The Association between Human Resource Investment by Audit Firms and Their Audit Quality

Minjung Kang, Incheon National University
Ho-Young Lee*, Yonsei University
Myungsoo Son, California State University
Michael Stein, Old Dominion University

Abstract
Utilizing unique data available only in Korea, we examine the association between investment in human resources and audit quality provided by audit firms. While human resources investment is important in improving audit quality, few studies have examined this association mainly because public data about human resources investment and financial statements of audit firms are unavailable. Using two proxies for audit quality (i.e. discretionary accruals and accounting conservatism), we provide evidence that higher compensation in audit firms improves audit quality. In addition, we find higher audit quality in audit firms with higher education expenses, when audit quality is measured by the level of conservatism of clients’ financial statements. These results support regulators’ stance that quality control through human resources investment in audit firms can effectively improve audit quality and therefore the quality of clients’ financial reporting. However, we find no association between education expenses and the average absolute value of discretionary accruals of audit clients. These results generally suggest that direct investment in human capital (i.e. compensation) is more effective in improving audit quality than indirect investment in human capital (i.e. education expenses).

Does the conflict of interest matter for credit ratings? The impact of the client’s economic importance and the CRA tenure

Yi-Ping Liao*, Ming-chuan University, Taiwan
Sheng-Min Hung, Soochow University, Taiwan
Kuei-Fu Li, Ming-chuan University, Taiwan

Abstract
We investigate whether the potential conflict of interest affects credit ratings. Based on US data, we find that: (1) the client’s economic importance is positively related to credit ratings, and impairs the rating accuracy, and (2) at first, the credit rating (rating accuracy) increases (decreases) in the early years of the CRA-client relationship, but when the length of the engagement relationship gets longer enough, the CRA tenure is negatively (positively) related to the credit rating (rating accuracy). Overall, it suggests that the CRAs’ contention that the conflict of interest has been well-managed does not appear to be convincing.

The role of regional institutional environment in the relationship between political participation and effective tax rates: Evidence from Chinese listed private firms before the financial crisis

Shuangyan Li*, Xi'an Jiaotong University
Genfu Feng, Xi’an Jiaotong University
Guangjun Cao, Georgian College, Canada

Abstract
Using a sample of Chinese listed private firms selected from the period of 1999–2007 before the financial crisis, we investigate that the role of regional institutional environment (RIE) in the relationship between political participation (POLP) and effective tax rates (ETR). We find that the correlation between POLP and ETR depends on RIE, which can be characterized in two ways: marketization and corruption levels; and in particular, a statistically significant positive relation is shown to exist between POLP and ETR among firms located in regions with low corruption levels, and so does a statistically significant negative correlation among firms located in regions with high corruption levels. Correlations of opposite nature exist if the marketization level is concerned, but the relations are not as strong as in the case of corruption level.

Market Reactions to Unexpected Relative Earnings Performance

Yen-Jung Lee*, National Taiwan University

Abstract
This paper documents that investors value unexpected changes in a firm’s relative earnings performance (REP) in addition to its absolute earnings surprise on the firm’s earnings announcement date. Consistent with REP filtering out industry-wide common shocks and conveying information about the firm’s competitive advantage over its industry peers, investors react more strongly to unexpected relative earnings for firms with a stronger peer-firm earnings correlation and for firms with fewer growth options in their operations relative to their industry peers. Moreover, current unexpected REP is positively associated future growths in sales, market share, and earnings performance, suggesting that firms with stronger REP are better able to capture future industry opportunities.

Deferred Taxes and Cost of Debt: Evidence from Japan

Yumi Inamura, Niigata University, Japan
Shin'ya Okuda*, Nagoya city university, Japan

Abstract
This paper investigates the information content of deferred taxes in the Japanese debt market by analyzing the relationship between deferred taxes and cost of debt. We find that while deferred tax liabilities are positively associated with cost of debt, deferred tax assets are not. This evidence may reflect the greater probability of tax obligations being realized compared to tax benefits. Further, we analyze the relationship between cost of debt and the various components of deferred taxes. We find that net deferred taxes caused by temporary differences are negatively related to cost of debt. On the other hand, net deferred taxes from net operating losses are positively related to cost of debt. Additionally, we find that valuation allowances are less positively related to cost of debt when firms are suspected of seeking to avoid losses or decreases in earnings. These results suggest that debt investors in the Japanese debt market evaluate the various components of deferred taxes differently.

Decomposing Exchange Rates of Asia into Financial and Real Factors

Dongchu Cho*, KDI School of Public Policy and Management
Kyuesook Han, University of Seoul

Abstract
This paper imagines a foreign exchange market in which a net financial flow curve and a current account curve interact to simultaneously determine equilibrium levels of exchange rate and current account. To identify the two curves, we selected four Asian countries (Indonesia, Korea, Philippines, and Thailand) that drastically liberalized financial accounts and exchange rate systems after the 1997 crisis, and assumed that the institutional changes altered the slopes of net financial outflow curves while maintaining those of current account. The results indicate that currency depreciation greatly contributes to stabilizing foreign exchange markets by suppressing financial outflows (or attracting inflows), although the effects are not uniform across the countries in the short-run.

Keywords: Exchange rate, financial flow, current account, SVAR

The effects of bank privatization on performance and prudential behavior in China: does state ownership matter?

Hong Zhao*, Xi’an Jiao Tong University
Maoyong Cheng, Xi’an Jiao Tong University
Jerry W. Lin, Colorado State University at Pueblo

Abstract
Using China’s data from 2000 to 2013, we examine the effects of bank privatization on performance and prudential behavior, and find the following results. First, bank operating efficiency, credit risk, and prudential behavior have improved after introducing foreign strategic investors (FSIs). However, these effects are diminished as time passes. Second, going public increases bank profitability, operating efficiency, and prudential behavior, and reduces credit risk, which are also reversed as time passes. Finally, the effects of introducing FSIs on credit risk and prudential behavior are weaker for state-owned banks than for other banks, while the opposite is true for going public.

Do regulator inspections of audit firms discern audit quality? Evidence from Korean Regulator Inspections

Young-soon Cheon, Chung-Ang University
Dan Dhaliwal, University of Arizona
Moonchul Kim, Kyung Hee University
Mun Ho Hwang*, Kyung Hee University

Abstract
During the past decade, many countries have adopted a regulatory inspection program to oversee the auditing profession. In general, the inspection programs consist of two components: evaluation of accounting firms’ quality control systems and review of selected audit engagements. This study examines whether quality control system deficiencies and audit engagement deficiencies identified in the inspections reflect the audit quality of accounting firms using the data from Korean regulator inspections. We find that both quality control system deficiencies and audit engagement deficiencies reflect the audit quality of the accounting firms under inspection. Our findings also suggest that quality control system deficiencies discern the audit quality of accounting firms better than audit engagement deficiencies. Our results are robust across audit quality measures and auditor size. This study expands the literature by providing evidence about quality control system deficiencies and providing evidence for more comprehensive measures of audit quality.

Disclosing material weakness in internal controls: Does the gender of audit committee members matter?

Robert James Parker*, University of New Orleans
Mai Dao, University of Toledo
Hua-Wei Huang, National Cheng Kung University
Yun-Chia Yan, University of Texas

Abstract
As mandated by Sarbanes-Oxley Act, firms must disclose material weaknesses in internal controls. This study extends the body of accounting research that seeks to identify the factors associated with such disclosure. Drawing upon gender research in the behavioral sciences, we argue that female audit committee members examine internal controls more critically and thoroughly than their male counterparts; hence, firms with females in these positions are more likely to report problems. A logistic regression model of material weakness disclosure is developed that includes, as a predictor variable, proportion of females on the audit committee. Results support the proposed relationship.

Audit committee accounting expertise, CEO power, and audit pricing

Hyungtae Kim, Arkansas State University
Byungjin Kwak*, Korea Advanced Institute of Science and Technology (KAIST)
Youngdeok Lim, The University of New South Wales
Jaeyoon Yu, Korea Advanced Institute of Science and Technology (KAIST)

Abstract
The Sarbanes–Oxley Act of 2002 (SOX) mandates that all listed firms disclose whether they have a financial expert on the audit committee, highlighting the committee’s expertise. However, some argue that non-accounting financial experts, compared to accounting financial experts, are not sufficient to ensure audit committee effectiveness because the former lack accounting knowledge. Accounting experts on audit committees may require higher audit efforts, while auditors may assess audit committees with accounting financial experts as effective, decreasing audit efforts. This paper first inspects the effect of audit committee accounting expertise on audit fees as a proxy for audit efforts, and then investigates whether the effect is moderated by powerful CEOs. Using post-SOX period data, our results show that, on average, firms with accounting experts on audit committees are more likely to pay higher audit fees, and the effect is less pronounced when a powerful CEO manages a firm.

Keywords: Accounting experts, audit committee, audit fees, CEO power

Do Social Ties between Individual Auditors and Client CEOs/CFOs Matter to Audit Quality?

Qi Baolei and Tian Gaoliang, Xi'an Jiaotong University
Yang Rong*, Rochester Institute of Technology

Abstract
The objective of this paper is to investigate whether and how the social ties between individual auditors and client chief executive officers (CEOs)/chief financial officers (CFOs) affect audit quality using a large sample of publicly traded firms in China. We define social ties between individual auditors and client CEOs/CFOs as ‘working or educational alumni.’ We find that clients with social ties are significantly and positively associated with abnormal accruals and the presence of reporting small profits, and are more likely to receive clean audit opinions compared to clients without social ties. Moreover, we find that the working-tie effect on audit quality is stronger than the school-tie effect. Furthermore, we find that socially connected clients are more likely to downward restate their audited earnings in subsequent years. In addition, we find that the social-tie effect on audit quality can be mitigated by several personal characteristics of individual auditors, such as partner, female, accounting major, auditing experience, etc. Overall, our study sheds new light on the impact of social ties between individual auditors and client executives on audit quality.

Keywords: Client executives, individual auditors, social ties, audit quality

Expanding distribution channels

Noriaki Matsushima*, Osaka University

Abstract
I provide a model in which upstream producers, whose production cost is quadratic in quantity, sell their products through two distribution channels, a traditional channel and an external retailer. Some producers (called ‘large’ producers) supply to both channels, whereas other producers (called ‘small’ producers) are only able to supply to the traditional channel. All producers compete in quantity in the traditional channel. The external retailer offers a nondiscriminatory per unit payment to upstream producers. I show that distribution channel expansion executed by a small producer can decrease the producer’s profit and the sum of the upstream producers’ profits.

Keywords: Channel expansion, dual channel, increasing marginal cost, retailers

Network Externalities and Tariff Structure

Leonard F.S. Wang*, National University of Kaohsiung
Wei Yu, Xi’an Jiaotong University

Abstract
In this paper, we show that with cost asymmetry, stronger network externalities and less differentiated goods, the uniform tariff rate set by the government of the importing country increases and the optimal discriminatory-tariff gap widens. In addition, under network externalities and good differentiation, we demonstrate that: (a) the optimal tariff policy is superior to free trade in maximizing the domestic social welfare; (b) the maximum-revenue tariff rate is always higher than the optimal tariff rate; (c) the consumer surplus and social welfare are always higher under the optimal tariff policy than under the maximum-revenue tariff policy.

Keywords: Network externalities, international differentiated duopoly, optimum-welfare tariff, maximum-revenue tariff