Abstract The SEC and FASB recently expressed concerns that investors do not fully assimilate all of the information provided by complex and incomplete derivatives and other comprehensive income ( OCI ) disclosures. My evidence supports these concerns. Specifically, I examine the information content of unrealized cash flow hedge gains/losses for future profitability and stock returns. An unrealized gain on a cash flow hedge suggests that the price of the underlying hedged item (i.e., commodity price, foreign currency exchange rate, or interest rate) moved in a direction that will impair the firm's profits after the hedge expires. Consequently, I find that unrealized cash flow hedge gains/losses are negatively associated with future gross profit after the firm's existing hedges have expired. This association only holds after the firm has reclassified its hedges into earnings, and is weaker for firms that can pass input price changes on to their customers. Finally, investors do not immediately price the cash flow hedge information. Instead, investors appear surprised by future realizations of gross margin, consistent with the view that complex and incomplete disclosures delay pricing. These results are relevant to policymakers involved in the current FASB and IASB project designed to simplify the accounting and disclosure for derivatives and, in particular, cash flow hedges.

Abstract. This paper describes a psychological framework that examines auditors' conceptions of independence in the context of ethical cognition. An experimental study of independence judgments of 119 partners and managers in two national public accounting firms is reported. Using a well‐known measure of ethical cognition, this study examines auditors' implicit reasoning in the resolution of an independence paradigm. The most significant are that (1) a systematic relationship between auditors' measured ethical cognition and their resolution of an independence conflict exists, (2) the penalty attribute is a much stronger influence than the affiliation attribute on the auditors' ethical resolve, and (3) the cognitive measure used in this study can be used efficiently to explain priority rankings of a majority of independence attributes developed in earlier research. Résumé. Les auteurs décrivent ici une grille psychologique permettant d'analyser la façon dont les vérificateurs conçoivent l'impartialité dans le contexte de la conscience éthique. Ils font état des résultats d'une étude expérimentale des jugements d'impartialité de 119 associés et chefs de groupe attachés à deux cabinets d'experts‐comptables nationaux. Utilisant une mesure bien connue de la conscience éthique, les auteurs ana‐lysent le raisonnement implicite des vérificateurs dans la résolution d'un paradigme d'impartialité. Les principaux résultats de l'étude sont les suivants: 1) il existe une relation systématique entre la conscience éthique mesurée chez les vérificateurs et la façon dont ils résolvent un problème d'impartialité, 2) l'attribut « sanction » a sur la décision éthique des vérificateurs une influence beaucoup plus grande que l'attribut « affiliation » et 3) la mesure cognitive utilisée dans cette étude est efficace dans l'explication des classements de la plupart des attributs d'impartialité définis dans le travaux de recherche antérieurs.

Abstract This study investigates whether an individual's status as a current or a prospective investor affects the investor's susceptibility to earnings fixation and proposes a mechanism to reduce earnings fixation. Our experimental results suggest that current investors are more susceptible to earnings fixation than prospective investors, and that current investors can reduce earnings fixation by explicitly forecasting future earnings as part of their evaluation process. We provide theory‐consistent evidence that current investors' prevention focus makes them elevate the importance of summary earnings in their evaluation of a company. However, after forecasting future earnings, current investors view summary earnings as only one of several similarly important evaluation inputs rather than as one substantially more important input (relative to its components). Our study contributes to research on earnings fixation and investor status. We also contribute to practice by documenting the moderating effect of investor status on earnings fixation and by identifying a simple mechanism that current investors can use to reduce their susceptibility to earnings fixation.

This study uses a unique institutional setting in China to investigate empirically the association between the organizational form of CPA firms (unlimited liability versus limited liability) and the reporting conservatism of auditors. Based on a sample of 5,007 audits of Chinese listed companies from the period of 2000 to 2004, we find that auditors in unlimited liability partnership firms are more likely to issue modified audit opinions than are auditors in limited liability CPA firms. This auditor conservatism stems from distressed firms with going-concern opinions, and we find no statistical evidence that partnerships give more modified opinions for non-distressed firms. In addition, auditors are less likely to issue modified reports after they incorporated the firm in the limited liability form. These analyses support our hypothesis that a limited liability regime induces lower auditor reporting conservatism. Our study contributes to the broader debate on liability reform in the auditing profession.

Abstract. The purpose of this paper is to describe certain aspects of specialized knowledge communication in auditing. The paper discusses the possible organizational responses an audit firm could make when competitive markets require efficient knowledge sharing among auditors and when economies of scale opportunities through division of responsibilities exist. Experienced auditors were surveyed about their consultation with others in their firms for specific types of clients and for different phases of audit engagements. In general, the results suggest limits to expertise‐related economies of scale in the audit setting studied. The required specialized knowledge seems to be close at hand and accessible in most engagements with little need to consult with nonlocal specialists. When consulted, however, the nonlocal specialists are believed to convey important information. Résumé. Les auteurs ont pour but de décrire certains aspects de la communication de connaissances spécialisées en vérification. Ils traitent des différentes réponses organisation‐nelles que peut donner un cabinet de vérification aux exigences des marchés concurrentiels relatives au partage efficient des connaissances chez les vérificateurs et à la possibilité de réaliser des économies d'échelle grâce au partage des responsabilités. Les auteurs ont interrogé des vérificateurs expérimentés dans le but de déterminer s'ils consultaient d'autres vérificateurs de leur cabinet au sujet de certains types précis de clients et pour différentes phases des missions de vérification. De façon générale, les résultats obtenus donnent à penser que les économies d'échelle reliées à l'expertise dans les contextes de vérification étudiés sont limitées. Dans la plupart des missions, il semble que les connaissances spécialisées requises soient à portée de la main et facilement accessibles, sans qu'il soit nécessaire de consulter des spécialistes de l'extérieur. On croit cependant que les spécialistes de l'extérieur livrent de l'information importante lorsqu'ils sont consultés.

Abstract This study examines the relation between audit quality and earnings management. Consistent with prior research, we treat audit quality as a dichotomous variable and assume that Big Six auditors are of higher quality than non‐Big Six auditors. Earnings management is captured by discretionary accruals that are estimated using a cross‐sectional version of the Jones 1991 model. Prior literature suggests that auditors are more likely to object to management's accounting choices that increase earnings (as opposed to decrease earnings) and that auditors are more likely to be sued when they are associated with financial statements that overstate earnings (as compared to understate earnings). Therefore, we hypothesize that clients of non‐Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accruals reported by clients of Big Six auditors. This hypothesis is supported by evidence from a sample of 10,379 Big Six and 2,179 non‐Big Six firm years. Specifically, clients of non‐Big Six auditors report discretionary accruals that are, on average, 1.5‐2.1 percent of total assets higher than the discretionary accruals reported by clients of Big Six auditors. Also, consistent with earnings management, we find that the mean and median of the absolute value of discretionary accruals are greater for firms with non‐Big Six auditors. This result also indicates that lower audit quality is associated with more “accounting flexibility”.

The issue of whether auditor fees affect auditor independence has been extensively debated by regulators, investors, investment professionals, auditors, and researchers. The revised Securities and Exchange Commission ( SEC ) requirements that resulted from the implementation of the Sarbanes‐Oxley Act (2002) limit nonaudit services ( NAS ) and mandate NAS fee disclosure. The SEC 's requirements are based on the argument that auditor independence could be impaired—and hence audit quality may be reduced—when auditors become economically dependent on their clients or audit their own work. Economic bonding leads to reduced independence, which can lead to reduced audit quality. We study a sample of firms sanctioned by the SEC for fraudulent financial reporting in Accounting and Auditing Enforcement Releases ( SEC ‐sanctioned fraud firms) and examine whether there is a relationship between auditor fee variables and the likelihood of being sanctioned by the SEC for fraud. We use SEC sanction as a measure of audit quality that has not previously been used in the auditor fee literature and is more precise than some of the other proxies used for flawed financial/auditor reporting. We find, in univariate tests, that fraud firms paid significantly higher (total, audit, and NAS ) fees. However, in multivariate tests, when controlling for other fraud determinants and endogeneity among the fraud, NAS , and audit fee variables, we find that while NAS fees and total fees are positively and significantly related to the likelihood of being sanctioned by the SEC for fraud, audit fees are not. These findings suggest that higher NAS fees may cause economic bonding, thereby leading to reduced audit quality. Our findings of significantly higher NAS fees and total fees in fraud firms hold after controlling for latent size effects and other rigorous testing. These results contribute to the literature that examines the SEC 's concerns regarding NAS and can be used by policy makers for additional consideration.