Journal of Accounting and Economics201254(2-3), 174-179
In their investigation of UK auditors that voluntarily switch from unlimited to limited liability, Lennox and Li (in this volume, The consequences of protecting audit partners' personal assets from the threat of liability. Journal of Accounting and Economics) provide new insights into a fundamental issue related to audit quality. This discussion attempts to place Lennox-Li into the broader auditing literature and to consider what we learn from their analysis.
Journal of Accounting and Economics201049(1-2), 104-108
In their investigation of the new PCAOB Inspections, Lennox and Pittman [Lennox, C., Pittman, J., 2009. Auditing the auditors: evidence on the recent reforms to the external monitoring of the audit firms. Journal of Accounting and Economics, forthcoming] address one of the most important and controversial features of the recent shift from self-regulation to government regulation in the US audit markets. In this paper I attempt to place their investigations into the broader auditing and regulatory literature, critique what we learn and do not learn from their analysis, and make suggestions for future related research.
Journal of Accounting and Economics201050(2-3), 402-409
This discussion makes several observations regarding the earnings quality research reviewed in Dechow, Ge and Schrand (2010) (DGS). I discuss some of the factors that led to the large growth in the earnings quality literature over the past two decades, and note a few of the important contributions from this literature. I also present what I view as several major challenges the literature faces as well as some avenues for future research. In addition, I discuss the difficulties in evaluating such a diverse body of literature, and comment on DGS’s major conclusions.
[Accounting Principles Board (APB) Statement No. 20 (1971) defines financial statement errors as items resulting "from mathematical mistakes, mistakes in the application of accounting principles, or the oversight or misuse of facts that existed at the time the financial statements were prepared" (APB 20, par. 13). This definition encompasses both intentional and unintentional misrepresentation by management. Errors affecting previously reported earnings are revealed as prior period adjustments as specified in Statement of Financial Accounting Standards No. 16 (1977). If the erroneous year's financial statements are presented, retroactive restatement is required (in accordance with APB 9 1966). Footnote disclosure of the nature of the error and its effect on earnings, earnings before extraordinary items, and earnings per share is also required. Although financial statement disclosures generally provide no indication that prior errors were intentional, they may be motivated by the same types of economic incentives influencing managers' choices of accounting methods or management of accruals. In this study, we examine the incidence of accounting errors revealed by prior period adjustments for 41 firms in comparison with a control group of another 41 firms. This comparison is used to highlight circumstances that are likely to motivate managers to use errors as an income management tool. While corrections of prior year earnings are rare for both over- and understatement errors, the latter are relatively less frequent. Our investigation revealed 41 overstatement firms but only three understatement firms, which is consistent with an income-increasing motivation. Because of the very small number of understatements, the analysis is limited to overstatement errors. We find that the earnings overstatements are negatively correlated with the growth in earnings. Analysis also indicates that earnings overstatements are more likely when firms have diffuse ownership, lower growth in earnings, and fewer income-increasing GAAP alternatives available. Overstatements are less likely among firms that have audit committees. These results are generally consistent with the view that overstatement errors are the result of managers responding to economic incentives.]
Journal of Accounting and Economics199417(1-2), 145-176
This paper examines the abnormal accruals of a sample of 94 firms that reported debt covenant violations in annual reports. We expect debt covenant restrictions to influence accounting choices in the year preceding and the year of violation. Time-series and cross-sectional models are used to estimate ‘normal’ accruals. In the year prior to violation, both models indicate that ‘abnormal’ total and working capital accruals are significantly positive. In the year of violation, there is evidence of positive abnormal working capital accruals after controlling for management changes and auditor going concern qualifications.
The Securities and Exchange Commission requires disclosure of auditor‐client disagreements that precede a change in auditor. Although prior research has documented that disclosure of disagreements is associated with a decline in equity value, no empirical work has examined factors that result in auditor‐client disagreements. We hypothesize that managers are motivated by debt and compensation arrangements to propose methods that are objected to by their auditors (resulting in a disagreement). Because of their greater independence, we also hypothesize that reported disagreements will be more likely for Big Eight (now Big Six) auditors, A comparison of 40 firms that changed auditors and reported a disagreement with a control group of 40 firms that simply changed auditors revealed that disagreement firms are more likely to have debt covenant violations. Disagreement firms are also more likely to have higher leverage, a decline in earnings, and Big Eight auditors. For firms that disclosed the magnitude of the disagreement's effect on earnings, the use of the questionable procedure tended to enhance “flat” earnings growth. Résumé. La Securities and Exchange Commission exige que soit publiée l'information relative aux désaccords vérificateur‐client qui précèdent un changement de vérificateurs. Bien que les recherches antérieures aient démontré que la publication de cette information est accompagnée d'un déclin de la valeur des titres, aucun travail empirique n'a examiné les facteurs qui sont à l'origine des désaccords vérificateur‐client. Les auteurs posent l'hypothèse selon laquelle ce sont le passif et les régimes de rémunération qui motivent les gestionnaires à proposer des méthodes auxquelles s'opposent les vérificateurs (et qui donnent lieu à un désaccord). Les auteurs posent également l'hypothèse selon laquelle il est plus probable que les désaccords déclarés mettent en cause les huit grands cabinets d'experts‐comptables (maintenant les six grands), étant donné leur indépendance plus grande. La comparaison de 40 entreprises ayant changé de vérificateurs et fait état d'un désaccord à un groupe de contrôle de 40 entreprises ayant simplement changé de vérificateurs a révélé que les entreprises en désaccord sont davantage susceptibles d'avoir dérogé à des clauses restrictives. Les entreprises qui déclarent être en désaccord avec leurs vérificateurs sont aussi davantage susceptibles d'être caractérisées par un levier financier élevé, un déclin dans les bénéfices et le recours aux services d'un cabinet d'experts‐comptables appartenant aux huit grands. Dans le cas des entreprises qui ont fait état de l'ampleur des conséquences du désaccord sur les bénéfices, l'utilisation du procédé discutable a eu tendance à favoriser une croissance « horizontale » des bénéfices.
Journal of Accounting and Economics199927(1), 35-56
Relative performance evaluation (RPE) is likely to improve boards of director's ability to identify unfit CEOs, and competition is likely to enhance the usefulness of RPE. Consistent with our hypotheses, the frequency of CEO turnover is greater in highly competitive industries than in less competitive industries. We also find that RPE-based (firm-specific) accounting measures are more closely associated with CEO turnover in high (low) competition industries than in low (high) competition industries. These findings suggest that the lack of support for RPE in prior studies results from not considering the effects of competition.