Reviews the book `The Accountant's Guide to Legal Liability and Ethics,' by Mark J. Epstein and Albert D. Spalding, Jr.

[The literature on the audit market has suggested that a valued attribute of audits is implicit insurance. The insurance stems from the investor's right to recover from auditors the losses sustained by relying on audited financial statements that contain misrepresentations. This "insurance hypothesis" has proven difficult to test empirically, despite the widespread evidence of litigation against auditors. In this paper we provide some empirical support, showing that investors assign a value to the right to recover investment losses from the auditor. We examine the effect on stock prices of Laventhol & Horwath (L&H) clients of two related events: first, the disclosure of their auditor's bankruptcy, and second, the appointment of a successor auditor. L&H's bankruptcy is a rare instance in which the insurance protection provided by the auditor was suddenly withdrawn and the ability of investors to recover losses from the auditor was significantly curtailed. We argue that the value assigned by investors to the right to recover potential losses from the auditor is a component of the stock price, and hypothesize that it varies with the likelihood that the right will be exercised. It is expected to increase with increasing magnitude of stock price declines and to be greater for recent initial public offerings (IPOs) than for seasoned securities. The results suggest that the disclosure of L&H's bankruptcy had an adverse effect on market prices of L&H clients. As hypothesized, the effect varied with previously incurred price declines, and was greater for IPOs. To more distinctly separate insurance and monitoring effects, we also examined the market reaction to clients' announcements of a replacement auditor. No significant reaction was observed, which is consistent with the insurance hypothesis. Overall, the results of the paper provide some empirical support for the theory that investors view the audit product as including insurance against potential investment losses.]

[Litigation risk is a significant and increasing concern for U.S. public accounting firms. Ernst & Young's recent 400 million settlement with the FDIC is an indication of the magnitude of the problem facing the Profession. A recent survey conducted by the AICPA shows that malpractice insurance premiums for CPA firms other than "Big 6" have increased 300 percent since 1985, while deductibles have increased almost six times. Forty percent of those firms surveyed are "going bare" due to the high cost of liability insurance. extasciicircum\1\ In addition, partners from Laventhol & Horwath, previously the seventh largest accounting firm in the U.S., cited litigation claims against their firm in their decision to declare bankruptcy, and Palmrose (1988) notes that litigation against an audit firm can impair its reputation by providing a negative signal about the quality of the firm's audit services. In an effort to combat the increasingly litigious business environment, the "Big 6" recently issued a Statement of Position which has been distributed to audit clients, accounting faculty, state and federal legislatures, and members of selected government organizations. extasciicircum\2$ In such an environment, it is important that auditors be able to effectively screen potential clients and accurately assess litigation risks. Indeed, many accounting firms already appear to be more carefully screening new clients and rejecting some who, prior to the litigation explosion, would have been accepted. The purpose of this study is to examine this screening process, and to determine whether auditor judgments of litigation risk and their recommendations for the preliminary audit plan and client fees are influenced by certain client characteristics that have been empirically related to audit litigation in the accounting literature. Specifically, we hypothesize that client financial condition, asset structure (proportion of receivables and inventory to total assets), sales growth, market value of equity, and variability in stock price returns relate to auditor judgments of litigation risk, to their recommendations for the amount of evidence required to reduce the risk of a material misstatement to an acceptable level, and to client fees. The hypotheses are tested in a field experiment where 243 audit partners and managers of four "Big 6" firms from offices throughout the U.S. were each asked to review a single case describing a prospective audit client, and then (1) assess certain elements of litigation risk associated with the engagement, (2) evaluate the financial condition of the client, and make recommendations for (3) the required amount of audit evidence and (4) client fees. Asset structure, sales growth, firm market value, and stock return variability were each assigned two levels (high/median) in the between-subjects experimental design, giving rise to 16 versions of the case which were distributed randomly across the subject sample. The results indicate that the client's overall financial condition is the primary consideration in the auditor's assessment of litigation risk and recommendations for the audit plan and fees. Poorer financial condition was associated with higher levels of litigation risk, more audit evidence, and higher audit fees. The results for asset structure (receivables and inventory as a percentage of total assets) were generally consistent with the hypotheses and with the results for financial condition, though much weaker. Client market value and sales growth were generally unrelated to litigation risk, and the variability of the client's stock price was either ignored or viewed as relating negatively to litigation risk. Additional tests suggest that audit fees reflect both the amount of audit evidence collected and an additional premium to cover litigation risks. That is, auditor assessments of a client's overall litigation risk explained a significant amount of the variance in audit fees over and above the amount explained by audit evidence, suggesting that auditors may be charging clients to insure against future litigation losses. The evidence does suggest, however, that the portion of the audit fee constituting the insurance premium is unrelated to the client characteristics examined in this study. Identifying the client characteristics that relate to the insurance premium may be an important area for future research. In the next section, prior research is reviewed and its relationship to the design of the reported study is explained, followed by descriptions of the theoretical model and related hypotheses. The data collection and analysis procedures are then described, and the paper closes with a discussion of the results and implications.]

Examines and determines the effect of client characteristics on auditor judgments in litigation risks. Financial condition considerations; Audit fees; Effect of rate of growth and market value to litigation risks; Table showing the summary of dependent and independent variables.

[Recently, management accountants have focussed attention on the appropriate treatment of costs associated with resources committed to support activities which do not vary proportionally to production once initial capacities have been set. In one typical case, it is assumed that costs of committed resources will be incurred irrespective of actual usage, and increasing initial capacities to accommodate unexpected demand involves penalties above normal costs. There are at least two important issues that arise in such a case: (1) how should costs of resources committed to, or subsequently required by, support activities enter into pricing and capacity decisions, and (2) what information should the accounting system provide to marketing and production in order to implement those decisions. Our objective in this paper is to address these two issues. The basic tension which underlies both pricing and capacity decisions is between the nonrecoverable cost of adding capacity before demand becomes known, and the expected penalty-adjusted cost of doing so after demand becomes known. In regard to the first issue, we find in our setting that only normal cost enters into pricing rules established at the time initial capacities are set. (Penalties for exceeding initial capacities are implicit in that for the marginal unit of each activity, normal cost equals expected penalty-adjusted cost.) Findings on the second issue are that the product costing system can be designed without knowledge of demand parameters; the marketing manager only requires activity-based unit costs provided by that system, along with knowledge of demand parameters, to make pricing decisions which are optimal from a firm-wide standpoint; and the production manager only needs expected demand from marketing, along with knowledge of the distribution of random demand shocks, and cost and production parameters, to make initial capacity decisions. The economic sufficiency of the activity-based unit cost in pricing decisions is in the spirit of Amershi et al. (1989), while the equivalence of marginal cost, normal cost, and expected penalty-adjusted cost of under-capacity bear similarity to results in studies by Miller and Buckman (1987), Whang (1989) and Hansen and Magee (1993). The main distinctions between these studies and ours lie in assumptions regarding production functions, the nature of information asymmetries, and our incorporation of pricing decisions as well as capacity decisions.]

Reviews the book `The Benchmarking Management Guide,' from the American Productivity & Quality Center.

[In this study, we extend existing municipal audit fee models (e.g., Rubin 1988; Baber et al. 1987) by incorporating additional variables that reflect unique aspects of the municipal accounting and auditing environment. These variables relate to auditor expertise, audit adjustments, audit qualifications, and measures of agency costs related to the level of taxpayer funding of services. We test our model on a sample of Michigan municipalities and find that the fee model explains a greater portion of the variation in audit fees than previous studies. Palmrose (1986) did not find a significant relationship between audit fees for private sector companies and measures of auditor industry experience. In a study of auditors of Texas school districts, Deis and Giroux (1992a) find that audit quality is positively associated with the number of school districts audited by the audit firm. In our study, the regional audit firm with the largest number of municipal clients received significantly higher fees. This result is consistent with the existence of a fee premium due to brand-name reputation based on industry experience. Previous research has not documented reputation effects for non-Big 6 firms. We also find that audit fees are positively associated with the number of audit adjustments. Many of the governmental entities in our sample have significantly more audit adjustments than entities in the private sector (Kreutzfeldt and Wallace 1986; Hylas and Ashton 1982), suggesting that there is opportunity for improvement in many municipal accounting and control systems. The frequency and nature of audit adjustments in the public sector may be an area of future research interest. Previous studies of municipal audit fees (Baber et al. 1987; Rubin 1988; Copley 1989) have not found a significant relationship between audit qualifications and audit fees. We separate audit qualifications into two types of qualifications expected to have different relationships to audit fees. However, neither qualification variable is found to be significantly related to audit fees. The frequent nature of opinion qualifications in the municipal sector suggests that these qualifications may not involve significant amounts of additional audit effort. We find some evidence that audit fees are positively related to agency variables which measure the extent of taxpayer funding of services (Copley 1991; Deis and Giroux 1992b). These variables may capture elected officials' incentives to demonstrate accountability to taxpayers. We do not find a relationship between audit fees and measures of agency costs related to the form of government. We also do not find a relationship between audit fees and measures of political competition. Future research should consider a broader set of incentives for monitoring in the public sector, including agency costs which measure taxpayer funding of services.]

Examines relationships between support activity costs and prices. Assumptions and definitions for various components of the cost and demand functions; Optimal pricing and capacity decisions of a centralized monopolist firm; Activity-based unit costs.

Develops a municipal audit fees model which incorporates additional variables that reflect unique aspects of the municipal accounting and auditing environment. Fee model for a sample of Michigan municipalities; Association of audit fees with the number of audit adjustments; Agency and political costs; Political competition; Auditor experience; Opinion qualifications.

Examines the effect Laventhol & Horwath's (L&H) disclosure of their auditor's bankruptcy and the appointment of a successor auditor on the company's stock prices. Insurance hypothesis; Investors' assignment of a value to the right to recover investment losses from the auditor; Adverse effect of bankruptcy disclosure on market prices of L&H clients.