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Review of Quantitative Finance and Accounting

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01-04-2013 | Original Research

Do abnormal accruals affect the life expectancy of audit engagements?

Authors: Steven Lustgarten, John Shon

Published in: Review of Quantitative Finance and Accounting | Issue 3/2013

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Abstract

We examine the cross-sectional determinants of audit engagement length, paying particular attention to abnormal accruals as a potential driver. We are interested in how the potentially incongruent incentives of managers and auditors can cause frictions, and in turn affect the audit engagement’s life expectancy. We estimate a hazard model in the form of a multi-period logit model, allowing us to estimate (the inverse of) the life expectancy of audit engagements. We find that audit engagement life expectancy at any age decreases when firms make relatively large positive or large negative abnormal accruals. One interpretation of these results is that large positive (negative) abnormal accruals make the auditor (client) more likely to terminate the engagement. Conversely, smaller abnormal accruals reflect a compromise which extends the life of the engagement. Our results are robust to several alternative specifications and controls. However, because there is no complete theoretical model that explains audit engagement length, our results should be interpreted with caution.

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E.g., Wall Street Journal, 4/25/1997, “More Accounting Firms Are Dumping Risky Clients.”.

The authors are careful not to interpret strict causality, and therefore discuss the association between accruals and tenure. However, they conclude that “auditors appear to place greater constraints on both income-increasing and income-decreasing accruals as the auditor–client relationship lengthens.” One interpretation of their results is that relatively moderate accruals are the effect of increasing engagement tenure (similarly, Johnson et al. 2002). However, our results (where future expected tenure is regressed on abnormal accruals) suggest an alternative story: perhaps relatively moderate accruals are the cause of the longer tenure.

Auditors’ need to balance the desire to minimize litigation exposure and reputation damage with the need to retain clients has been noted by Arthur Levitt, former Chair of the SEC: “This is the pattern that earnings management creates: companies try to meet or beat Wall Street earnings projections… Auditors, who want to retain their clients, are under pressure not to stand in the way (emphasis added).” Levitt expresses the concern that auditors may overlook earnings management in hope of extending the audit engagement (e.g., DeAngelo 1981).

Specifically, Antle and Nalebuff posit that the accruals ultimately reported in a firm’s financial statements can be viewed as a “joint statement” of the auditor and the firm—a result of accounting choices made by managers, but ultimately negotiated with the auditors.

To retain/earn the current year’s audit fees, the auditor may allow the income-increasing accruals to be recognized, and then subsequently resign from the engagement. If the auditor is extremely against certain accruals, he/she may resign from the engagement before the annual audit is complete such that a new auditor must be found; but such resignation would certainly mean a forgoing of a non-trivial portion of the audit fees.

The full text of this Act is available at: http://www.sec.gov/about/laws/iaa40.pdf. Sections 302 and 404 deal with internal controls. See also, Doyle et al. (2008, p. 1).

For our original sample, we also exclude observations from audit engagements that start prior to 1988 (since the true start date of such engagements is not 1988 and therefore the baseline hazard is would be measured with bias); results are unchanged.

Altman’s Z-score is calculated as: 1.2 * (net current assets/total asset) + 1.4 * (retained earnings/total assets) + 3.3 * (operating income/total assets) + 0.6 * (equity market value/total liabilities) + (revenues/total assets).

High litigation risk industries are determined from the ex post rate of lawsuits in each industry, as determined by prior studies (see, e.g., Francis et al. 1994). These industries include SIC codes: 2833–2836, 3570–3577, 3600–3674, 5200–5961, 7370–7374, 8731–8734.

High litigation risk years are determined from the ex post rate of lawsuits in each year as well as the nature of certain court case proceedings, as determined by prior studies (see Kothari et al. 1988). These years are: 1975, 1983–1985, 1988–1991, 2002–2009; results are robust to excluding 2002–2009 as high litigation years.

The model (estimated at the two-digit SIC industry-year level) is: TACC_t = β₁ INT_t + β₂ ΔREV_t + β₃ PPE_t + β₄ NI_t + ε_t. Where TACC = change in non-cash current assets — change in current liabilities + change in current portion of long term debt — depreciation expense), INT_t = 1, ΔREV_t = change in revenues—change in accounts receivable, PPE = property, plant, and equipment, NI = net income. All variables are scaled by lagged total assets. In robustness tests, we also estimate the model using the Fama and French (1997) 48 industry classification; results are unchanged.

To control for this possibility, we use performance adjustment procedures for our estimation of abnormal accruals (and in robustness tests, also use performance-matched accruals as per Kothari et al. 2005). However, to the extent that these procedures are insufficient, we include these further controls in our main hazard model. In untabulated robustness tests, we have also included proxies for the level and changes in operating cash flows.

Higher values of DCRATIO and DALTMAN_Z indicate less financial distress and longer life expectancy while higher DLEVERAGE indicates more financial distress and shorter life expectancy.

Big-N auditors are also more skilled and have larger resources and are therefore more likely to find unexpected income-increasing earnings management (e.g., Li et al. 2008). Moreover, this can also affect the managers’ incentives to try to carry out earnings management, since such actions are more likely to be discovered by Big-N auditors; however, this should be part of the ex ante contracting before the engagement was signed.

Alternatively, a decrease in the number of clients may signal involuntary dismissals from clients, prompting the auditor to increase efforts to retain the remaining number of clients. Conversely, an increase in the number of clients may put a strain on the auditor’s resources, thus increasing the likelihood of the auditor resigning from other engagements.

Kothari et al. (2005, 167) argue that performance-matched discretionary accrual measures are more reliable indicators of earnings management in specific cases when using non-random samples of firms. Because we examine all audit engagements, we do not have a non-random sample, and choose to include a performance adjustment into the estimation model itself in lieu of performance matching.

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Title: Do abnormal accruals affect the life expectancy of audit engagements?
Authors: Steven Lustgarten
John Shon
Publication date: 01-04-2013
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 3/2013
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-012-0276-1

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