Independence, low balling and learning effects

Independent auditors serve as gatekeepers of public securities markets, but ongoing competition among audit firms could harm auditors’ independence. For instance, a Green Paper of the European Union finds that especially audits of large and prestigious clients are hard-fought in terms of price competition. Major concerns are related to a pricing behavior called low balling. Here, the auditor sets the first period’s fee below the audit costs -incurring a loss for the initial audit- in order to win the client. However, as a quasimonopoly emerges for the incumbent auditor, he expects to offset this loss in the future. Mainly, this offset occurs due to reduced audit costs in subsequent periods. Recent management publications highlight that learning effects influence the cost behavior over time in two ways. On the one hand, cost reductions emerge from experience due to performing jobs repeatedly. Thus, learning is supposed to be an important strategic factor in lowautomation industries, like auditing. On the other hand, learning effects can be fostered by investments in learning, i.e., learning is manageable. Bundling non-audit services, like risk advisory- or performance measurement-related assurance services, with audits could be interpreted as audit-quality improving investments in learning about a client’s business. Accordingly, the goal of our paper is to analyze how learning effects according to the theory of learning curves affect competition on the audit market and thus the low-balling problem. Our analysis proceeds in several steps: In the first step, we model-endogenously identify conditions for the existence of price competition in audit markets. This step of analysis is important, because in most low-balling models competition is assumed to exist, although empirical evidence is mixed. In the second step, we analyze how different types of learning influence fee setting over time. Here, we assume auditors to have identical learning rates. This means competition in a given segment is considered, e.g., between Big-4 auditors or between National Majors. In the third step, we regard auditors with different learning abilities. Thus, auditors of different size -measured in number of clients- occur. In this step we capture the fact that empirically size is an important competition factor. Our results give hints to regulators under which conditions low balling might be a threat to auditor independence. Further, some recently introduced regulations, which aim at improving auditor independence, can be evaluated using the framework of our analysis.

European Court upholds criminal conviction for purchasing illegal firearm as a form of 'check it out' journalism in Salihu ao v. Sweden

Investigative journalism sometimes operates at the limits of the law. This is especially true of what could be called ‘check it out’ journalism: reporting in which a journalist tests how effective a law or procedure is by attempting to circumvent it. A recent decision shows that those who commit (minor) offences during this type of newsgathering activity cannot count on (major) support from the European Court of Human Rights (ECtHR)

European Court upholds criminal conviction for purchasing illegal firearm as a form of ‘check it out’ journalism in Salihu ao v. Sweden

A recent decision of the European Court shows that journalists who commit (minor) offences during newsgathering activities cannot invoke robust protection based on their rights to freedom of expression and information as guaranteed by Article 10 of the European Convention on Human Rights. Journalists of the Swedish newspaper Expressen had undertaken to demonstrate the easy availability of illegal firearms by purchasing one. The Swedish courts were of the opinion that the editor and the journalists could not be exempted from criminal liability as they had wilfully breached the Swedish Weapons Act. In a unanimous decision, the European Court confirmed the necessity of the journalists’ criminal conviction. It declared the application for alleged breach of the right of journalistic newsgathering under Article 10 of the Convention manifestly ill-founded

Independence, low balling and learning effects

Independent auditors serve as gatekeepers of public securities markets, but ongoing competition among audit firms could harm auditors’ independence. For instance, a Green Paper of the European Union finds that especially audits of large and prestigious clients are hard-fought in terms of price competition. Major concerns are related to a pricing behavior called low balling. Here, the auditor sets the first period’s fee below the audit costs-incurring a loss for the initial audit- in order to win the client. However, as a quasimonopoly emerges for the incumbent auditor, he expects to offset this loss in the future. Mainly, this offset occurs due to reduced audit costs in subsequent periods. Recent management publications highlight that learning effects influence the cost behavior over time in two ways. On the one hand, cost reductions emerge from experience due to performing jobs repeatedly. Thus, learning is supposed to be an important strategic factor in lowautomation industries, like auditing. On the other hand, learning effects can be fostered by investments in learning, i.e., learning is manageable. Bundling non-audit services, like risk advisory- or performance measurement-related assurance services, with audits could be interpreted as audit-quality improving investments in learning about a client’s business. Accordingly, the goal of our paper is to analyze how learning effects according to the theory of learning curves affect competition on the audit market and thus the low-balling problem. Our analysis proceeds in several steps: In the first step, we model-endogenously identify conditions for the existence of price competition in audit markets. This step of analysis is important, because in most low-balling models competition is assumed to exist, although empirical evidence is mixed. In the second step, we analyze how different types of learning influence fee setting over time. Here, we assume auditors to have identical learning rates. This means competition in a given segment is considered, e.g., between Big-4 auditors or between National Majors. In the third step, we regard auditors with different learning abilities. Thus, auditors of different size -measured in number of clients- occur. In this step we capture the fact that empirically size is an important competition factor. Our results give hints to regulators under which conditions low balling might be a threat to auditor independence. Further, some recently introduced regulations, which aim at improving auditor independence, can be evaluated using the framework of our analysis

Costs, Benefits, and Tax-induced Distortions of Stock Option Plans

In recent years stock option plans (SOPs) have become an important component of managerial remuneration in most industrialized countries. Commonly accepted, corporate as well as individual taxes have a major impact on the costs of a SOP. In contrast, the tax influence on the benefits of a SOP remains widely unperceived. This article deals with both –cost and benefit– aspects simultaneously by integrating taxation into a principalagent model, where the agent is compensated in options. Deriving the optimal quantity of options to be granted and the optimal exercise price to be set, resulting profits for managers and shareholders can be quantified. Comparing the results in a tax-free world to the results taking into account different levels of taxation several tax-induced incentive distortions can be identified.stock options, principal-agent, taxation

A rationale for the payback criterion

Textbooks on financial management have emphasized the shortcomings of the payback criterion for decades. However, empirical evidence suggests that in actual capital budgeting procedures the payback method is used quite regularly. Mostly, it is implemented supplementary to net present value or internal rate of return, but small companies tend to rely on payback times as single criterion. A convincing theoretical foundation for the observed use of the payback criterion is lacking. Consequently, our goal is to provide such an explanation for the payback criterion’s popularity. We demonstrate from a decision theoretical perspective how relying on payback times simplifies investment decisions in modern organizations. Gathering information from different management levels and ensuring the utilization of individual skills requires a multi-stage capital budgeting process. Accordingly, we consider fundamental organizational features of this process with respect to their impact on the payback method’s use. For this purpose, we built upon almost stochastic dominance (ASD) as modeling device. Firstly, we show that applying his concept allows to include the risk preferences of all relevant decision makers into the analysis. Secondly, we illustrate that the criteria derived from this model help conveying these preferences to those who do the preparatory work preceding the final decision. To some extent, these new criteria are generalizations of payback times. This finding provides a potential explanation for the payback’s persisting prominence.

The rights of journalistic newsgathering during demonstrations

In a case about a Ukrainian journalist being arrested during an anti-globalisation protest in Russia, the European Court of Human Rights (ECtHR) in Butkevich v. Russia (13 February 2018) has clarified that the gathering of information is an essential preparatory step in journalism and an inherent, protected part of press freedom. The ECtHR found that the arrest, prosecution and conviction of the journalist had violated his right to freedom of expression under Article 10 of the European Convention of Human Rights (ECHR). The ECtHR also found violations of Article 5 § 1 (right to liberty) and of Article 6 § 1 (right to a fair trial). This blog focuses on the aspects of journalism and freedom of expression under Article 10 ECHR, and in relation to the right of peaceful demonstration under Article 11 ECHR. The judgment offers important support to journalists covering public events, demonstrations and police actions, especially after the disappointing outcome in the case of Pentikäinen v. Finland

A rationale for the payback criterion : an application of almost stochastic dominance to capital budgeting

Textbooks on financial management have emphasized the shortcomings of the payback criterion for decades. However, empirical evidence suggests that in actual capital budgeting procedures the payback method is used quite regularly. Mostly, it is implemented supplementary to net present value or internal rate of return, but small companies tend to rely on payback times as single criterion. A convincing theoretical foundation for the observed use of the payback criterion is lacking. Consequently, our goal is to provide such an explanation for the payback criterion’s popularity. We demonstrate from a decision theoretical perspective how relying on payback times simplifies investment decisions in modern organizations. Gathering information from different management levels and ensuring the utilization of individual skills requires a multi-stage capital budgeting process. Accordingly, we consider fundamental organizational features of this process with respect to their impact on the payback method’s use. For this purpose, we built upon almost stochastic dominance (ASD) as modeling device. Firstly, we show that applying his concept allows to include the risk preferences of all relevant decision makers into the analysis. Secondly, we illustrate that the criteria derived from this model help conveying these preferences to those who do the preparatory work preceding the final decision. To some extent, these new criteria are generalizations of payback times. This finding provides a potential explanation for the payback’s persisting prominence

Costs, Benefits, and Tax-induced Distortions of Stock Option Plans

In recent years stock option plans (SOPs) have become an important component of managerial remuneration in most industrialized countries. Commonly accepted, corporate as well as individual taxes have a major impact on the costs of a SOP. In contrast, the tax influence on the benefits of a SOP remains widely unperceived. This article deals with both cost and benefit aspects simultaneously by integrating taxation into a principalagent model, where the agent is compensated in options. Deriving the optimal quantity of options to be granted and the optimal exercise price to be set, resulting profits for managers and shareholders can be quantified. Comparing the results in a tax-free world to the results taking into account different levels of taxation several tax-induced incentive distortions can be identified

Kosten aus einer asymmetrischen Informationsverteilung zwischen Abschlussprüfer und Mandant

Die Einschätzungen des Abschlussprüfers über die Eigenschaften eines Mandanten fließen in die Annahme eines Prüfungsauftrages sowie die Festsetzung der Prüfungsgebühr ein. Der vorliegende Beitrag analysiert, wie die Informationsasymmetrie über das beim Mandanten vorliegende Risiko in der Gebührensetzung bei Erst- und Folgeprüfungen berücksichtigt werden kann. Für den Mandanten werden dabei zwei Risikotypen unterschieden, so dass die Informationsunsicherheit sich darauf bezieht, ob ein hohes oder ein geringes Prüfungs- oder Auftragsrisiko vorliegt. Ein Vergleich der Gebührensetzung bei symmetrischer und asymmetrischer Information zeigt, wann der Abschlussprüfer oder der Mandant die Kosten der vorvertraglichen Informationsasymmetrie trägt. Im Ergebnis ist festzuhalten, dass es bei asymmetrischer Information allein von den mandantenspezifischen Prüfungskosten abhängig ist, ob der riskante oder nicht riskante Mandant die Kosten trägt. Die Zusammensetzung des Mandantenportfolios beim Abschlussprüfer nimmt hingegen keinen Einfluss auf die Kosten, die der Informationsasymmetrie zurechenbar sind