External Auditor Reassessment of Client Business Risk Following the Issuance of a Comment Letter by the SEC

Abstract

Following Arthur Andersen's conviction for obstructing justice, auditors faced a one-time significant change in their regulatory environment because it was clear that (i) major audit partnerships could be closed and (ii) post Sarbanes-Oxley Act (SOX), regulators would take a far more attentive (aggressive) role. In response auditors considered whether the pricing of audits should be revised to take account of the increased risk of regulatory intervention and litigation. Obviously such re-pricing would need to be targeted at those firms for which the risks were greatest. One early warning signal of such events occurring is the issuance by the Security Exchange Commission (SEC) of a Comment Letter (CL). We investigate whether there is any evidence that if a client receives a CL this is used to re-price audit services. Specifically, we investigate whether issuance resulted in upward pressure on audit fees, and whether this effect was simply transient around the issuance period or alternatively persisted some years into the future. This research finds that after a client receives a CL, auditors adjust audit fees upwards in the period in which the CL is received. In addition it is shown that for subsequent periods in which the auditor does not spend time assisting the client respond to a specific CL, an initial rise in audit fee persists. This is consistent with the hypothesis that auditors reassess the reputation and litigation risk of the client on the basis of the SEC issuance of a Comment Letter.

Theorizing Financial Crimes as Moral Actions

“…This study is among the first to take stock of this gap to address the reified sphere of fraudulent activities and their manifestations in collective actions. Thirdly, the paper acts as a reference point on intervention efforts Donegan & Gagon, 2008;Gabbioneta et al, 2013) by providing a conceptual anchor to understand the relational connection ensuing from the organisation and its environment as the context and enactment of fraud (Davis & Pesch, 2013;Gietzmann & Pettinicchio, 2014;Power, 2013).…”

“…This manifestation of fraud and fraud risks encourages auditors to look for fraud in areas where there are individual risks and shifts organisational surveillance to systems of controls (Gietzmann & Pettinicchio, 2014;Lokanan, 2015a;Power, 2013;Williams, 2013 The micro-epistemological framing serves to sustain a narrow conceptualisation of fraud and prevention (Stalebrink & Sacco, 2007). Many individuals are exposed to various pressures and opportunities to commit fraud but, despite this exposure, a significant number of them choose not to engage in fraudulent behaviour (Greve, Palmer, & Pozner, 2010;Lokanan, 2015a;Morales et al, 2014;Powers, 2013).…”

Does Securities Commission Oversight Reduce the Complexity of Financial Reporting?

“…These signals really lead to additional scrutiny by auditors, institutional investors and other stakeholders (Bens et al, 2016), because it affects "information asymmetries about latent and unobservable quality" (Connelly et al, 2010) of financial reports. For example, Gietzmann and Pettinicchio (2014) suggest that auditors incorporate the signal from comment letter in determining the client audit risk and increase their scrutiny and audit quality and adjust fees upwards in the period during which the comment letter is received. This additional scrutiny, in additional to restricting the opportunistic behavior, directly increases the financial reporting precision and reduces complexity (Johnston and Petacchi, 2017).…”

Comment Letter Frequency and CFO Turnover

“…Potential choices (see Gietzmann & Isidro, 2013;Gietzmann & Pettinicchio, 2014;Johnston & Petacchi, 2013) include REVPROP = total company's revenue / total revenues of the industry. This variable is a proxy of the company's ''importance'' in a specific industry.…”

“…Here, we model the effect of severity as generating a discrete shift up in the likelihood of turnover once the first severe CL is received. Following the earlier literature (see, for example, Gietzmann & Pettinicchio, 2014;Johnston & Petacchi, 2013), we measure ''severity'' by first recording the number of days that passes between the initial CL being issued by the SEC (relating to a particular fiscal year) and the final date at which the SEC after (typically) multiple response letter exchanges agrees that issues have been resolved. This is called the ''conversation time.''…”