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Volume 23-2

The Effect of PCAOB Inspections on Big 4 Audit Quality

Joseph V. Carcello, University of Tennessee, Carl Hollingsworth, Clemson University, Stacy A. Mastrolia, Bucknell University

This paper examines whether the PCAOB inspection process results in an improvement in the quality of audits provided by Big 4 firms. We measure audit quality by examining changes in auditee abnormal accruals following each of the first two PCAOB inspections. We find a significant reduction in abnormal accruals in the year following the first PCAOB inspection, and we find a further reduction in abnormal accruals in the year following the second PCAOB inspection. These results are generally stronger for auditees that reported positive abnormal accruals before the initial PCAOB inspection. Our results provide preliminary evidence that the PCAOB inspection process has led to improved audit quality, at least as measured by a reduction in auditee earnings management.


Developments in Accounting Regulation: A Synthesis and Annotated Bibliography of Evidence and Commentary in the 2008 Academic Literature

Stephen R. Moehrle, University of Missouri, Timothy Farmer, Jennifer A. Reynolds-Moehrle, Pamela Stuerke

In this paper we synthesize in annotated bibliography form, selected regulation-related findings and commentaries which appear in the 2008 academic literature. We annotate results of regulation-related research studies and key points from regulation-related commentaries. This annotated bibliography contributes to the existing series appearing in recent volumes of this journal beginning in volume 18 and appearing regularly in each volume thereafter covering the research literature from 1999 through 2007. We have included academic outlets such as The Accounting Review, Journal of Accounting Research, Journal of Accounting and Economics, Accounting Horizons, Journal of Accounting, Auditing & Finance, Journal of Accounting and Public Policy, Journal of Business, Finance & Accounting, Auditing: A Journal of Practice and Theory, and Research in Accounting Regulation. Other journals, most recently Contemporary Accounting Research, are added as the debate and materials have increased and matured.


Audit Firm Industry Specialization and Audit Outcomes: Insights from Academic Literature

Ahsan Habib, Auckland University of Technology

Audit firms vary with respect to the quality of services they provide to their clients. One differentiation strategy is related to providing services to clients that are based on in-depth industry knowledge. Industry specialization helps audit firms increase the demand for audit and non-audit services, improves audit efficiency through economies of scale, creates barriers to entry by requiring new entrants to invest significant resources in relevant industries, and affects client-relevant audit outcomes like audit fees and financial reporting quality. This review attempts to evaluate critically the archival research on the effect of audit firm industry specialization on client-relevant audit outcomes. Some suggestions for future research are offered.


The Book–Tax Divide: Perceptions from the Field

Wendy Heltzer, DePaul University, Sandra Waller Shelton, DePaul University

Academics, practitioners and policymakers are engaged in a debate regarding the divide between financial statement income (“book income”) and taxable income. Some posit the divergence primarily reflects upward management of book income, while others believe it primarily reflects downward management of taxable income. Consequently, regulators believe that increased disclosure of book–tax differences, and possibly convergence of earnings measures, may help detect or prevent financial accounting fraud and/or tax sheltering. We provide new information concerning the book–tax divide, via the first large-scale study of professional perceptions concerning the book–tax divide. Based upon 781 survey respondents, we find accountants predominantly perceive the book–tax divide to be caused by both increased upward management of book income and downward management of taxable income. Our findings suggest that increased disclosure of book–tax differences, or alignment of book income with taxable income, may help detect or prevent aggressive reporting. We also find that downward management of taxable income is viewed as the primary contributor to the book–tax divide. Finally, we find a greater percentage of auditors (vis-à-vis tax professionals) believe downward management of taxable income contributes to the book–tax divide, while a greater percentage of tax professionals (vis-à-vis auditors) believe upward management of book income contributes to the book–tax divide. Thus, both disciplines “pass-the-blame”, suggesting perceptions of aggressive reporting may be more extreme than they actually are in practice.


Audit Committee Effectiveness: Perceptions of Public Company Audit Committee Members Post-SOX

Kathleen Rupley, Portland State University, Elizabeth Almer, Portland State University, Donna Philbrick, Portland State University

Effective audit committees provide numerous public benefits including better financial reporting and reduced corporate report. Prior to the passage of the Sarbanes-Oxley Act (SOX), research identified specific features of audit committee effectiveness, many of which were subsequently included in SOX sections 301 and 407 regulations on audit committees. Using survey methodology, this study examines the extent to which public company audit committee members believe this effectiveness features are operating with their committees today. Eighty public company audit committee members from a variety of industries completed a survey and indicated that overall, features of effective audit committees are present. A number of areas for potential improvement were noted. By soliciting post-SOX  information about audit committee effectiveness from a difficult to access subject tool, our study provides researches, educators, public company management and public company boards of directors with an updated understanding of the current state of public audit committee effectiveness. Results from this study can inform policy makers as they consider the adequacy of current regulations for audit committees.


The Value Relevance of Goodwill Impairment

Wei Xu, New Jersey Institute of Technology, Asokan Anandarajan, New Jersey Institute of Technology, Anthony Curatola, Drexel University

After a 5 year deliberation, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 142, Goodwill and Other Intangible Assets. The main objective of SFAS 142 is to increase transparency. We find that goodwill impairment charges are negatively viewed by investors, on average, but financial health moderates the relation. Returns for profitable firms are negative, but returns for loss firms are positive. The regulatory implications are that the goodwill impairment charge is conveying value relevant information.


Bank Response to SEC Disclosure Guidance Issued during the 2007–2008 US Financial Crisis

Susan B. Hughes, University of Vermont, Amy L. Wood, Gallagher Flynn & Company LLP, Christopher Hodgdon, Quinnipiac University

During 2008 the SEC increased its focus on the need for additional disclosures by banks and financial institutions, and issued specific guidance on disclosures of fair value estimates in the Management’s Discussion and Analysis (MD&A). In addition, the SEC and FASB issued joint guidance for determining estimates of fair value. In this study we analyze the critical accounting policy and estimate disclosures in the MD&A of 20 of the largest publicly-traded US banks for 2007 and 2008. The results of prior research into disclosure change in response to additional regulatory guidance predict that the length of the disclosures will increase; it is more difficult to predict changes in disclosure content in response to such guidance. We find the number of total sentences and accounting topics the banks disclosed significantly increased. The increases occur in accounting topics most severely affected by the financial crisis, and often specifically identified in SEC guidance. The disclosure content of these topic disclosures also significantly increased. However, we find that only 35% of the banks disclosed that they had discussed the estimates with their audit committee, and only two disclosed the accuracy of past estimates.


Are Mandatory Disclosure Decisions Made Strategically? The Case of SAB 74 Estimates Preceding Adoption of FIN 48

Raquel Alexander, University of Kansas, Mike Ettredge, University of Kansas, Mary Stone, University of Alabama, Lili Sun, University of North Texas

SEC Staff Accounting Bulletin No. 74 (SAB 74, U.S. Securities, 1987) requires registrants to provide information about the predicted financial statement effect of an enacted but not yet adopted accounting standard. The objectives of SAB 74 disclosures are to inform users the registrant will be required to adopt a new standard, and to assist users in assessing the impact of adoption on the registrant’s financial statements. Investors find SAB 74 disclosures useful for their decision-making (Davis-Friday et al., 1999, 2004). Some evidence suggests that the SEC also uses such disclosures (SEC, 2005). We investigate whether firms strategically disclose SAB 74 estimates in the context of one recently enacted accounting standard (ASC Topic 740, colloquially “FIN 48”).

Our results indicate substantial variation in how companies complied with SAB 74 when adopting FIN 48. For example, we find that less than 20% of companies provide dollar estimates of the standard’s adoption effect. Controlling for other factors, we find that firms that are more tax aggressive and those for which adoption increases tax liabilities are less likely to provide SAB 74 estimates. This suggests that managers likely responded strategically in making their SAB 74 disclosure decisions related to FIN 48 adoption.


Has Form 8-K Reporting Become Timelier Post-Regulation Fair Disclosure and the Sarbanes–Oxley Act? Initial Evidence

Khondkar E. Karim, University of Massachusetts Lowell, Robert E. Pinsker, Florida Atlantic University

Our paper examines the timeliness of Form 8-K filings immediately after significant US regulation and legislation. Our events are issuance of regulation fair disclosure by the SEC and Congress’s passage of the Sarbanes–Oxley Act. We use Carter and Soo’s (1999) sample from 1993 for the pre-SOX and pre-FD data. For all firms that filed an 8-K in the sample periods, the post-FD sample filings are timelier than the pre-FD sample, and the post-SOX filings are more timely than most of the post-FD filings. For large firms, the post-SOX sample has significantly shorter filing lags in most cases relative to the post-FD sample, but we only find weak evidence of the shorter filing lags resulting in improved compliance with stated Form 8-K filing deadlines. We conclude that management reporting behavior has positively changed post-SOX, but that the results are less conclusive post-FD.


The Emergence of Second-Tier Auditors in the Post-SOX Era: An Analysis of Accounting Conservatism

David S. Jenkins, University of Delaware, Uma Velury, University of Delaware

The increased resource constraints experienced by Big-N audit firms as a result of the passage of Sarbanes-Oxley Act (SOX) contributed to the emergence of second-tier audit firms as viable alternatives to the Big N for public company clients, as suggested by the PCAOB. This study provides a comparative examination of an important property of accounting numbers, earnings conservatism, for clients of Big-N and second-tier audit firms in both the pre- and post-SOX periods. Our findings indicate that, while there is a general increase in conservatism in the post-SOX period, there is no significant difference in conservatism between clients of Big-N and second-tier auditors in either the pre- or post-SOX periods. In addition, the results show greater conservatism in the post-SOX period among clients of Big-N and second-tier firms relative to that of other (non-Big-N/non-second-tier) audit firms. Overall, the results lend support to the PCAOB’s recommendation concerning the use of second-tier auditors as a viable alternative to the Big-N and to the effectiveness of SOX in increasing reporting conservatism among clients of all auditors conducting public company audits in the post-SOX period.


Changing Audit Risk Characteristics in the Public Client Market

Gary Giroux, Texas A&M University, Cory Cassell, University of Arkansas

Financial audit services have changed in the US over the last half century, resulting in distinct cyclical patterns of relative audit risk. The purpose of this project is to describe changing patterns in the economic and institutional risk environment over time and investigate differences using empirical surrogates as measures of relative audit risk. Economic, competitive, and regulatory differences are analyzed over the period of study. Particularly important events included the Foreign Corrupt Practices Act of 1977 (likely reducing audit risk), the elimination of rules against advertising and direct solicitation in 1979 (increasing audit risk), the Private Securities Litigation Reform Act of 1995 (increasing risk), and the collapse of Arthur Andersen and Sarbanes–Oxley Act (2001–2002, reducing risk). Empirical models are used to evaluate financial risk (Altman’s Z-score), earnings manipulation risk (Sloan’s measure of accruals), and litigation risk (litigation index). Averages by year suggest cyclical patterns of relative audit risk that parallel regulatory, economic and institutional changes over the period.


Discontinued SEC Required Disclosures: The Value of Repairs and Maintenance Expenses

Bruce K. Behn, The University of Tennessee, Richard Riley, West Virginia University, Giorgio Gotti, University of Texas at El Paso, Richard C. Brooks, West Virginia University

On December 13, 1994, the US Securities and Exchange Commission (SEC) eliminated certain schedules including repairs and maintenance (R&M) disclosures previously required in annual reports and registration statements. This SEC decision provides us a research setting where disclosure has been decreased. The purpose of this study is to determine if market participants used R&M information prior to its elimination. The findings indicate that R&M disclosures did provide value-relevant information. Further, the year following the elimination of mandatory R&M disclosures, only 4% of the firms in the sample voluntarily disclosed R&M information. Hence, it appears that decreased disclosures deprived the market participants, not only in principle but also in practice, of value-relevant R&M expenses information. The results also suggest that if R&M disclosures are not required firms will not voluntarily provide the information.


The Impact of Regulation on Firms’ Ability to Habitually Meet or Beat Analysts’ Expectations

Jan L. Williams, University of Baltimore, Huey-Lian Sun, Morgan State University

Firms are pressured to meet or beat analysts’ expectations (MBE) to avoid being penalized by the market. Some firms sporadically MBE while other firms are able to consistently, or habitually, MBE. This study is an exploratory attempt to investigate how habitual MBE firms are different from firms that sporadically MBE, and whether regulation FD and the Sarbanes–Oxley Act have affected firms’ ability to habitually MBE in the post regulation periods. We find that habitual MBE firms are different than sporadic MBE firms, and that they use strategies less to MBE than sporadic MBE firms. Furthermore, it has become more difficult for firms to habitually MBE in the post-regulation periods.