Audit Fees and Fair Value Accounting: Evidence from Other Comprehensive Income Solomon Huang, National Cheng Kung University Steve Lin, Florida International University Kannan Raghunandan, Florida International University 1

Introduction Background: I. Traditional arguments over Historical Cost vs Fair Value accounting; II. U.S. FASB clearly states its aim to eventually value all financial instruments at fair value (SFAS No. 159) III. Financial Crisis 2

Prime Qualities of Accounting Information: Relevance vs Reliability Data source: Intermediate Accounting, Keiso, Weygandt and Warfield 3

Current U.S. GAAP Fair Value Regulation I: NI or OCI? 4

Other Comprehensive Income (OCI) I. The reason that OCI is created and excluded from net income is because these items are more related to a firm’s fundamental risks rather than core operation performance. II. They are ‘recognized’ but ‘unrealized’ gains and losses caused by the price fluctuations of long-term financial assets and liabilities. III. Including gains or losses from foreign currency translation, available-for-sale (AFS) investments, minimum required pension liabilities, and derivatives held as cash flow hedges. 5

Current U.S. GAAP Fair Value Regulation II: I/S or B/S? I. SFAS No.130 also allows firms to disclose OCI in a single statement of comprehensive income (CSI_CI), a separate statement of comprehensive income that begins with net income from the income statement (CSCI), or a statement of changes in shareholders’ equity (CSSE). II. To be consistent with the International Accounting Standards No.1 and to mitigate managerial discretionary over the location of reporting OCI, on June 16, 2011 the FASB and the International Accounting Standards Board (IASB) eliminated the option of reporting OCI in CSSE (FASB, 2011). 6

Motivation/Importance I. No study has examined the extent to which OCI may have affected the decision making of auditors; II. The nature of OCI is not only volatile and uncontrollable, but is also largely judged by management - OCI could be more susceptible to misstatements than any other accounting items; III. Due to the increasing use of fair value, auditors are required to assess the risks of material misstatements resulting from OCI in accordance with SAS No.101, “Auditing Fair Value Measurements and Disclosures”; IV. The SEC and the PCAOB have noted that auditing fair value measurements poses unique challenges to auditors (SEC 2008, and Olson 2008). 7

Research Purpose This study examines: I. The statistical association between audit fees and the volatility of other comprehensive income (OCI); II. The impacts of internal controls & specialist auditors; III. The location choice of reporting OCI in financial statements on the association. 8

Literature I. Value Relevance: some studies find that OCI and its components provide incremental value relevant information beyond net income (Biddle and Choi 2006; Chambers et al. 2007; Kanagaretnam et al. 2009). II. Risk-relevance: the volatility of estimated fair-value income (i.e. NI plus unrealized gains or losses on investment securities) is higher than NI volatility, but the difference in volatilities is not priced by the market as an additional risk (Barth et al. 1995; Hodder et al. 2006). 9

Hypothesis Development I. Audit efforts and demand of specialization increase in the difficult verifiability of assets fair values (SEC 2008; Olson 2008; Ettredge et al. 2009): H 1 : audit fees are positively associated with OCI volatility. II. Specialist auditors and a stronger internal control system may help mitigate the risk of material misstatement resulting from fair value measurements (Martin et al. 2006; Kolev 2008): H 2a : auditor specialists lower the positive association between audit fees and OCI volatility. H 2b : internal controls lower the positive association between audit fees and OCI volatility. 10

Hypothesis Development III. The location choice of reporting OCI in financial statements affects pricing decision of investors and analysts and reflects managerial opportunistic activities (Hirst and Hopkins 1998; Maines and McDaniel 2000; Lee at al. 2006; Bamber et al. (2010): H 3 : the association between audit fees and OCI volatility is conditional on the location choice of disclosing OCI in financial statements. H 4 : audit fees associated with OCI volatility are lower if firms disclose OCI in a single statement of comprehensive income or a separate statement of comprehensive income. 11

Sample Data and Method I. Sample: hand-collected data for non-financial S&P 500 firms during II. Traditional audit fee models are used (e.g., Simunic 1980, Francis and Wang 2005, Raghunandan and Rama 2006, and Huang, Raghunandan and Rama 2009) 12

Sample Selection 13

Results: Test for H 1 14

Results: Test for H 2a 15

Results: Test for H 2b 16

Results: Test for H 3 and H 4 17

Conclusion I. OCI volatility provides incremental risk information over and above NI volatility for auditors; II. Audit specialists mitigate the influence of OCI on audit fees, but evidence on the impact of internal controls on audit fees appears to be weak; III. Auditors consider the location of reporting OCI, and charge less (higher) audit fees for firms reporting OCI in a single statement of comprehensive income or a separate statement of comprehensive income (a statement of changes in shareholders’ equity). 18

Contribution/Extension I. First study documents that auditors perceive and price additional risks resulting from OCI; II. Indicates the importance of using industry-specialist auditors (but not internal controls) in fair value audits; III. Our finding supports the elimination of the option of reporting OCI in CSSE (FASB and IASB, 2011); IV. Our results also raise some interesting questions for future research such as the nature and extent of audit tests and internal control evaluations in significant volatilities of fair value measurements, such as OCI. 19

Thank you so much! 20