Auditor Independence: A Synthesis of Theory and Empirical Research
Gary Kleinman, Dan Palmon, and Asokan Anandarajan
The United States Securities and Exchange Commission has continued to demonstrate interest in matters relating to auditor independence. The recent formation of the Independence Standards Board further indicates a need for an understanding of the research which has been undertaken with regard to auditor independence. This paper focuses on studies of factors that affect perceptions of the auditors independence or provide information on the factors that actually affect auditor independence [i.e., archival research]. We begin with a review of definitions of independence and major models of auditor independence. Our review then discusses empirical research on auditor independence and compares research within the AICPA "White Paper" (1997) with attention to differences between that effort and our work. We conclude our work with conclusions and suggestions for further research. Volume 12, 1998, pgs. 3- 42.
Self-Regulatory Organizations: Developments and Prospects
Wanda A. Wallace
The privilege of self regulation, if worth preserving and enhancing warrants attention to attributes of similar self regulatory processes and entities employed in other parts of the capital market system. Self-Regulatory Organization [SRO] models which are employed in the market sector, including the National Association of Securities Dealers [NASD], the American and New York Stock Exchanges and the Chicago Board of Options Exchange, are possible models for such a comprehensive approach to regulation of public accountancy. The impact of changing practice environments and technologies on the practice of public accountancy point out also that it is important to understand those attributes of current self regulation which lend themselves to use in what may be required in revisions to existing entities or possibly altogether new structures. Volume 12, 1998, pgs. 43-59.
An Investigation of Audit Failures in New Audit Engagements
Paul L. Walker, Jeffrey R. Casterella, and Lisa K. Moet
Opponents of mandatory audit firm rotation have argued that new audit engagements are at greater risk of audit failure and have asserted that the auditors lack of knowledge contributes to this heightened risk. This study is the first to examine whether all new engagements are equally at risk of audit failure or whether there are distinguishable differences by which risky clients can be identified. Additionally, this study examines the role of industry knowledge and knowledge related to account complexity. This study examines only audit engagements where there was an auditor change in the last three years, thus addressing the differences between new engagements (1-3 years) that result in an audit failure and new engagements that do not result in an audit failure. The results indicate that new engagements that result in an audit failure are not a random sample of all new engagements; but instead, can be identified using publicly available information. Furthermore, the results show that knowledge is an important factor in new engagements that have an audit failure. Volume 12, 1998, pgs. 61-75.
Earnings Management and Bond Risk Premia in the Individual Versus Institutional Bond Markets
Thomas Robinson, Julia Grant, Robert Kauer, and Peter Woodlock
Recent analytical research had posited a demand for managers to smooth a firm's earnings stream to reduce the risk premium on bonds (Trueman and Titman 1988; Dye 1988), and empirical research in finance has shown a relationship between earnings variability and bond risk premia. However, bonds are traded in two separate markets, one with individual and the other with institutional investors. These markets are conducted under different regulatory and information structures. Robinson and Grant (1997) found that while earnings variability was positively associated with risk premia in the individual bond market, firms were not able to reduce the risk premia through the smoothing of income. The institutional bond market is separate and distinct from the individual bond market, and public disclosure requirements are much less stringent. Since these two markets are subject to different regulatory frameworks, there is no required flow of information from the institutional to the individual setting, creating the possibility of disadvantage to individual investors. This separation of markets and the lack of publicly available information from the institutional market create settings within which income smoothing could be priced differently, a situation that could be of concern to regulators. This paper examines a matched sample of institutional and individual bond prices to determine whether there is a difference in the determination of risk premia between the two markets. In contrast to the individual market, these research results suggest that institutional bondholders penalize the use of smoothing, suggesting that participants in the individual market may be placed at a pricing disadvantage compared to institutional investors. The Appendix contains detailed empirical results. Volume 12, 1998, pgs. 77-92.
The Association between States Educational Requirements and CPA Exam Performance
Gary Colbert and Dennis Murray
States licensing requirements for CPAs presumably exist to ensure that the public receives competent accounting and auditing services. To date, surprisingly little research has examined the effectiveness of these regulations. This study examines the efficacy of one type of regulation: college education requirements. Effectiveness is measured based on candidates CPA Exam performance. The results show that total required semester hours, required semester hours in accounting, auditing and law, and the option to sit for the exam while still completing the education requirements are positively associated with CPA Exam performance. Policy makers should evaluate these benefits in light of the additional costs of those requirements. Volume 12, 1998, pgs. 93-108.
An Analysis of the FASB's New Standard on Earnings Per Share Computations
Ted D. Englebrecht and Huong Ngo Higgins
In this study, several tests are conducted to examine whether the Earnings Per Share (EPS) computations as prescribed in SFAS 128 issued in February 1997 cause a significant change in EPS figures reported by firms. Specifically, 1994 financial data for a group of Fortune 500 firms are used to simulate their diluted EPS under SFAS 128 requirements. The simulated diluted EPS figures are then compared with firms fully diluted EPSs reported in 1994 annual reports. Our findings provide empirical evidence that there exists a statistically significant increase in EPS numbers for these firms. Furthermore, the more potentially dilutive that the capital structure is, the larger the difference is between the reported fully diluted EPS and the simulated diluted EPS figures. These findings are important because they indicate that this standard change may have an artificial impact on the market's earnings expectation surrounding the change date. These results are especially notable for future market-based research because earnings numbers may convey different information before and after the change date. Volume 12, 1998, pgs. 109-125.
Market Valuation of Current Value Accounting Adjustments:
Sati P. Bandyopadhyay and Terry Warfield
One important current financial reporting issue is the extent to which fair values should be used as a basis of measurement in accounting. The accounting profession, accounting regulators and accounting academics have all deliberated on the importance of incorporating fair value numbers in financial statements. For example, the AICPA Special Committee on Financial Reporting (Jenkins Committee) found that users of financial statements believe that fair value information is useful, though selectively, for certain types of assets and liabilities in particular industries. Also, many financial analysts maintain that current cost disclosures provided by firms under SFAS No. 33 (FAS33) were useful to analysts and should be given a chance once again to prove their usefulness (AIMR 1993 position paper). The FASB has called for recognition of more up-to-date values of financial instruments in financial statements (SFAS Nos. 114 and 115) and a number of accounting studies, though mostly restricted to the financial services industry, have examined the relevance to fair values of financial instruments.
In comparison with recent fair value research, this paper, using FAS33 data, examines the relevance of current cost estimates of capital and other assets of firms in manufacturing, retailing, and other industries. Prior FAS33 based research focused on current cost earnings numbers instead and concluded that FAS33 data lack relevance. Unlike prior FAS33 research, the assumption that current cost numbers are equally value relevant to all firms is also relaxed in this study.
We find that current cost asset book values are associated with equity values for firms with relatively long operating cycles, low levels of unrecorded assets, and for firms in the utility industry though not in some other industry groups. The selective usefulness of current cost book value numbers supports the Jenkins Committee concept of flexible reporting, wherein certain elements of business reporting will be provided only if users and management agree on their reporting, that is, conditional on its usefulness. Furthermore, the evidence that current value measures are most useful for firms with high levels of recognized assets supports the call for recognition of intangibles and other "soft" assets in financial statements. Volume 12, 1998, pgs. 127-148.
Some Implications of Homogenizing Restrictions on
John A. Brozovsky and Frederick M. Richardson
Many of the proposed and enacted regulation of the audit profession (e.g., peer review, standards increasing the minimum level for an acceptable audit) tend to increase auditor homogeneity. This paper reports on a laboratory market study that provides preliminary evidence on the effect of increasing the homogeneity of audit providers in the market for audit services. Results indicate that higher quality audits are conducted in homogeneous auditor markets. Moreover, increased homogeneity increases market efficiency. This increased efficiency accrues to the benefit of the audit clients rather than to the auditors, however, as evidenced by the result that auditors in the homogeneous markets earn smaller profits than those in the heterogeneous markets. Volume 12, 1998, pgs. 149-162.
Does Auditor Tenure Matter?
Claire Kamm Latham, Fred A. Jacobs, and Pamela B. Roush
The purposes of this paper are: (1) to provide a regulatory perspective of the tenure discussion, (2) to compare and contrast the various theories related to why tenure should make a difference in an auditor-auditee relationship and, (3) to critically review prior research and to provide additional empirical evidence regarding the impact of the length of auditor-client relationships in an audit failure setting. Our synthesis and evaluation confirms the perceptions of certain regulatory and oversight commissions and committees while discounting the concerns of others. Our study concludes with a call for additional research to focus on the proper diagnosis of the cause of problem audits in early tenure settings. Volume 12, 1998, pgs. 165-177.
The Effect of the Reform Act and Central Bank on
Ross D. Fuerman
In passing the Private Securities Litigation Reform Act of 1995 (the "Reform Act"), Congress intended to reduce meritless securities class actions. Congress also intended to reduce the naming of auditors as secondary defendants. Early studies suggest that Congress first expectation has not been met. This study empirically examines whether the second expectation of Congress has been met. The results of univariate and multivariate analysis of federal and state court litigation data from twenty months before the United States Supreme Court's April 19, 1994 Central Bank of Denver decision to ten months after the effective date of the Reform Act suggest that Congress second expectation has also not been met. The proportion of securities lawsuits with auditor defendants is unchanged, in comparison to the pre-Reform Act period. This finding is, due to the recency of the passage of the Reform Act, preliminary and tentative. Volume 12, 1998, pgs. 179-191.
Case Law 1997: O'Hagan and Miller
Mark A. Segal
This paper examines two 1997 judicial decisions with important implications to the accounting profession. One decision involved recognition of the misappropriation theory as ground for finding 10(b)(5) liability (O'Hagan). In this decision the Supreme Court appeared to indicate the allowance of some judicial flexibility in applying the language of 10(b)(5), in contrast to the strict construction approach reflected in Central Bank of Denver. In the other decision (Miller) the Eleventh Circuit upheld a lower federal court finding that certain restrictions on the ability of a licensee (CPA) to disclose their possession of a license violated the licensee's right of commercial free speech. This decision continued a trend involving rejection of accountancy statutes prohibiting certain types of speech by licensees (see Ibanez and Edenfield). Volume 12, 1998, pgs. 193-199.
The Stock Index and Market Seasonals (SIMS) Data Base
Anthony J. Cataldo, II
This paper introduces the contents and structure of the first version of an historical capital markets data base. The Stock Index and Market Seasonals (SIMS) data base is currently available.
In developing SIMS, Fosbacks's (1976) assertions with respect to a three-day holiday effects-based market reaction/sequence were investigated. Prior studies have found support for the existence of a two- or one-day market reaction/sequence for aggregate holiday effects. This paper finds support for Fosbacks "three-day" holiday effects sequence, in the form of a test of market efficiency.
Furthermore, SIMS provides for the identification of both separate and aggregate holiday effects. Many prior studies have analyzed holiday effects, but only in their aggregate form. Separate descriptive statistics of ten holidays illustrates their very different seasonal patterns.
SIMS provides 100 years of selected daily index measures and contains dummy variables for all "seasonals" identified and supported in the accounting, finance, and economics literature streams. This first version will be useful primarily as a source of "control" variables, and will be of greatest interest to academics engaged in capital markets research streams employing CRSP and/or COMPUSTAT data bases. The user will merely include the variable(s) of interest to conduct statistical analyses of hypotheses. Volume 12, 1998, pgs. 201-221.
The SEC's Differential Disclosure Requirements: An Update
Jimmy W. Martin
Approximately ten years ago, the author published a paper in this periodical which focused on areas where SEC accounting requirements exceeded those of GAAP accounting. The purpose of that paper was to provide a reference for educators who deal with SEC topics in the classroom. However, over the past decade, reporting requirements have changed, and there is a need to take a fresh look at this differential area. Volume 12, 1998, pgs. 223-252.
Politicization and Seven Other Recent Trends in Financial Accounting in the United States
This paper discusses several recent trends in financial accounting in the United States. They are divided into four external trends and four internal trends depending upon whether the forces behind the trends are external or internal to accounting. They are, in short, external trends toward (1) "politicized" accounting, (2) "internationalized" accounting, (3) "technologized" accounting, and (4) "customized" accounting, and internal trends toward (5) "staticized" accounting, (6) "diversified" accounting, (7) "futurized" accounting, and (8) "complexity" accounting. After a brief review of each of the eight trends, the paper presents an evaluation and an interpretation of these trends in terms of their potential impact on accounting theories in the twenty-first century. Volume 12, 1998, pgs. 255-270.
The Euro: Breakthrough or Fisaco?
In less than a year, a newcomer should start glittering in the small world of glamorous convertible currencies. In a period of heavy turbulence in monetary markets, how can a new member be knocking at the door of this restricted Club with apparently valid arguments to justify its request for adherence and with valid chances of success. For those that would like to know more about it, let me provide you with some of these arguments and describe how this may impact our future wherever we do business on the globe. Volume 12, 1998, pgs. 271-275.
1998 AICPA "Amicus" Brief in the Matter of Silicon Graphics, Inc.
The American Institute of Certified Public Accountants has sought leave to participate as amicus curiae in three federal appeals involving the questions of the proper pleading standard for Section 10(b) scienter under the Private Securities Litigation Reform Act of 1995 ("Reform Act"). The cases include In re Silicon Graphics, Inc. Securities Litigation (Ninth Circuit), Zeid v. Kimberly (Ninth Circuit), and Hoffman v. Comshare, Inc. (Sixth Circuit).
The institute is the national organization of the certified public accounting profession, with more than 331,000 members. The Institute develops authoritative accounting, auditing, and ethical standards of practice which, in conjunction with SEC rules, govern independent auditors in reporting on a company's financial statements in publicly filed disclosure documents. The Institute has a long-standing interest in the scope and bases of civil liability sought to be imposed on accountants under the federal securities law, and supported passage of the Reform Act.
Accountants have been commonly targeted as perceived "deep pocket" defendants in securities class actions. Prior to the Reform Act, the lower federal courts had adopted varying "recklessness" theories for pleading scienter in Section 10(b) cases. This allowed class action plaintiffs to ensnare accountants in costly litigation merely be alleging than an auditor had acted "recklessly" in conducting an audit of a publicly traded company whose stock had fallen significantly. Congress passed the Reform Act to protect accountants and others from such abusive strike-suits. The Reform Act imposes several important provisions designed to realign the incentives of the securities litigation system, including a heightened pleading standard to filter out boilerplate complaints and a safe harbor for forward-looking statements intended to increase disclosure of company information to investors.
The Institute's amicus briefs demonstrate that the Reform Act and its legislative history leave no doubt Congress intended to eliminate "recklessness" as a basis for pleading scienter under Section 10(b). The briefs also explain how continued acceptance of a "recklessness" approach would undermine the very protections that Congress intended to extend to accountants and others under the Reform Act. The briefs conclude by showing that adherence to the Reform Act's heightened pleading requirements will not raise too high a barrier for meritorious claims, while enabling courts to dispose of non-meritorious ones at the pleading stage, as Congress intended. Volume 12, 1998, pgs. 277-297.
Auditor Independence: A Perspective on Its Origins and Orientations
Gary John Previts
[This paper is based on a presentation made to the first public meeting of the Independence Standards Board [ISB] in New York City, October 20, 1997. The meeting was held at the AICPA Board Room and commenced with a commentary by Arthur Leavitt, Chairman of the U.S. Securities and Exchange Commission [SEC]. On February 18, 1998 the SEC issued a general policy statement [Financial Reporting Release No. 50/FRR 50] which provides the ISB a status such as that afforded in 1973 by Accounting Series Release No. 150 to the Financial Accounting Standards Board [FASB]. The ISB is considered by the SEC as the sole source of substantial authoritative support for principles, standards, interpretations and practices relating to the independence of auditors of publicly held companies. FRR 50 became effective 30 days after date of issue. This paper, along with presentations by Professor William Kenny and Professor Baruch Lev, comprised the opening session of the day long background program for the ISB.
Beginning with America's early Industrial capital market era to the present, the nature of the contract between the independent auditor and society/the investment public has been a matter of debate and controversy. Recent recommendations by special study groups, changes in corporate governance and investment community constituencies, as well as in the scope of services provided by firms once identified solely as attest service providers has once again brought attention to traditional issues raised about potential for conflicts of interest which affect the fact and/or appearance of auditor independence.
The direction of the paper is guided by the need to gain understanding about the following: (1) The related development of U.S. capital markets and the CPA profession's franchise to provide attest and, more recently in competitive markets, advisory services during the past century. (2) The origins in law and custom of the auditor independence issue during the eras noted above, and how the Securities and Exchange Commission [SEC], since its formation in 1934, and the CPA profession and its forebears, have viewed and managed the issue to the present day. Volume 12, 1998, pgs. 299-317.
Securities and Exchange Commission
Joseph P. Kennedy
…The S.E.C. desires to encourage proper investments. But, at the same time, it should be pointed out that the speculative risk in any investments, whether it be stocks or bonds, will be present in the future as it has been in the past; for no body of men—no government-no nation, is sufficiently wise to define the perfect investment, or to guarantee it, or to eliminate the risks of speculation … Volume 12, 1998, pgs. 319-323.