deangelo - 1982 - the auditor-client contractual relationship - an economic analysis

The Auditor-Client Contractual Relationship: An Economic Analysis by Linda Elizabeth DeAngelo Review by: Wanda A. Wallace The Accounting Review, Vol. 57, No. 3 (Jul., 1982), pp. 643-644 Published by: American Accounting Association Stable URL: http://www.jstor.org/stable/246890 . Accessed: 08/05/2014 19:02 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. . American Accounting Association is collaborating with JSTOR to digitize, preserve and extend access to The Accounting Review. http://www.jstor.org This content downloaded from 169.229.32.137 on Thu, 8 May 2014 19:02:28 PM All use subject to JSTOR Terms and Conditions Book Reviews 643 Inflation Will Ration The Goods of The Nation As the title suggests, this book is aimed prin- cipally at practicing managers. As a brief but far-ranging introduction to the subject designed to elicit interest and stimulate further thought and study, it has much to recommend it, not- withstanding the shortcomings noted above. A simple and straightforward explanation of this subject is a daunting challenge and will in- evitably sacrifice some of the finer distinctions to achieve simplicity. The need for such an explana- tion is great. This book might also be useful as supplemental reading to introduce the problem of changing prices in an undergraduate course on managerial accounting, especially one that emphasizes capital budgeting decisions. TIMOTHY S. LUCAS Project Manager Financial Accounting Standards Board LINDA ELIZABETH DEANGELO, The A uditor- Client Contractual Relationship: An Economic Analysis (Ann Arbor, MI: UMI Research Press, 1981, pp. ix, 129, $24.95). The primary strengths of this work include its integration of economic literature in the dis- cussion of conventional wisdom regarding the nature of audit services and related contractual arrangements and its formal structuring of arguments. The reader is provided with an easy- to-read description of how agency theory affects demand for audits and why the public-good attributes of an audit do not preclude its analysis as a private good. Interesting points that are discussed include a rationale for why bond- holders require covenants, an explanation of "sorting"-determining the "quality" of com- panies' securities-and the use of the audit as a sorting mechanism, the ability of the corporate structure with its ex ante sharing rule to effec- tively prevent intra-shareholder free rider problems, and the use of the brand-name mechanism as one means of making the audit process observable. The formal discussion of hypotheses and the model development concisely summarize such intuitive concepts as: "The average length of the auditor-client relationship will increase when, ceteris paribus, (1) the transactions costs of changing auditors increase, or (2) learning-by- doing advantages increase" (p. 97). The eco- nomic analysis explains the practice of "low- balling" or undercharging for audits in an initial engagement as a response to the CPA's invest- ment in specialized assets in the form of client- specific information which will produce cost savings in future years. The specialized assets are claimed to impair independence since the CPA has a vested interest in future audits of the client. With this central theme, issues concerning the average length of auditor-client relationships, auditor concentration over time, and the selec- tion of client portfolios when industry, general, and client-specific knowledge on the part of auditors, as well as differential costs of coor- dinating a number of audit clients, are incor- porated in the model. The analysis includes a summary of empirical evidence from other researchers' studies which is thought to be relevant to the model's predictions; however, no new evidence is presented, nor are any rigorous analyses of existing data performed that might appropriately control for numerous competing hypotheses. In this reviewer's opinion, the study suffers from a flaw which is common to such economic analyses: the model merely formalizes basic assumptions and computes deterministic com- parative statics predictions of the model, as is apparent in the text from such phrases as "Given the definitions and assumptions of the model" (p. 59), "We can see that, by assumption," (p. 71), and "This result obtains because of the assumed relationship between" (p. 90). Un- fortunately, few new insights are gained, and the assertion that the critical components of the contracting decision have been isolated and that material effects are implied by the analysis is left unsubstantiated. The material provides an interesting frame- work for future research and shares numerous research ideas; however, the reader should be wary of those claims that are, in the opinion of this reviewer, counterintuitive. Examples include the following claims: (1) "the client is able to impose material costs on the auditor by termi- nating him" (emphasis added, p. 37) or threaten- ing to terminate, and can thereby impair independence-if this were true, the essence of the auditing service would be undermined; (2) "consumers' assessments of the auditor's incen- tives for false attestation decline as the total number of two period clients of that auditor increases" (p. 66), thereby implying that smaller CPA firms are not independent; and (3) "main- This content downloaded from 169.229.32.137 on Thu, 8 May 2014 19:02:28 PM All use subject to JSTOR Terms and Conditions 644 The Accounting Review, July 1982 training a relationship with an auditor who possesses "future economic interest" in the client" (as described in this study) has a "negative impact on client firm value" (p. 3), despite the conflicting empirical fact that a change of auditors is considered to be a "red flag" to auditors in evaluating audit risk and may itself be the negative information signal. While the economic analysis acknowledges that the auditor's "specialized assets on all clients serves as a sort of collateral bond which con- strains auditor opportunism" (p. 96), the relative importance of the specialized assets as a threat to independence is, in the opinion of this reviewer, strongly overstated, to the detriment of the model. The existence of companies with policies of changing auditors frequently and the common practice by acquired companies of changing to the parent company's auditor have implications regarding the magnitude of the cost savings from specialized assets and suggest the importance of embellishing the model to consider additional dimensions of the auditor-client contractual relationship. This work is likely to be of interest to those who are curious as to alternative approaches to modeling the auditor-client relationship. WANDA A. WALLACE Assistant Professor of Accounting The University of Rochester J. R. EDWARDS, Company Legislation and Changing Patterns of Disclosure in British Company Accounts 1900-1940 (London: The Institute of Chartered Accountants in England and Wales, 1981, pp. ii, 77, ?5.95). The study of the history of accounting is not merely an academic exercise of interest to a relative few specialist accountants. Due to the comparatively brief history of modern account- ing, it is a study of a subject striving to reach maturity. As such, it is important that present- day accountants and students of accounting are fully appreciative of relatively recent develop- ments and issues. At times, this therefore means studying events, activities, and data of the immediate past. But such examinations ought to highlight successes and failures in accounting development which can be emulated or avoided in the future. In a sense, what is being argued is that the study of "contemporary" history is a substantial part of the present-day accountant's learning curve. Edwards' study for The Institute of Chartered Accountants in England and Wales falls easily into the above format. It is "contemporary" history (covering a recent period of 1900 to 1940); and it deals with corporate financial reporting (a matter which has and will continue to occupy the attention of accountants to a considerable extent). Thus, it is important to view Edwards' work as a contribution to the future development of such reporting as well as a review of past practices. The period of research commences with the time at which UK reports effectively became an established part of corporate legal requirements (the Companies Act 1900 introducing a compul- sory audit) and ending with a point of time that marked the beginning of the substantial influence of the major professional accountancy bodies through recommendation and standardization. The basis for the research is an examination of the published financial reports of 12 steel com- panies-thus the study must be regarded as a very limited one, both in terms of time period and subject material (how representative of reporting practices were those of steel com- panies?). The text includes various commentaries on the substantial reporting requirements of the period -these all being contained in the various Com- panies Acts. None of this material is original, although it is helpful to the reader to have it explained as a context to the analysis of specific reporting practices by the steel companies. Edwards deals with such matters as the format of financial statements, the detail of the data dis- closed, accounting practices such as deprecia- tion of fixed assets, and secret-reserve account- ing. In doing so, Edwards reveals how little infor- mation was disclosed to stockholders compared with the volumes of data which can appear in present-day reports; the considerable delay that could take place in producing financial state- ments-mainly due to the difficulties of estimating tax; the slowness of reporting on consolidated financial results (the latter were not seen in the UK until the 1930s); the problem of determining whether depreciation was to be treated as an expense or an appropriation; evidence of considerable, and then acceptable, use of secret-reserve accounting; and the pub- lication of reports of directors many years before this practice became legally required. The overall conclusions that come from the study are of substantial lack of disclosure by these companies to their stockholders; of relative consistency in this lack of disclosure; and an This content downloaded from 169.229.32.137 on Thu, 8 May 2014 19:02:28 PM All use subject to JSTOR Terms and Conditions . The Auditor-Client Contractual Relationship: An Economic Analysis by Linda Elizabeth DeAngelo Review by: Wanda A. Wallace The Accounting Review, Vol. 57, No. 3 (Jul., 1982) , pp. 64 3-6 44 Published. LUCAS Project Manager Financial Accounting Standards Board LINDA ELIZABETH DEANGELO, The A uditor- Client Contractual Relationship: An Economic Analysis (Ann Arbor, MI: UMI Research. require covenants, an explanation of "sorting"-determining the "quality" of com- panies' securities-and the use of the audit as a sorting mechanism, the ability