Auditing, Auditor decision making, Uncertainty qualifications, Auditor decision aid

[Watts and Zimmerman [1978] tested their theory regarding management preferences over accounting standards using submissions on the General Price Level Discussion Memorandum. We first replicate the Watts-Zimmerman study using the same sample and then compare these results with identical tests based on a larger sample comprised of Exposure Draft submissions. Several biases are identified in the Watts-Zimmerman test procedures. When corrected, the theory's classificatory power deteriorates significantly on both the DM and ED samples. Alternative measurements of the predictor variables are introduced, as well as additional tests, in an attempt to improve the theory's performance. However, the theory's performance remains unimpressive.]

ABSTRACT The adoption of business risk audit (BRA) approaches during the 1990s by several leading audit firms has been the subject of considerable scrutiny and commentary. Under BRA, the auditor responds to the increasing complexity of auditee financial reports by acquiring a deep and comprehensive understanding of the auditee's industry, strategy, business models, and processes—tasks best accomplished by higher‐ranked labor—and by employing this understanding to make audit labor allocations. Using proprietary data for 165 audits conducted in 2002, we investigate three propositions about audit labor use under BRA. First, relative to pre‐BRA benchmarks for the same auditor, we expect BRA audits to use a greater proportion of higher‐ranked labor. Second, we expect engagements with high assessed auditor business risk (ABR), a summary risk assessment that reflects the BRA auditor's rich understanding of the auditee, to be allocated more labor and more higher‐ranked labor than pre‐BRA benchmarks. Third, at all ranks of labor, we expect a positive association between assessed ABR and levels of labor use. We find empirical evidence consistent with these propositions. We also find that total labor use in our sample is only modestly lower than pre‐BRA norms. Analysis of fee data from these engagements suggests that audit fees in 2002 are substantially less than would be expected under pre‐BRA benchmarks. After controlling for audit labor use, both total fees and fees per hour increase with assessed ABR for first‐year auditees but not for continuing auditees. Overall, our results provide evidence on the impact of the BRA audit regime and speak to the likely impact of BRA on audit effectiveness and efficiency.

Abstract ABSTRACT: Watts and Zimmerman [1978] tested their theory regarding management preferences over accounting standards using submissions on the General Price Level Discussion Memorandum. We first replicate the Watts-Zimmerman study using the same sample and then compare these results with identical tests, based on a larger sample comprised of Exposure Draft submissions. Several biases are identified in the Watts-Zimmerman test procedures. When corrected, the theory's classificatory power deteriorates significantly on both the DM and ED samples. Alternative measurements of the predictor variables are introduced, as well as additional tests, in an attempt to improve the theory's performance. However, the theory's performance remains unimpressive.

ABSTRACT We use data from internal assessments of audit quality in a Big 4 firm to investigate the impact of audit firm tenure and auditor‐provided non‐audit services (NAS) on audit quality. We find that first‐year audits receive lower assessments of audit quality and that quality improves shortly thereafter and then declines as tenure becomes very long. Partitioning our sample between SEC registrants and private clients, we find that the decline in audit quality in the long tenure range is attributable to audits of private clients. For audits of SEC registrants, the probability of a high quality audit reaches its maximum with very long tenure. We also find that audit fees are discounted for first‐year audits but auditor effort is higher than in subsequent years. We find no association, on average, between total NAS fees and audit quality in the full sample but observe that total NAS fees are positively associated with quality for SEC registrants and negatively associated with quality for privately held clients. Our findings are important for regulatory policies related to audit firm tenure and auditor‐provided NAS.

This study analyzes the relation between auditors' perceived business risk and audit fees to determine whether audit firms or their clients bear the expected legal costs of business risk. We predict that hourly audit fees and the number of audit hours are increasing in business risk. Using confidential survey data collected by a large international accounting firm for 422 audits, we find that high business risk increases the number of audit hours, but not the fee per hour. This implies that firms perceive firm‐level differences in business risk and obtain compensation through billing additional hours, not by raising the hourly charge.

We use the Ohlson (1995, 1999) and Feltham and Ohlson (1999) valuation models to investigate the market's perception of the economic effect of employee stock options (ESOs) on firm value for a sample of 85 profitable computer software companies. Our results suggest that the market appears to value these firms' ESO expense not as an expense but as an intangible asset (even after controlling for the endogeneity bias arising from the mechanical relation between ESOs and the underlying stock prices). However, we also find a conflict between: (1) the positive manner in which investors appear to value ESO expense, and (2) the negative relation between current ESO expense and future abnormal earnings. This conflict not only could be an artifact of the restrictiveness of the abnormal earnings forecasting equation we estimate, but it also calls into question whether investors assess correctly the effect of ESOs on profitable software firm value.