The Impact of Litigation Risk on Auditor Pricing Behavior: Evidence From Reverse Mergers

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Abbott, L. J., et al. (2017). "The Impact of Litigation Risk on Auditor Pricing Behavior: Evidence From Reverse Mergers." Contemporary Accounting Research 34(2): 1103-1127.

We use reverse mergers to examine the impact of litigation risk on audit fees. In a reverse merger, a private company merges with a public company, and the private company's management takes over the resulting publicly traded firm. Reverse mergers create a unique test setting to provide estimates on the litigation risk premium because, while the litigation risk for formerly private firms whose equity becomes publicly traded increases, the remaining auditee- and auditor-related characteristics remain virtually unchanged. We document a litigation risk premium of approximately 27 percent. Moreover, we document that equity dispersion impacts the audit fee pricing of litigation risk and this relation is dramatically magnified in the publicly traded realm. Finally, we find that institutional investors demand higher audit effort in the form of higher audit fees in both the private- and public-equity settings.

Anderson, S. W., et al. (2017). "Getting to Know You: Trust Formation in New Interfirm Relationships and the Consequences for Investments in Management Control and the Collaboration." Contemporary Accounting Research 34(2): 940-965.

Trust is often posited to substitute for management control in interfirm transactions. However, this raises questions of how trust arises in new relationships, and whether trust that is not based on prior experience transacting together is sufficient to persuade managers to forgo investments in management controls. We use an experiment to test whether two features of the early stage of an interfirm relationship influence a buyer's initial trust in a supplier and have consequences for subsequent investments in management controls and in the collaboration. These two features are the autonomy of the buyer's manager to choose a supplier (i.e., delegation of decision-making authority) and the supplier's willingness to share information with the buyer. We find that the buyer manager's initial trust in the supplier is associated positively with both the autonomy to choose the supplier and the supplier's willingness to share information. Information content and supplier characteristics are held constant, so these results are novel and distinct from prior studies of the antecedents of trust. We find that higher initial trust is associated with reduced expenditures for management controls and increased investments in the collaboration. Thus, we conclude that delegation of decision-making authority and supplier information-sharing behavior in the early stages of a relationship influence the formation of initial trust, which has real consequences for investments in management control and in the collaboration.

Batta, G. and V. Muslu (2017). "Credit Rating Agency and Equity Analysts’ Adjustments to GAAP Earnings." Contemporary Accounting Research 34(2): 783-817.

Moody's analysts and sell-side equity analysts adjust GAAP earnings as part of their research. We show that adjusted earnings definitions of Moody's analysts are significantly lower than those of equity analysts when companies exhibit higher downside risk, as measured by volatility in idiosyncratic stock returns, volatility in negative market returns, poor earnings, and loss status. Relative to the adjusted earnings definitions of equity analysts, adjusted earnings definitions of Moody's analysts better predict future bankruptcies, yet they fare significantly worse in predicting future earnings and operating cash flows. These findings persist after controlling for optimism incentives of analysts, reporting incentives of companies, credit rating levels, and industry and year effects. Our findings suggest that credit rating agencies cater to their clients’ demand for a more conservative interpretation of company-reported performance than what is offered by equity analysts.

Black, E. L., et al. (2017). "The Relation Between Earnings Management and Non-GAAP Reporting." Contemporary Accounting Research 34(2): 750-782.

Managers have a variety of tools at their disposal to influence stakeholder perceptions. Earnings management and the strategic reporting of non-GAAP earnings are just two of the available menu choices. We explore how real earnings management and accruals management influence the probability that a company will disclose a non-GAAP adjusted earnings metric in its earnings press release and the likelihood that it will do so aggressively. We first investigate situations where managers already meet analysts’ expectations either based on strong operating performance or after employing real and accruals management. We find that when solid operating performance alone allows firms to meet expectations, managers do not employ earnings management or non-GAAP reporting. However, when managers meet expectations using real and accruals management, they are significantly less likely to report a non-GAAP earnings metric. Next, we explore scenarios where companies fall short of expectations. We find that when they just miss expectations after managing GAAP earnings, they are significantly more likely to employ non-GAAP reporting, suggesting that the timing and relatively costless nature of non-GAAP reporting allows managers to appear to meet expectations on a non-GAAP basis when managed GAAP earnings fall short. Moreover, we find that companies are more likely to report non-GAAP earnings (and to do so aggressively) when (i) they are unable to use real or accruals earnings management, (ii) are constrained by prior-period accruals management, and (iii) their operating performance is poor. Taken together, our results are consistent with a substitute relation between non-GAAP reporting and both real and accruals management.

Bonsall, S. B., et al. (2017). "Deciphering Tax Avoidance: Evidence from Credit Rating Disagreements." Contemporary Accounting Research 34(2): 818-848.

This study investigates the role of tax avoidance in the credit-rating process and whether differences exist in how rating agencies account for the risk relevance of tax avoidance. Using a sample of initial credit ratings assigned to public debt issuances during 1994–2013, our evidence is consistent with Moody's Investors Service and Standard & Poor's assessing the costs and benefits associated with tax avoidance differently from one another, resulting in more frequent and pronounced rating agency disagreement. Rating agency disagreement over tax avoidance is most evident when it is accompanied by relatively high levels of uncertain tax positions, foreign activities, research and development activities, or tax footnote opacity. We also find evidence that decreases (increases) in tax avoidance or tax footnote disclosure opacity are positively (negatively) associated with the convergence of split ratings. This suggests that firms can exacerbate or mitigate rating agency disagreement subsequent to bond issuance. Our study complements prior research by examining why sophisticated information intermediaries disagree about the risk relevance of tax avoidance. It also sheds light on how firms can influence rating agencies’ understanding of tax avoidance.

Burgstahler, D. and E. Chuk (2017). "What Have We Learned About Earnings Management? Integrating Discontinuity Evidence." Contemporary Accounting Research 34(2): 726-749.

The accounting literature includes numerous examples of discontinuities at prominent benchmarks that are widely interpreted as evidence that earnings are managed to meet those benchmarks. However, there are a few examples where discontinuities do not exist, which are sometimes interpreted as inconsistent with earnings management. Alternative explanations for discontinuities have also been suggested. This paper reviews, evaluates, and integrates the available evidence and concludes that the theory that earnings are managed to meet benchmarks provides the simplest and most complete explanation for the body of discontinuity-related evidence.

Carter, M. E., et al. (2017). "Executive Gender Pay Gaps: The Roles of Female Risk Aversion and Board Representation." Contemporary Accounting Research 34(2): 1232-1264.

Using a large sample of executives in S&P 1500 firms over 1996–2010, we document significant salary and total compensation gaps between female and male executives and explore two possible explanations for the gaps. We find support for greater female risk aversion as one contributing factor. Female executives hold significantly lower equity incentives and demand larger salary premiums for bearing a given level of compensation risk. These results suggest that females’ risk aversion contributes to the observed lower pay levels through its effect on ex ante compensation structures. We also find evidence that the lack of gender diversity on corporate boards affects the size of the gaps. In firms with a higher proportion of female directors on the board, the gaps in salary and total pay levels are lower. Together, these findings suggest that female higher risk aversion may act as a barrier to full pay convergence, despite the mitigating effect from greater gender diversity on the board.

Chen, K. C. W. and F. Tang (2017). "Post-IFRS Revaluation Adjustments and Executive Compensation." Contemporary Accounting Research 34(2): 1210-1231.

International Financial Reporting Standards (IFRS) allow firms to record adjustments (gains or losses) from the revaluation of investment properties in their income statements. After Hong Kong adopted IFRS in 2005, property companies were required to move their revaluation gains and losses (RGL) from equity to income. We find RGL to be a significant determinant of executive compensation in these firms after 2005, but not before. We further find evidence that the RGL-compensation association is driven by firms with relative weak corporate governance structure, such as firms in which the controlling shareholders own a relatively small percentage of shares, firms in which the controlling shareholders have control rights that exceed ownership rights, and firms that are no longer run by their founders.

Choi, J.-H., et al. (2017). "Did the 1998 Merger of Price Waterhouse and Coopers & Lybrand Increase Audit Quality?" Contemporary Accounting Research 34(2): 1071-1102.

We examine the effects of the 1998 merger of Price Waterhouse (PW) and Coopers & Lybrand (CL) on the audit quality of the merged firm PricewaterhouseCoopers (PwC) at both the firm and office levels, where audit quality is surrogated by the auditor's propensity to issue a going-concern opinion, clients’ likelihood of meeting or beating analysts’ earnings forecasts, and clients’ accrual quality. At the firm level, we find that the merger increased audit quality for PwC relative to the audit quality of the other Big N firms. At the office level, our findings, albeit mixed, collectively suggest that the improvement in firm-level audit quality was likely driven by the improvement in audit quality at PwC's overlapping offices, that is, offices in cities where both PW and CL had separate offices prior to the merger. Further, our findings suggest that although the PW/CL merger increased auditor concentration in local audit markets with PwC overlapping offices, the merger improved (rather than hurt) audit quality in those markets. Overall, our study contributes to the extant sparse literature on the effect of Big N mergers on audit quality, and is of potential interest to regulators.

Cohen, J., et al. (2017). "Enterprise Risk Management and the Financial Reporting Process: The Experiences of Audit Committee Members, CFOs, and External Auditors." Contemporary Accounting Research 34(2): 1178-1209.

The recent financial crisis has brought to the forefront the need for companies to effectively manage their risks. In this regard, one approach that has gained prominence is enterprise risk management (ERM). Importantly, little is known about the link between ERM and the financial reporting process. This link is critical, because it is imperative that financial reporting adequately depicts the financial status (e.g., valuations, estimates) and associated risks of a company as revealed by ERM. Additionally, from an auditing perspective, ERM affects the risks of misstatement, which should impact audit planning. Accordingly, the objective of this study is to examine the experiences of audit partners, CFOs, and audit committee (AC) members (“the governance triad”) on the link between ERM and the financial reporting process. To determine whether members of the governance triad focus on monitoring, strategy, or both, we also examine their definition of and experiences with ERM with respect to agency and/or resource dependence theory. To address these issues, we conduct semistructured interviews of experienced individuals that form the governance triads from 11 public companies. There are three major findings from our study. First, importantly, all three types of participants see a strong link between ERM and the financial reporting process. Second, despite recognition of the broad nature of ERM, the predominant experiences of the actual roles played by triad members center on agency theory, while resource dependence may be relatively underemphasized by all triad members. Finally, CFOs and AC members indicate that auditors may be especially underutilizing ERM in the audit process, suggesting an “expectations gap.”

Cooper, D. J., et al. (2017). "Popularizing a Management Accounting Idea: The Case of the Balanced Scorecard." Contemporary Accounting Research 34(2): 991-1025.

We explore how the Balanced Scorecard (BSC), as a management accounting technique, was developed and marketed as a general management practice. Drawing on actor network theory (ANT), we analyze interviews with key actors associated with the BSC, insights gained from attending BSC training workshops, and other documentary evidence to construct a history of the BSC. Our historical analysis offers theoretical tools to understand how the various features of the accounting technique were translated and transformed, that is, shaped and solidified. This translation entailed processes of modification, labelling, framing, and specification of abstract categories and cause-effect relations. We also examine the networks and associations that both shape the form of the BSC and mobilize the interests of various constituencies around it to produce what can be regarded as a global management technology. Finally, we highlight the strategies and actions used to maintain control of this technique through its continuous reinvention, and, by doing so, we emphasize the idea of strategic agency.

Davies, S. P., et al. (2017). "Ambient Influences on Municipal Net Assets: Evidence from Panel Data." Contemporary Accounting Research 34(2): 1156-1177.

Governments’ net assets balances are viewed as a measure of fiscal health and have been linked to municipal credit ratings. This study explores the extent to which ambient socioeconomic factors are captured in aggregated restricted and unrestricted net assets balances (termed “liquid net assets”) to understand why such balances are relevant to credit analysts and others. We model liquid net assets balances using observable nonaccounting factors (e.g., unemployment rates) to learn whether they reflect such influences. We use panel data for fiscal years 2007–2011 so our results comprehend effects of recent economic fluctuations. We find that liquid net assets balances impound a rich array of influences, bearing a positive association with the mayor-council form of government, community wealth, the incidence of property crimes, and increases in governments’ business-type net assets. Liquid net assets balances bear a negative association with liabilities for postemployment benefits, unemployment, and violent crime. The results indicate that net assets balances capture noteworthy debt burden, administrative, and socioeconomic influences and, as such, have meaning beyond their basic accounting interpretation.

Dyreng, S. D., et al. (2017). "Evidence of Manager Intervention to Avoid Working Capital Deficits." Contemporary Accounting Research 34(2): 697-725.

We study managers’ interventions in financial reporting by examining working capital deficits, measured as current ratios less than 1.0. Current ratios represent important balance sheet liquidity indicators to lenders and creditors, and have an identifiable and naturally occurring reference point at 1.0, analogous to the profit/loss income statement reference point. We find that distributions of reported current ratios of both U.S. and non-U.S. firms exhibit a discontinuity at 1.0. For U.S. firms, we find that the discontinuity increases with exogenous increases in the cost of credit in the economy, and that determinants of the likelihood to achieve a given current ratio are diagnostic precisely at the 1.0 discontinuity location but not at other nearby locations in the current ratio distribution. U.S. firms that avoid working capital deficits report lower proportions of inventory and higher proportions of accounts receivable in current assets and, when credit is tight, higher proportions of cash, consistent with managers increasing sales volume so as to capitalize profit margins and thereby increase current assets. For non-U.S. firms, the discontinuity is more pronounced for observations from common law countries, a proxy for jurisdictions where financial reports are more intended to provide decision-useful information. The evidence suggests that managers intervene to achieve a balance sheet reporting objective that stems from stakeholder use of reference points.

Griffin, P. A., et al. (2017). "The Relevance to Investors of Greenhouse Gas Emission Disclosures." Contemporary Accounting Research 34(2): 1265-1297.

This study finds that investors price firms' greenhouse gas (GHG) emissions as a negative component of equity value, and this valuation discount does not differ between firms that voluntarily disclose to the Carbon Disclosure Project (CDP) and nondisclosing firms. We derive the GHG emissions for nondisclosers from an estimation model that incorporates firm characteristics and industry. The finding that investors view CDP amounts and estimates of emissions as equally value-relevant suggests that equity values reflect GHG information from channels other than the CDP. An event study of investors' response to emission-related information in firms' 8-K filings further supports this finding. Economically, our results suggest that, for the median S&P 500 firm, GHG emissions impose a market-implied equity discount of $79 per ton, representing about one-half of 1 percent of market capitalization.

Huang, S. X., et al. (2017). "Analyst Coverage and the Likelihood of Meeting or Beating Analyst Earnings Forecasts." Contemporary Accounting Research 34(2): 871-899.

This paper examines the relation between analyst coverage and whether firms meet or beat analyst earnings forecasts. We distinguish between whether a firm's reported quarterly earnings meet (i.e., equal or exceed by one cent) or beat (i.e., exceed by more than one cent) its consensus analyst earnings forecasts. We find a positive relation between analyst coverage and whether a firm meets or beats analyst forecasts. However, the more pronounced relation is that between analyst coverage and meeting analyst forecasts. Also, when we consider exogenous shocks to analyst coverage due to brokerage mergers or closures and conglomerate spinoffs, we continue to find a robust positive relation only between analyst coverage and meeting analyst forecasts. To shed light on the causal relation involved, we examine and find that greater analyst coverage is associated with a significantly larger market reaction to negative earnings surprises. We also document that firms with greater analyst coverage are more likely to guide analyst earnings forecasts downwards. Taken together, our evidence suggests that greater analyst coverage raises the pressure on managers to meet analyst earnings forecasts.

Johnston, R. and R. Petacchi (2017). "Regulatory Oversight of Financial Reporting: Securities and Exchange Commission Comment Letters." Contemporary Accounting Research 34(2): 1128-1155.

The Securities and Exchange Commission (SEC) reviews company filings (10-Q, 10-K, S-1, etc.) submitted to them. If a review identifies potential deficiencies, the SEC staff sends the company a comment letter seeking clarification, additional information, and ultimately, perhaps, revision of the filing or future filings. We examine the content, resolution, and ensuing informational consequences of SEC comment letters. The content analysis shows that nearly half of all comments involve accounting application, financial reporting, and disclosure issues. More than 17 percent of our sample cases result in immediate amended filings to resolve the issue(s) arising from the comment letters, and financial statements and/or footnotes are frequently revised. Following comment letter resolution, the adverse selection component of the bid-ask spread declines and Earnings Response Coefficients (ERCs) increase. Our results provide little support for the conjecture that the market interprets the receipt of a comment letter as a signal that the firm has poor reporting quality. Finally, we find no evidence that comment letter firms increase the quantity or change the type of voluntary disclosure, thereby eliminating a possible competing explanation for the improved information environment. We conclude the SEC's oversight has beneficial informational effects.

Jorgensen, B. N. and J. Morley (2017). "Discussion of “Are Related Party Transactions Red Flags?”." Contemporary Accounting Research 34(2): 929-939.

Kohlbeck and Mayhew () create a new data set featuring two types of related party transactions. They use empirical-archival methods to investigate the effect of such transactions on the likelihood of restatements and on audit fees. Their findings suggest that related party transactions related to directors, officers and major shareholders are associated with poor “tone at the top” and that this leads management to negotiate for lower-quality audits to minimize monitoring costs. To offer avenues for future research, we focus our discussion on three aspects of their paper related to causality, definitions of variables, and generalizability to non-U.S. jurisdictions.

Kohlbeck, M. and B. W. Mayhew (2017). "Are Related Party Transactions Red Flags?" Contemporary Accounting Research 34(2): 900-928.

This study investigates whether or not related party transactions serve as “red flags” that warn of potential financial misstatement. We hand-collect related party transactions for S&P 1500 firms in 2001, 2004, and 2007 and find a positive correlation between these transactions and future restatements, suggesting restatements are more likely when a firm engages in related party transactions. The association is concentrated among transactions that appear to reflect “tone at the top” rather than arguably more necessary business transactions. We also find RPT firms pay lower audit fees. However, “tone RPT” firms that subsequently restate pay higher audit fees, providing evidence that auditors recognize the individual restatement risks of these firms. Our results suggest that tone-based RPTs serve as signals of higher risk of material misstatement.

Perreault, S., et al. (2017). "The Relative Effectiveness of Simultaneous versus Sequential Negotiation Strategies in Auditor-Client Negotiations." Contemporary Accounting Research 34(2): 1048-1070.

Since most audit engagements identify multiple proposed audit adjustments, auditors must decide how best to present and negotiate these adjustments with their clients. Prior research indicates that auditors can negotiate adjustments individually (a sequential strategy) or can negotiate multiple adjustments within the same negotiation setting (a simultaneous strategy). This paper examines the relative effectiveness of a simultaneous versus sequential negotiation strategy in eliciting concessions from clients and engendering greater client satisfaction. Participants negotiated audit adjustments with a simulated auditor who employed one of the two negotiation strategies. We find evidence that a simultaneous strategy elicits significantly greater total concessions from client managers and also generates more positive attitudes toward the auditor. We also manipulate the magnitude of the issues negotiated and find that significantly greater concessions are offered when larger issues are presented first. These findings have important implications for auditors, as they suggest that negotiating issues simultaneously and presenting larger issues first can result in significantly improved negotiation outcomes.

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