihui Chang, and Yi-Ching Kao

Palmrose, Z. 1986b. The Effect of Nonaudit Services on the Pricing of Audit Services: Further Evidence. Journal of Accounting Research, 24(2): 405-411. Palmrose, Z. 1989. The Relation of Audit Contract Type to Audit Fees and Hours. The Accounting Review, 64(3): 488-499. Shephard, R. W. 1970. Theory of Cost and Production Functions. Princeton, N.J.: Princeton University. Simon, D. 1985. The Audit Services Market: Additional Empirical Evidence. Auditing: A Journal of Practice & Theory, 5(1): 71-78. Simon, D. T. and Francis, J. R. 1988. The Effects of Auditor Change on Audit Fees: Tests of Price Cutting and Price Recovery. The Accounting Review, 63(2): 255-269. Simunic, D. A. 1980. The Pricing of Audit Services: Theory and Evidence. Journal of Accounting Research, 22(2): 119-148. Turpen, R. A. 1990. Differential Pricing on Auditors’ Initial Engagement: Further Evidence. Auditing: A Journal pf Practice & Theory, 19(1): 157-167. Walker, P. L. and Casterella, J. R. 2000. The Role of Auditee Profitability in Pricing New Audit Engagements. Auditing: A Journal of Practice & Theory, 19(1): 157-167. Zellner, A. 1962. An Efficient Method of Estimating Seemingly Unrelated Regressions and Tests of Aggregation Bias. Journal of the American Statistical Association, 57: 500-509.

Factors Affecting Staff Allocations, Costs and Prices for Audit Engagements: Discussion Mike Stein, University of Oregon

eading Banker, Chang, and Kao (2002, hereafter BCK) one is reminded of how difficult it is to marry tight economic theory with econometric estimation. A successful union requires adroit modeling along with an

unusually cooperative data set. Consequently, I was not surprised when data limitations constrained the ultimate contribution of the paper. I. Introduction While the conference paper stated an ambitious research objective: Motivated by the production economic theory, we propose the first economic model for the cost minimization decision in audit services production in this paper (BCK page 1, emphasis added). it later appears to soften that objective: Consequently, to address the variable substitutability among the input factors, we adopt a translog functional form for our audit cost model (BCK page 7, emphasis added). These statements suggest that BCK would have preferred to bring both modern economic production theory and applied econometric techniques to bear on the problem of audit production. Unfortunately, the nature of the paper’s panel data limits what we ultimately learn. II. The Model and Econometric Theory Based on the introduction and the theoretical modeling in the paper, I expected BCK to both derive and estimate an audit cost function. Then, following the practice in the economics literature, they could calculate price elasticities of factor substitution. Finally, applying standard duality results, they could then recover the production function from their estimated cost function. Chambers (1988) provides a useful summary of the duality and estimation procedures used in applied production studies.

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48 Mike Stein

To go from theoretical arguments to estimation, it is necessary to specify a functional form for the cost estimating equation. Given that the actual functional form of the auditor’s cost function is unknown, a common practice in the economic production literature is for the researchers to choose a flexible functional form, such as the translog utilized by BCK. The translog function is a second-order approximation to an arbitrary function. By using a flexible functional form, the researchers do not impose a prior on the selection of functional form. Essentially, the data are allowed to speak. More importantly, subject to a set of reasonable conditions on the underlying production function and input requirement set, an approximating flexible functional form maintains the duality properties between cost and production functions (Blackorby and Diewert 1979). As usual, some caveats apply. Chambers (1988, 173-180) points out that the estimated translog function cannot be assured to result in the recovery of a globally concave production function. Additionally, all approximations are inherently local and therefore may not provide a very good approximation to the true functional form over a wide range of observations. III. Estimation Having derived a translog cost function, BCK fit the data to their empirical model. Their data consist of three years of observations for 112 clients audited by a single office of a large international auditing firm. In addition to audit fees, audit hours by staff category, and various explanatory variables of interest, BCK’s data include the wage rates paid to audit staff by category of labor. It is the availability of these wages that sets their data apart from prior research and also allows them to estimate an audit cost function. Estimation of the cost function and the resulting estimates of the price elasticities of factor substitution require cross-sectional variation of the wage ratios. However, as previously mentioned, their data were collected from a single office of one firm and therefore lack sufficient variation to estimate the effect of changes in the wage ratios. Consequently, BCK diminish their hopes of estimating a cost function (most of the theory used to motivate the study applies to cost functions) and estimate cost share equations that are arguably similar to other models currently found in the audit fee/audit hour literature. IV. Additional Considerations Theory Development Despite the limitations of their data for estimating an auditing cost function, BCK have an interesting data set which is unique in possessing both cost and price panel

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data. They exploit the data by formulating a system of fee and cost share equations and then look at explanations for the variation of these cost shares. However, a number of questions regarding the cost share equations, the data, and the estimations remain unanswered and would be interesting if addressed. For example, the model development in the paper does not provide an adequate foundation for understanding the properties of the cost share equations that are ultimately estimated. It would be especially helpful to know how to interpret these equations relative to the price equations and hour equations currently used in the literature. In particular, are there theoretical reasons to prefer cost share equations over the hour equations already found in the literature? Do cost share equations lead to different conclusions about audit labor mix than labor hour equations? Cost share equations (with constant wage rate) do directly estimate changes in mix; however, this feature is not obviously an advantage over labor hour equations where changes in mix can be inferred by tests of the equality of coefficients across the different labor hour categories. Estimation and Data The estimation of a cost share system requires one cost share equation to be dropped from the model to avoid perfect linear dependence in the system, since the sum of the cost shares equals one for each observation. BCK should test for serial correlation in their panel data since if serial correlation is present, the results could depend significantly upon which equation is dropped (Chambers 1988). It is instructive to consider the extent to which the choice of model ought to depend upon the econometric properties of the competing approaches. To get a sense of this, Table 1, Panel A shows the results of hour share regressions for 247 clients audited by a Big-5 firm in 1989. For a description of these data, see Stein, Simunic, and O’Keefe (1994). To approximate econometrically the BCK approach, hour shares (the proportions of total audit effort contributed by each class of audit labor) are calculated and used as the dependent variables in a system of three equations, with the partner hours equation estimated separately, as discussed in the previous paragraph. These regressions show that assets, whether the client is publicly traded, client complexity, and leverage affect the hour shares for at least one category of labor. Interestingly, when the same model is run in labor hour levels (Table 1, Panel B), tests of the equality of coefficients across the equations can be rejected for each of the variables in the model (Chi-squared test, p-value of .05 or better, results not reported). These tests imply a change in factor mix for percentage of foreign assets and the number of reports prepared as well as the variables previously mentioned. Apparently, the form of the equations does matter, but it is unclear which form provides the most powerful test. The question of which approach is more efficient does not obviously favor a particular model, since the hour levels equations can be

50 Mike Stein

estimated in a single system of seemingly unrelated regressions, while the hour share equations cannot. Turning to the data, the measurement of the cost share attributed to partners seems particularly problematic as partners are both wage earners and residual claimants. How does one separate their compensation for these distinct roles? A related issue is how the “profits” on a given engagement are measured. Two concerns are the potential lack of separability of the cost function across engagements due to the contribution of partner effort and the exclusion of ex post audit losses. Further, although future versions may do so, the conference version of the manuscript reported almost no testing for influential observations, multi-collinearity, heteroskedasticity, serial correlation, or model fit. Given the emphasis placed by BCK on the use of the translog function, specification tests would be appropriate with some attention paid to how well alternative specifications currently used in the literature perform. Using data in Stein, Simunic, and O’Keefe (1994), I performed specification tests for the functional form of the model (Ramsey reset and Davidson and McKinnon J-test, results not reported). These tests do indicate that when the translog functional form is fitted to the SSO data, it does provide a marginally better fit than the log-linear specifications used in the literature. However, this improvement in fit comes at the price of using considerably more degrees of freedom and a less straightforwardly interpreted model. One also wonders whether the independent variables used in BCK—profit, net margin, and recent loss—are collinear. Further, since the data combines several industries into a single sample, misspecification due to industry heterogeneity should be tested. Last, perhaps the most intriguing result reported in BCK relates to the cost and pricing of audits in which the auditor is an industry specialist. Ferguson and Stokes (CAR, forthcoming) report that specialist pricing results are sensitive to the definition of industry specialist used. Sensitivity analysis is suggested. V. Final Thoughts While BCK pursue a tight link between economic production theory and the econometric specification of their empirical model, data limitations hinder those worthwhile efforts. The resulting paper is long and technical and fails to convincingly connect the developed and estimated models. Empirically, BCK have an interesting result in the finding that specialist audits have higher prices with commensurately higher costs. It would be valuable to assess the robustness of this result and to explore for additional specialist results in the data.

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Finally, BCK may have under exploited the time-series properties of their data. The current literature contains very little evidence on how audits evolve over time, and this is an important topic ripe for investigation. References: Banker, R. D., H. Chang and Y. Kao. 2002. Factors Affecting Staff Applications, Costs and Prices for Audit Engagements. Working Paper. Blackorby, C., and W. E. Diewert. 1979. Expenditure Functions, Local Duality and Second Order Approximations. Econometrica 47: 579-603. Chambers, Robert G. 1988. Applied production Analysis: A dual approach. Cambridge, U.K.: Cambridge University Press. Ferguson, A. and d. Stokes. 2002. Brand Name Audit Pricing, Industry Specialization and Leadership Premiums post-Big 8 and Big 6 Mergers. Contemporary Accounting Research 19: 77-110. Stein, M. T., D. A. Simunic, and T. B. O’Keefe. 1994. Industry Differences in the Production of Audit Services. Auditing: A Journal of Practice & Theory 13 Supplement: 128-142.

52 Mike Stein

Table 1. Estimate of Hour Share and Hour Level Equations Panel A. Hour Share Model, Partner Hour Share Estimated Separately

Hour Share Models Variable Junior Senior Manager Partner In assets Public % Foreign Complexity Leverage # Reports constant

0.0298** -0.0008 -0.0001 0.0008

-0.0003 -0.0001 -0.0888

-0.0241** -0.0020** 0.0001

-0.0004 -0.0011 0.0000 0.8125**

-0.0058** 0.0017** 0.0000

-0.0002 0.0010** 0.0000 0.2219**

0.0001 0.0011** 0.0000

-0.0002* 0.0004* 0.0000 0.0543**

**t-value greater than 2 *t-value greater than 1.75 Panel B. Hour Levels Models, All Hours Estimated in a Single SUR

Hour Level Models Variable Junior Senior Manager Partner In assets Public % Foreign Complexity Leverage # Reports constant

0.37877 0.02110

0.00053 0.01175 0.00665 0.00075

-1.42130

0.23720 0.01779 0.00078 0.00871 0.00374 0.00103 0.95462

0.27001 0.03463 0.00076 0.00795 0.01270 0.00089

-0.74929

0.31047 0.04289 0.00065 0.00606 0.01233 0.00093

-2.30030 All coefficients except Leverage in the Junior model have t-values greater than 2

Factors Affecting Staff Allocations, Costs and Prices for Audit Engagements: Reply Rajiv D. Banker, The University of Texas at Dallas Hsihui Chang, The University of Texas at Dallas Yi-Ching Kao, University of Wisconsin-Milwaukee

n this brief reply, we respond to a few of the remarks by the discussant with which we disagree. We refer interested readers to our study and a related article so that they can draw their own conclusions about the applicability of the

discussant’s remarks (Banker, Chang, Kao 2002; Banker, Chang, Cunningham 2003).

1. We disagree with the discussant’s assertion that “once the data are added to the theoretical structure, the research retreats significantly from its stated goal (of bringing) . . . . .the weight of modern economic production theory and applied econometric techniques to bear on the problem of audit production.” The objective of our study is to evaluate factors affecting staff allocation, costs and prices of audit engagements. For this purpose, we rely on production economics theory and, as in Banker, Chang and Cunningham (2003,) extend the existing econometric methods for cost function estimation to deal with the characteristics of the data set available for our study. An innovation in our study is the derivation of estimable equations when the relative input prices are cross-sectionally constant. Our approach enables us to retrieve consistent estimators of the impact of factors affecting staff allocations and costs. Note that our main research objective is to evaluate the impact of different client characteristics, and our estimation procedure does retrieve the requisite parameters.

2. That translog functions cannot assure global concavity of the production function has been known since at least Caves and Christensen (1980) and not Chambers (1988). Much progress has been made since the early 1980s in methods available for estimating cost and production functions. Note that for our study, we focus on a parametric translog specification, but several sources discuss alternative nonparametric and semiparametric approaches that have been designed and employed to ensure globally concave production functions (Banker and Maindiratta 1988; Banker 1993; Banker, Janakiraman, Natarajan 2002).

3. Reasons for the inclusion of the cost share equations in the estimation of the translog cost function are described in detail in econometrics textbooks

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54 Rajiv D. Banker, Hsihui Chang, and Yi-Ching Kao

(e.g., Greene 2002). A key consideration in production economics is that input quantities are endogenous in the sense that efficient decision makers will optimally trade off the relative cost of different inputs in selecting the appropriate mix of inputs (Zellner, Kmenta, Dreze 1966). In our context, an audit firm will choose the optimal input mix based on the given input prices, client size and client characteristics. The theoretically derived expressions for the optimal input quantities given a translog cost function can be reduced to the cost share equations we employ in our study. It is important to include in the estimation model the information about the endogenous optimal input mix decisions, as represented by the cost share functions, to avoid loss of relevant information (Walters 1963). If these equations are omitted then the resultant estimators obtained from estimating only the single equation will be inefficient. We estimate the cost function together with the multiple cost share equations to obtain more efficient estimators than those feasible with the estimation of a single equation as commonly done in the prior research in auditing.

4. We disagree with the discussant’s remark that “estimation of the cost function…require(s) cross sectional variation of the wage ratios.” In fact, Banker Chang and Cunningham (2003) and the part of our paper that the discussant described as “long and technical” show how traditional cost function estimation methods are extended to retrieve the requisite cost function parameters when data on prices is not available or when there is no variability in relative prices. Again, our objective is not the estimation of price elasticities, but rather the estimation of cost elasticities with respect to various client characteristics.

5. We believe the discussant’s assertion that our approach is “similar to other models currently found in the audit fee/audit hour literature” is incorrect. Notably, in contrast to extant models, our cost share equations capture the optimal tradeoff between different professional staff categories.

6. We believe the estimation of hour share equations suggested by the discussant is conceptually flawed. The estimation of the system with cost share equations incorporates the optimal behavior of the firm in allocating staff resources based on their relative prices. In contrast, the use of the discussant’s hour share equations method is atheoretical. It can be rationalized only by making the untenable assumption that the wage rate is the same across different professional categories. Therefore, it is conceptually superior to employ the cost share equations method instead of the hour share equations method. This conceptual choice stems from

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fundamental production economics theory, and not from the econometric properties of estimated functions.

7. Last, contrary to the discussant’s assertion, many diagnostic checks developed for single equation estimation cannot be applied to the estimation of a system of equations as in our case. When we omitted all cost share equations and estimated (albeit, in a statistically inefficient manner) only the single translog cost equation, we conducted robustness and diagnostic checks. Our estimation results are qualitatively similar and all our inferences are identical after running these checks.

References: Banker, R. D. 1993. Maximum Likelihood, Consistency and Data Envelopment Analysis. Management Science. October, 1265-1273. Banker, R. D., A. Maindiratta. 1988. Nonparametric Analysis of Technical and Allocative Efficiencies in Production. Econometrica. November, 1315-1332. Banker, R. D., H. Chang and R. Cunningham. 2003. The Public Accounting Industry Production Function. Journal of Accounting and Economics. April. Banker, R. D., H. Chang, and Y. Kao. 2002. Factors Affecting Staff Allocations, Costs and Prices for Audit Engagements. Working Paper. Banker, R. D., S. Janakiraman and R., Natarajan. 2002. Evaluating the Adequacy of Parametric Functional Forms in Estimating Monotone and Concave Production Functions. Journal of Productivity Analysis. 17, ½, (January/March), 111-132. Caves, D. and L. Christensen. 1980. Global Properties of Flexible Functional Form. American Economics Review. 422-432. Greene, W. H. 2000. Econometric Analysis. 4th edition, Prentice Hall, New Jersey. Walters, A.A. 1963. Production and Cost Functions: An Econometric Survey, Econometrica, 31 (1/2): 1-66. Zellner, A., J. Kmenta and J. Dreze. 1966. Specification and Estimation of Cobb-Douglas Production Function Models. Econometrica, October, 785-795.

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The Effects of a Fraud-Triangle Decomposition of Fraud Risk Assessments on Auditors’ Sensitivity to Incentive and Opportunity Cues

T. Jeffrey Wilks, Brigham Young University Mark F. Zimbelman, Brigham Young University

n this study, we examine whether decomposing fraud risk assessments into separate risk assessments for management’s attitude, opportunities, and incentives increases the sensitivity of auditors’ overall fraud risk assessments to

changes in opportunity and incentive risks. We specifically examine whether a fraud-triangle decomposition increases auditors’ sensitivity to opportunity and incentive risks when perceptions of management’s attitude would suggest a low likelihood of fraud. Prior research has shown that auditors tend to rely heavily on their perceptions of management’s attitude when assessing fraud risk (Heiman-Hoffman et al. 1996). Practitioners and regulators are concerned that heavy reliance on attitude cues that suggest low fraud risk may be problematic because (1) accurately assessing management’s attitude is difficult, especially if management wishes to feign integrity, and (2) management’s attitude can change quickly given enough incentive or opportunity. This concern is reflected in the recently issued exposure draft of the new fraud auditing standard (just adopted as SAS No. 99) which argues that,

Although the risk of material misstatement due to fraud may be greatest when all three fraud conditions are observed or evident, the auditor cannot assume that the inability to observe one or two of these conditions means there is no risk of material misstatement due to fraud. In fact, observing that individuals have the requisite attitude to commit fraud, or identifying factors that indicate a likelihood that management or other employees will rationalize committing a fraud, is difficult. (AICPA 2002).

To examine how audit policy could increase auditors’ sensitivity to opportunity and incentive risks, we first conduct a pilot study to confirm that auditors consider fraud risk factors associated with management’s attitude to be more important than those associated with opportunities and incentives. Consistent with Heiman-Hoffman et al. (1996), our results show that auditors view the attitude cues currently found in audit standards to be more important than incentive and opportunity cues. Next, we conduct an experiment wherein 52 practicing audit managers from two Big Five audit firms review an audit case and assess fraud risk. This experiment manipulates

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58 T. Jeffrey Wilks and Mark F. Zimbelman

two variables between subjects—fraud risk and risk assessment method. The fraud risk manipulation holds attitude risk factors constant at low levels while manipulating the risk level of both incentive and opportunity risk factors. The manipulation of risk assessment method requires that auditors make either a holistic or a decomposed fraud risk assessment. Under the holistic method, auditors review client information and a fraud checklist and assess overall fraud risk. Under the decomposed method, auditors review identical information but make separate component risk assessments for each dimension of the fraud triangle (i.e., attitude, incentive, and opportunity) before making their overall fraud risk assessment. Zimbelman (1997) shows that auditors’ attention to fraud risk factors is higher when auditors separately assess the risk of intentional (i.e., fraudulent) and unintentional misstatement than when they assess only the overall risk of misstatement. Similarly, we expect that auditors who perform decomposed fraud risk assessments via the fraud triangle will attend more to and thus be more sensitive to variation in opportunity and incentive risks relative to auditors who perform holistic fraud risk assessments. This behavior may well address policymakers’ concern that auditors’ fraud judgments are not sufficiently sensitive to opportunity and incentive risks when management’s attitude suggests low fraud risk. However, decomposition via the fraud triangle may also increase auditors’ attention to attitude risk if their attention to attitude risk is not already maximized. This increased attention to attitude risk when attitude suggests low fraud risk may offset any benefit from increased sensitivity to opportunity and incentive risks. We investigate the potential for a fraud-triangle decomposition to address policymakers’ concerns by examining two dependent measures: (1) component assessments of attitude, opportunity, and incentive risks and (2) overall fraud risk assessments. Our analysis of the component judgments shows that auditors’ sensitivity to each of the three dimensions of fraud risk increases with decomposition. Similarly, our analysis of the effects of decomposition on auditors’ overall fraud judgments shows that under low attitude risk, decomposition increases auditors’ sensitivity to variations in incentive and opportunity risks. However, under decomposition, overall fraud risk judgments are also reduced by auditors’ increased sensitivity to low attitude risk. Thus, our results suggest that an audit policy requiring auditors to separately consider the components of the fraud triangle when assessing fraud risk may not effectively address policymakers’ concerns because auditors’ increased sensitivity to opportunity and incentive risks is likely to be offset by an increased sensitivity to attitude risk. One important limitation of our study is that we focus on fraud risk assessments, but we do not investigate the impact of this decomposition, if any, on auditors’ planning decisions and the actual work performed in the audit. Other research on fraud has questioned the linkage between risk assessments and planning decisions, especially

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the nature of audit tests (e.g., Zimbelman 1997; Glover, et al. 2002; Asare and Wright 2002). This area is critical for future research, especially if decomposition is deemed beneficial from the standpoint of auditors’ fraud risk assessments. References: AICPA. 2002. Proposed Statement on Auditing Standards—Consideration of Fraud in a Financial Statement Audit. New York: AICPA. Asare, S. and A. Wright. 2002. The impact of risk checklists and standard audit programs on the planning of fraud detection procedures. Working paper. University of Florida. Glover, S., D. Prawitt, J. J. Schultz, Jr., and M. F. Zimbelman. 2002. Changes in auditors’ fraud-related planning judgments since the issuance of SAS No. 82. Working paper. Brigham Young University. Heiman-Hoffman, V. B., K. P. Morgan and J. M. Patton. 1996. The warning signs of fraudulent financial reporting. Journal of Accountancy (October): 75-77. Zimbelman, M.F. 1997. The effects of SAS No. 82 on auditors’ attention to fraud risk factors and audit planning decisions. Journal of Accounting Research (Supplement): 75-97.

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The Effects of a Fraud-Triangle Decomposition of Fraud Risk Assessments on Auditors’ Sensitivity to Incentive and Opportunity Cues: Discussion

Richard M. Tubbs, University of Iowa

n this paper, Wilks and Zimbelman employ audit managers to experimentally investigate (1) the risk factors that are related to three dimensions of fraud risk (attitude, incentive, and opportunity) and the importance of those risk factors and

(2) the effect of decomposition on auditors’ sensitivity to the dimensions of fraud risk. I enjoyed reading this paper. The paper is well written and very topical. It is also ambitious. Information integration is a complicated area, and this paper attempts to alter how auditors integrate information. The paper made me think about topics that I had not previously considered. However, a number of questions occurred to me that the paper really did not address, and I believe that it could be improved by addressing those questions. My discussion will be organized around the implicit model of fraud risk, the motivation, the theory, the measurement of variables, and the analysis performed. I. Fraud Risk Model The following model of fraud risk is implicit in this manuscript and explicit in Loebeccke et al (1989): FR = f (I, O, A) where: FR: assessed fraud risk, f: unknown function, I: management’s incentive or pressure to commit fraud, O: management’s opportunity to commit fraud, and A: management’s attitude allowing them to rationalize fraud. We are not told the form of the function (e.g., additive, multiplicative). However, we are told that FR involves the “interaction of three causal influences” (Wilks and Zimbelman 2002, 4). Therefore, the function is not additive. We also are told that “each of these factors is a necessary but not a sufficient condition for fraud” (Wilks and Zimbelman 2002, 5). Therefore, if either I=0, O=0, or A=0, then FR=0. In addition, if either I=1, O=1, or A=1, then FR≤1.

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II. Motivation There are two primary motivations for the paper. The first is that “ . . . auditors may rely too much on their perception of management’s attitude when evaluating fraud risk” (Wilks and Zimbelman 2002, 2). In terms of the FR model, this concern is that “actual ∂FR/∂A > optimal ∂FR/∂A.” Rather than comparing “actual ∂FR/∂A” with “optimal ∂FR/∂A,” though, H1 compares “actual ∂FR/∂A” with “actual ∂FR/∂I” and “actual ∂FR/∂O.” Following previous research (Heiman-Hoffman et al. 1996), the paper tests H1 by soliciting auditors’ “importance ratings” of risk factors classified as A, I, or O. The preceding development needs clearer explanation because “actual ∂FR/∂A > actual ∂FR/∂I, actual ∂FR/∂O” is not the same as “actual ∂FR/∂A > optimal ∂FR/∂A” unless optimal ∂FR/∂A, optimal ∂FR/∂I, and optimal ∂FR/∂O are equal to each other. In addition, past research (for a summary, see Ashton 1982, 40-41) has demonstrated that “importance ratings” are not particularly good surrogates for the “weights” that are assigned to pieces of information during information integration. The second motivation is that “ . . . when management’s attitude suggests low fraud risk, auditors will not be sufficiently sensitive to incentive and opportunity risk cues” (Wilks and Zimbelman 2002, abstract). In terms of the FR model, the concern is that “actual ∂FR/∂I < optimal ∂FR/∂I” when A=low and “actual ∂FR/∂O < optimal ∂FR/∂O” when A=low. Rather than comparing “actual ∂FR/∂I” to “optimal ∂FR/∂I” when A=low, the paper tests hypothesis 3 by manipulating I and O and examining the statistical significance of the effect upon FR. This approach seems reasonable. However, while we don’t know the form of function f, it seems as if as A→0, then ∂FR/∂I and ∂FR/∂O should →0. That is, when A is low, one would expect ∂FR/∂I and ∂FR/∂O to be small. III. Theory Attribution bias (i.e., when explaining or predicting the behavior of others, dispositional cues are likely to have a larger effect than situational cues) is provided as a theoretical explanation of the overweighting of A (a dispositional cue) relative to I and O (situational cues). Decomposition is proposed as a debiasing procedure. However, no explanation is provided regarding why decomposition would be an appropriate debiaser for attribution bias in particular. Perhaps a review of how attribution bias has been debiased in past research would be helpful. IV. Measurement of Variables In the survey, audit managers classify 40 FR factors as A, O, or I and rate their importance. Besides providing a test of H1, these classifications and ratings are used to create the surrogate for FR Level employed in the experiment. This approach greatly enhances the construct validity of the experiment. Since the 40 FR factors

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also are categorized as A, O, or I in the recent revision to SAS No. 82 (AICPA 2002), the authors could provide a measure of agreement (see, for e.g., Cohen 1960) between the AICPA and the auditors’ classifications. I believe that doing so would not only provide further evidence of construct validity regarding the surrogates for A, O, and I, but also would be quite useful to other researchers in this area. V. Analysis No justification is given for the particular statistical models that are employed. For example, in the ANOVA for “Opportunity/Incentive Risk Assessment (Table 3, Panel B), the FIRM*METHOD and the FIRM*METHOD*RISK effects could be included. In Panel D of Table 3, an ANCOVA is performed with “Component Opportunity/Incentive Risk Judgment” as the covariate. Based on other results, I suspect that the covariate interacts with METHOD. If this were the case, test statistics regarding other variables likely would be affected. An assumption of ANCOVA is that the covariate does not interact with any other effects in the model. Related to this issue, I believe that it would be quite helpful to the reader if a separate correlation matrix for each method was provided. A number of statistically significant interactions are found without performing analyses of simple effects as follow-ups. For example, a particularly important finding (the test of H3) is the statistically significant METHOD*RISK effect in the ANOVA for “Overall Fraud Risk Assessments” (Table 3, Panel C). The simple effects of RISK at the two levels of METHOD are not reported. My own calculation indicates that the simple effect of RISK is statistically significant at both the holistic and decomposed levels of METHOD. This provides evidence that auditors do attend to incentive and opportunity risk cues even when attitude risk is low. References: AICPA. 2002. Proposed Statement on Auditing Standards - Consideration of Fraud in a Financial Statement Audit. New York: AICPA. Ashton, R. H. 1982. Human Information Processing in Accounting. Studies in Accounting Research no. 17. Sarasota, FL: AAA. Cohen, J. 1960. A coefficient of agreement for nominal scales. Educational and Psychological Measurement 20 (Spring): 37-46. Heiman-Hoffman, V., K. Morgan, and J. Patton. 1996. The warning signs of fraudulent financial reporting. Journal of Accountancy (October): 75-77.

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Loebbecke, J., M. Eining, and J. Willingham. 1989. Auditors’ experience with material irregularities: Frequency, nature, and detectability. Auditing: A Journal of Practice and Theory 8 (Fall): 1-28. Wilks, T., and M. Zimbelman. 2002. The effects of a fraud-triangle decomposition of fraud risk assessments on auditors’ sensitivity to incentive and opportunity cues. Working paper (September), Brigham Young University.

Credits The Symposium on Auditing Research is a biannual event organized by the Office of Accounting Research of the University of Illinois at Urbana-Champaign with the support of the KPMG Foundation. For further information, please contact: Mark E. Peecher Department of Accountancy College of Business University of Illinois 360 Wohlers Hall 1206 South Sixth Street Champaign, IL 61820 Timothy B. Bell Director, Assurance Research

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