We provide a litigation-based model for the relationship between auditor tenure (the length of an auditor-firm engagement) and financial reporting quality (the unbiasedness of financial report). Featuring audit as estimation and issuance by an auditor on its client’s earnings, we show that the auditor’s minimization of expected litigation costs from potential audit errors creates a downward bias in its attested report of earnings. In addition, we show that the magnitude of such downward bias declines as the auditor accumulates experience with its client over time (tenure improves reporting quality). To distinguish this litigation-induced result from the independence-driven explanation that also claims higher earnings for longer auditor tenure, we further our analysis by offering an identification mechanism which unveils a new result that for firms with increased litigation risks, longer auditor tenure increases the downward biases (tenure impairs reporting quality). Such an inverse U-shaped relationship derived from our theoretical model may reconcile much of the mixed evidence in prior empirical studies.

Auditors’ propensity to issue Going Concern Audit Reports (GCARs) is one of the proxies often used for audit quality. Although this propensity is a distinguishing characteristic of auditors, it does not indicate quality according to both theory and practice. In theory, higher quality auditors make fewer audit errors; they are more likely to issue GCARs to clients that deserve them and less likely to issue GCARs to clients that do not. Therefore, the propensity itself does not indicate quality. In practice, Public Company Accounting Oversight Board (PCAOB) inspection reports reveal that the GCAR is rarely mentioned as a deficiency, and in the few cases in which it is discussed, the deficiency is attributed to evidence gathering and estimations, rather than to the GCAR decision itself. The theory and practice motivate our study. This article investigates the empirical ability of the GCAR propensity to proxy for audit quality and finds that different samples and different models yield different determinations of auditor quality. Our findings caution against the use of the propensity to issue GCARs as a proxy for audit quality.

ABSTRACTMost studies on the impact of capital expenditure on future performance use the aggregate capital expenditure disclosed in the cash flow statement. In this study, however, we distinguish between growth capital investments (that increase production capacity) from nongrowth capital investments (that only maintain or reduce current capacity). For growth capital investments, we document a negative association with year‐ahead performance, which becomes positive in the subsequent year. For nongrowth capital investments, we observe a non‐negative association with year‐ahead performance. For nongrowth capital investments, we document a positive association, suggesting that the divestment is beneficial. That is, firms are likely disposing of nonproductive assets. Our results suggest that disclosing the nature of capital investments is important to better assess the future impact of a firm's investment decisions.

Most studies on the impact of capital expenditure on future performance use the aggregate capital expenditure disclosed in the cash flow statement. In this study, however, we distinguish between growth capital investments (that increase production capacity) from nongrowth capital investments (that only maintain or reduce current capacity). For growth capital investments, we document a negative association with year-ahead performance, which becomes positive in the subsequent year. For nongrowth capital investments, we observe a non-negative association with year-ahead performance. For nongrowth capital investments, we document a positive association, suggesting that the divestment is beneficial. That is, firms are likely disposing of nonproductive assets. Our results suggest that disclosing the nature of capital investments is important to better assess the future impact of a firm's investment decisions.

The extant auditing literature documents an inconsistent relationship between audit fees and market concentration. In this paper, we argue that the impact of market concentration on audit fees is auditor and auditee specific. Based on the fact that the audit services to an auditee are generally provided in their entirety by one auditor, we conjecture that the competition for an engagement is essentially based on costs (i.e., Bertrand competition) and that larger auditors are more efficient. Accordingly, we develop an audit fee determination framework that predicts that the disparity in sizes of the largest and the second-largest auditors result in differential audit fees charged by the largest auditor and other auditors. Since the concentration of an audit market is inherently associated with the size disparity in the market, our fee determination framework suggests that market concentration does not affect audit fees uniformly. Indeed, we document that market concentration increases the audit fees to auditees (in particular the large auditees) serviced by the largest auditor in a market and decreases the audit fees to all auditees serviced by other auditors. The results are consistent with our theory and explain the inconsistent empirical relationship between concentration and audit fees documented in the literature.

This study investigates whether and how market concentration (measured by the Herfindahl-Hirschman Index, hereafter HHI) affects competition in an audit market. In this paper, we argue that the impact of HHI on audit fees is auditor and auditee specific. Since market concentration is innately associated with two fundamental competitive factors - transaction costs and a tension between supply and demand, the market concentration does not uniformly affect the audit fees of all engagements in a market. Our results suggest that market concentration is positively associated with large auditors’ competitive positions and negatively associated with small auditors’ competitive positions in the market. Furthermore, increasing market concentration reduces the number of available suppliers to auditees, which in turn reduces the intensity of competition for the auditees, particularly for larger auditees. We conclude that market concentration is indeed relevant to market competition, but that its effects are not uniform on all engagements.

Using a sample of new bank loans, we investigate the impact of business risk on the usefulness of operating income after controlling for the proportion of independent directors. Consistent with the literature, our initial analyses reveal that the presence of independent directors on a board reduces the interest rate directly and indirectly through an increase in the usefulness of operating income. However, we further provide evidence that the indirect benefit of a high proportion of independent directors is reduced when we account for the presence of business risk. This suggests that studies examining the usefulness of operating income should take into account the effect of business risk. © 2018 ASAC. Published by John Wiley & Sons, Ltd.

We examine whether Asset Retirement Obligations (AROs) are value relevant to investors and credit market participants. Whereas prior research has examined the value relevance of environmental disclosures, we extend this line of inquiry by examining whether AROs are priced the same as other recognized liabilities that have less managerial discretion in their estimation. Using a sample of 1,076 mining and oil & gas observations for the equity market model, we provide evidence that even though AROs are value relevant, there is no distinction between AROs and other recognized liabilities. For the debt market, we find that the while AROs are priced by banks and affect companies’ credit ratings, their impact on interest rates and credit ratings is much less than that of other recognized liabilities.

We develop a measure to capture an audit firm's competitive position in a local audit market based on the transaction costs of changing audit firms included in DeAngelo's (1981) multi-period audit pricing model. Our competition measure reflects the size difference between the largest audit firm in a market specified by client industry at the city level and the other audit firms operating in that market. We find that audit fees of a client decrease as this size difference increases. This result suggests that smaller audit firms charge lower audit fees because of their competitive disadvantage to the local largest firm.

This paper examines the association between elements of the financial statement and the interest rates banks charge on loans. We examine whether the volatility of earnings and the probability of bankruptcy have an impact on banks' use of accounting information in setting the interest rates. The results suggest that while these accounting variables are associated with bank interest rates, the impact of the accounting variables is stronger when the volatility is lower. We also provide evidence that the association between bank interest rates and the net book value of assets and operating income is stronger when the probability of bankruptcy is low. This relationship is opposite for the presence of a loss. When the probability of bankruptcy is high, banks appear to focus less on the income statement and more on the balance sheet. This is likely due to the fact that the balance sheet provides an estimate of the liquidation value of the firm.

Prior studies in general suggest a positive association between auditor tenure (the length of an auditor–firm relationship) and reporting quality (the informational content of reported earnings). In this study, we present evidence that the association is reversed when clients represent increased litigation risks to their auditors. Featuring downward biases in reported earnings as a measure of reporting quality that stem from auditors’ minimization of costs from potential audit errors, we argue that the magnitude of such downward bias decreases in auditors’ experiences with their clients (tenure improves reporting quality). Furthermore, we predict that longer auditor tenure is associated with larger downward bias for firms with increased audit risks (tenure impairs reporting quality). Using non-operating accruals as proxy for downward bias in reported earnings, we find robust empirical evidence in support of our prediction.

This case has been developed for an introductory management accounting course at the undergraduate and MBA levels. Although the setting is relatively simple, it illustrates several management accounting issues that are relevant to firms of every size that produce a product or service under competitive pressures and capacity constraints. The case also integrates several topics that are often viewed as abstract by the students. Specifically, it deals with the concepts around cost-volume profit analysis in a realistic environment, the tension between short-term and long-term decisions, discounted cash flow analysis, the impact of managerial incentives and compensation on decision making and the impact of operating leverage on profitability. The case was used successfully several times in an introductory course at the MBA level. Surveys of the students reveal that the case has contributed significantly to their learning and has clarified the concepts introduced in the case.

This case has been developed for an introductory management accounting course at the undergraduate and MBA levels. Although the setting is relatively simple, it illustrates several management accounting issues that are relevant to firms of every size that produce a product or service under competitive pressures and capacity constraints. The case also integrates several topics that are often viewed as abstract by the students. Specifically, it deals with the concepts around cost-volume profit analysis in a realistic environment, the tension between short-term and long-term decisions, discounted cash flow analysis, the impact of managerial incentives and compensation on decision making and the impact of operating leverage on profitability. The case was used successfully several times in an introductory course at the MBA level. Surveys of the students reveal that the case has contributed significantly to their learning and has clarified the concepts introduced in the case.

This study uses a very simple but intuitive model to examine how audit quality is determined. It concludes that audit quality is higher if two forces have opposite effects on an auditor’s conservatism are balanced and significant. A force that makes an auditor less conservative is the benefit from future engagements with a client, while the force that makes the auditor more conservative is the expected liabilities from overstated accounting values. Given that the expected auditor’s liabilities from overstated accounting values are usually significant, we find that significant rents from future engagements with a client improve audit quality through inducing greater audit efforts and less biased reports. Our analysis suggests that learning costs and non-audit services would be sources for these future rents, and auditors should be allowed to provide non-audit services to their clients and these revenues should be higher as auditor tenure lengthens. Furthermore, our analysis shows that mandatory auditor rotation is detrimental to audit quality since it reduces the future rents to auditors which lead to lower audit effort and more biased report. Finally, well-developed auditing standards need to be properly enforced by the regulator/profession for auditors to render appropriate audit quality when the costs associated with over and under reporting are low and/or not balanced.

This paper uses a model extended from DeAngelo (1981) to examine audit market and audit pricing. When auditors have differential operational efficiencies, the audit market becomes delicate. On one hand, auditees would like to reduce audit fees by to purchasing audit services from the most efficient auditors. On the other hand, the competition in the market can be significantly reduced when there are few auditors in a market. The auditees can end up paying the highest fees despite the auditors are very efficient. This paper concludes that auditees can minimize auditing fees by maintaining an optimal number of auditors in the market, including some less efficient auditors. The large auditees would have to pay more for they have fewer choices in a market than small auditees. In order to maintain reasonable competition among auditors in a market, auditees pay the more efficient auditors higher fees.

The objective of this paper is to investigate whether banks view the information on the off-balance sheet liabilities (specifically, operating leases) disclosed in the notes to the financial statements as more reliable when it is audited by brand name auditors (i.e., a Big 4 audit firm). To the extent that banks assess a higher likelihood that the financial statements could have material misstatements if it is not audited by a Big 4 audit firm, they should charge a higher interest rate on private loans. Our findings suggest that the impact of operating leases on the interest rate is higher if the firm is audited by non-Big 4 audit firms.

Regulators have shown a renewed interest in considering the merits of mandatory auditor rotation. A fundamental concern is that long tenure may undermine auditor independence. We conduct a study to investigate the effects of long tenure on companies’ allowance for bad debts (ABD). We focus on ABD, as opposed to total accruals, because it allows us to hone in on the effect of auditor tenure on a specific accrual. By examining ABD, we are able to conduct a more direct and powerful test and avoid some of the measurement error and noise associated with total accruals (e.g., discretionary or abnormal). We find evidence of a negative association between auditor tenure and estimated ABD. The finding holds across a series of robustness tests. Further analyses suggest that long tenure (around 15 years) is associated with downward bias in estimated ABD. With long tenure, the auditor endorses an estimate of ABD that is too aggressive. This result is consistent with the argument that long tenure leads to compromised independence. Our findings suggest that a term limit of 10 years, which has been suggested elsewhere (e.g., PCAOB 2010; Chasan 2011), is sufficient to preserve auditor independence.

This article is a comprehensive legal and policy review of an amendment introduced in the 2010 Canadian federal budget to exclude cosmetic medical expenses from the medical expense tax credit. The analysis is guided by knowledge relevant to these expenses from the fields of medicine and the social sciences.The budget amendment is shown to be well justified in tax policy terms, despite the increased complexity it brings. A review of experience with similar rules in the United States, Australia, and Quebec suggests that few disputes with taxpayers should be expected if the enforcement level is similar to that in those jurisdictions.The wording of the legislation (new subsection 118.2(2.1)) provides taxpayers with two separate avenues for avoiding the exclusion of cosmetic medical expenses: (1) the service for which the expense is paid is “necessary for medical or reconstructive purposes,” or (2) it is not “purely for cosmetic purposes.” Both of these exceptions may be subject to expansive interpretation by taxpayers.The medical necessity exception is likely to be used extensively by taxpayers who obtain cosmetic medical treatment in order to alleviate appearance-related psychological distress. In light of the limited scientific evidence that cosmetic procedures are therapeutic for this problem, it might be desirable to legislate that this exception will be limited to distress related to gender identity disorder.The second exception could potentially apply to almost any expenditure for cosmetic dentistry (which currently represents about one-fifth of all cosmetic medical expenses). Other jurisdictions have had a similar problem in this area. Filling this gap in the rules is difficult and would likely require removing the requirement that expenses be “purely” cosmetic to be caught. Detailed guidance from the Canada Revenue Agency would also be required.