This study provides a more in-depth understanding of current audit practices related to auditors’ use of substantive approaches outlined in AS 2502. These results provide several important new insights, including more clearly distinguishing between auditors’ use of pricing services and valuation specialists and factors that drive this decision, as well as provide additional insights regarding differences in the use of valuation specialists for financial and nonfinancial FVMs. Finally, the results shed new light on whether audit challenges differ for financial versus nonfinancial FVMs.

Glover, S. M., M. H. Taylor, and Y. Wu. 2017. Current Practices and Challenges in Auditing Fair Value Measurements and Complex Estimates: Implications for Auditing Standards and the Academy. Auditing: A Journal of Practice and Theory 36 (1): 63 – 84.

The subjectivity inherent in estimating future events, coupled with the potential high degree of measurement uncertainty, makes auditing fair value measurements and other complex estimates challenging for auditors. Because of this difficulty, auditors frequently rely on valuation specialists; however, the PCAOB has voiced criticisms as a result of such reliance. To provide a more complete picture of current practices and challenges encountered when auditing complex FVMs, this study has three primary objectives:

• To obtain deeper insights into auditors’ use of substantive approaches to audit FVMs given criticisms of auditors’ substantive approaches
• To provide improved understanding of auditors’ use of pricing services and valuation specialists (in-house and third-party) when auditing complex FVMs
• To further explore challenges auditors encounter when auditing FVMs by distinguishing between financial versus nonfinancial FVMs and investigating how auditors respond when they encounter problems with management’s valuation expertise and knowledge

The authors employ a field-based survey that provides a channel for practitioners to openly express their opinions and views. 

• The authors find that auditors are likely to use the first substantive approach (i.e., test management’s assumptions and underlying data) when auditing typical or lower-risk estimates, but as audit risk and complexity increase, they are more likely to use a combination of approaches.
• The authors find that, despite AS 2502 allowing auditors to use management’s assumptions when developing an independent estimate, the results indicate that auditors typically opt instead to use the audit team’s own assumptions to derive independent estimates.
• The authors find that a greater percentage of audit partners report using third-party valuation specialists to develop independent estimates for financial FVMs than for nonfinancial FVMs.
• The authors find that a majority of the participants believe that challenges differ between financial and nonfinancial FVMs and the key reason is the lack of observable market information for nonfinancial FVMs. 

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This study reviews academic literature to not only offer insights into how well recent audit reporting initiatives gives users the information they need to understand the audit, but also suggest future research that academics can perform to help standard setters improve the auditor’s report.  The authors argue that (1) disclosure of the audit partner’s name does close the information gap, (2) disclosures related to auditor independence and tenure only partially closes the information gap, and (3) auditor commentary on going concerns does not close the information gap; however, not enough is known about how well either (4) disclosure of critical or key audit matters or (5) assurance on other information in the audit report closes the information gap.  These insights may be of interest to stakeholders in the standard setting process who wish to evaluate the success of currently enacted audit reporting initiatives and the potential costs and benefits of proposed audit reporting initiatives.

Bédard, J., P. Coram, R. Espahbodi, and T.J. Mock. 2016. Does Recent Academic Research Support Changes to Audit Reporting Standards?. Accounting Horizons 30 (2): 255-275.

Regulators interested in improving the informativeness of the auditor’s report have recently proposed/required new disclosures to be made by the auditor to help information users better understand the audit.  Academic researchers studied whether these new disclosures fulfill their intended purpose and/or have unintended consequences.  The purpose of this study is to synthesize the academic literature related to the new disclosures in order to identify (1) whether the benefits of specific new disclosures outweigh the costs, (2) whether further changes to the auditor’s report are needed, and (3) where more research is needed to better understand the effects of the new disclosures.  Thus, this study serves as a means of communicating the findings of academic research to standard setters in order to enable academics to better fulfill their information-gathering role in the standard setting process.

The author perform a review of the academic literature relevant to PCAOB, IAASB, and U.K. FRC audit reporting initiatives, specifically focusing on (1) disclosure of critical or key audit matters, (2) assurance on other information in the audit report, (3) auditor commentary on going concerns, (4) disclosure of audit partner name, and (5) disclosures related to auditor independence and tenure.  They obtain research published, posted online, or presented at conference(s) from 2007 through mid-2015, but mostly after 2011.

• Not enough is known about how well disclosure of critical or key audit matters gives users the information they need to understand the audit.
  • Experimental evidence suggests that Critical Audit Matters (CAMs) disclosed in the auditor’s report may (1) draw users’ attention to areas discussed in the CAMs, (2) scare some nonprofessional investors away from companies with CAMs, (3) influence auditor liability and legal damages in unintended ways, (4) and discourage auditors from bringing problems to the attention of passive audit committees.  Furthermore, experimental evidence suggests that (1) the impact of additional disclosure from the auditor upon users may vary depending upon management disclosures and (2) managers may be reluctant to share information about accounting estimates with auditors who are required to make additional disclosures about these estimates.
  • Preliminary archival evidence from the U.K. is mixed in terms whether CAMs have a positive association with audit fees and audit quality, but suggests CAMs have no relationship with financial statement’s informativeness. 
  • Research about the French justifications of assessments disclosure suggests that they are generally boilerplate and uninformative, and they have no impact on audit quality (after the year of implementation).
  • Archival research from the U.S. on the effect of explanatory language on unqualified audit reports suggests that (1) some types of explanatory language provide information about financial reporting quality and (2) non-going concern explanatory language can increase/decrease disagreement among investors.
  • A review of stakeholder responses to the IAASB’s proposed audit reporting initiatives suggests that stakeholders generally approved of the changes, but had differing opinions of how much change was needed.
• There is no evidence available about whether assurance on other information in the audit report gives users the information they need to understand the audit.
• Auditor commentary on going concerns appears to not give users the information they need to understand the audit.
  • Although most studies find the going concern audit reports useful, one study finds them not incrementally valuable when they merely focus users’ attention on management’s going concern disclosures.
• Disclosure of the audit partner’s name does give users the information they need to understand the audit.
  • Although some studies provide mixed evidence about whether disclosing the audit partner’s name increases audit quality, other studies suggest that (1) different audit partners are associated with different levels of audit quality and (2) the restatement history of the audit partner may scare off some potential investors.  However, higher audit fees appear to be the cost of disclosing this useful information.
• Disclosures related to auditor independence and tenure give users some of the information they need to understand the audit.
  • Although a review of prior research suggests no link between non-audit services (NAS) and auditor independence, a recent study found that total NAS fees are associated with higher (lower) audit quality for issuers (non-issuers).
  • Although a review of prior research does not find decreased audit quality for firms with longer audit firm tenure, a recent study suggests that long audit firm tenure is only associated with decreased audit quality for audits of non-issuers.

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The findings of this study have important implications for practice. Although prior research has suggested that an audit judgment rule may improve audit quality, findings from this research suggest that audit quality may decrease. This is seen indirectly by the audit committee members’ belief that accounting estimates become less conservative and due diligence decreases when there is an audit judgment rule. However, this was not directly tested, and future research is needed to determine whether audit judgment rules are beneficial or not.

Kang, Y.J., A.J. Trotman, and K.T. Trotman. 2015. The effect of an Audit Judgment Rule on audit committee members’ professional skepticism: The case of accounting estimates. Accounting, Organizations and Society 46: 59-76.

The purpose of this study is to examine how a proposed audit judgment rule impacts the professional skepticism of the members of an audit committee. Prior research has suggested that an audit judgment rule be implemented that requires courts and inspectors to not second-guess auditors’ reasoned judgments when they are made in good faith and in a rigorous manner. Currently, the concern is that auditors are engaging in defensive auditing and fearful of using innovative approaches to auditing accounting estimates. By examining the audit committees’ reaction to the proposed rule, the researchers are able to examine how audit committees believe this change impacts audit quality and how it impacts the behavior of the audit committee.

Data for this paper was collected prior to March 2015 by using an experiment with audit committee members from Australia. All participants had been on an audit committee in the past, and on average they had been on audit committees for 10.33 years.

With the introduction of the audit judgment rule, there was an increase in perceived accountability in ensuring the reasonableness of the financial statements from the audit committee members. This was due to a belief that accounting estimates become less conservative and due diligence decreases. This increase in perceived accountability did not necessarily lead the audit committee members to act more professionally skeptical by asking more probing questions. However, the audit committee was more comfortable when they used innovative techniques in developing their accounting estimates. This was due to a belief that innovation leads to improved audit quality. Additional analysis demonstrates that former audit partners showed greater skepticism (by asking more probing questions) than other audit committee members.

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Auditor aggressive/conservative reporting style may be a systematic audit partner attribute and non-randomly distributed across engagements. Particular market participants (in this case, lenders) appear to recognize and price these differences in reporting style. While the particular mechanism through which these different reporting styles occur is not possible to determine, the results suggest the importance of individual audit partners in influencing audit reporting decisions. Therefore, current regulations in both the US and EU to identify the individual partner’s identity could potentially offer valuable information to market participants.

Knechel, W. R., A. Vanstaelen, and M. Zerni. 2015. Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions. Contemporary Accounting Research 32 (4):1443-1478.

Current debate exists as to whether requiring individual auditor identification would enhance audit quality and, if so, whether investors understand and respond to these differences. This study provides empirical evidence to support the assertions that:

1. Reporting style (i.e. consistently conservative or aggressive reporting) is an individual partner attribute that systematically differs between partners.  
2. Investors understand and respond to these differences when assessing a company’s risk.

This study is especially relevant given both the EU’s decade old requirement to disclosure of audit engagement partner and the recent, similar PCAOB requirement that US audit partners do the same.

The authors use archival methods. They acquired panel data between 2001 – 2008 of the total clienteles of individual Big 4 audit partners of statutory audits for small, private companies in Sweden. This excludes non-Big 4 auditors and joint auditors.

In general, the frequency of Type I and II reporting errors is correlated over time for an individual partner both (1) across time for the same client and (2) between clients. As such, aggressive or conservative accounting appears to be a systematic partner attribute. Regarding investors, they appear to understand that partner reporting style is systematic across time and between clients and penalize firms audited by partners with a history of aggressive reporting via higher interest rates, lower credit ratings, and higher credit/insolvency risk. These results are, generally, economically significant.

More specific results include:  

• Predictive ability of both accruals and cash flows on future OCFs are lower when prior reporting errors of either Type have previously occurred.
• Prior aggressive reporting results in lower persistence of current accrual estimates.  
• Type I (Type II) reporting errors are negatively (positively) associated with abnormal accruals.
• Conservative accrual reporting is positively (negatively) associated with Type I (Type II) reporting errors in all settings. Aggressive accrual reporting is positively (negatively) associated with Type II (Type I) reporting errors in low-risk settings.  
• Clients of partners with aggressive reporting style have higher implicit interest rates, lower credit ratings, higher assessed insolvency risk, and lower Tobin’s Q. Conservative reporting styles has no effect on these credit measures.  
• Past partner reporting style differentially affects market reaction to a new Going Concern Opinion.
• Past partner Type II reporting errors has an economically marginally-significant effect on insolvency risk.

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The study results are important to regulators and audit practitioners as they show the differential audit quality for participating auditors used in issuer audits. The results show that audit quality declines when audit engagements use participating auditors that are not experienced in auditing SEC issuers. This indicates that public disclosure of the principal and participating auditors in the audit report can provide useful information to evaluate audit quality.  

Dee, C.C., A. Lulseged, and T. Zhang. 2015. Who Did the Audit? Audit Quality and Disclosures of Other Audit Participants in PCAOB Filings. The Accounting Review 90 (5): 1939-1967.

The Public Company Accounting Oversight Board (PCAOB) introduced in 2011 and re-proposed in 2013, an auditing standard that would require audit reports of SEC issuers to disclose participants in the audit other than the principal auditor. The PCAOB introduced the proposal to provide investors with full disclosure of the participants in the audit process, including affiliated firms of international audit firm networks. The underlying assumption of the proposed standard is that participating auditor involvement may negatively effect audit quality.   However, using a participating auditor may not effect audit quality due to the market pressure on the principal auditor to maintain high audit quality. The authors investigate whether the proposed standard would provide market participants with additional information to evaluate audit quality.

The paper addresses whether there is a difference in audit quality between issuer audits with and without participating auditors. Using publicly available PCAOB filings, the authors identify an issuer sample that uses a participating auditor and a control sample that does not. The use of PCAOB filings allows the authors to identify participating auditors with limited experience in serving as a principal auditor for an issuer audit. The authors believe these auditors have a higher likelihood of low audit quality. If audit quality is not reduced using this auditor population, there is lower likelihood that audit quality reductions would occur in an expanded auditor sample. However, if audit quality is reduced, it would provide evidence that the proposed standard would benefit market participants in assessing audit quality.   

The authors employ an archival research methodology in this study and obtain PCAOB Form 2 filings from 2010-2012 to identify the sample. The study includes an experimental sample (use a participating auditor) and a control sample (does not use a participating auditor). To assess differences in audit quality, the authors use four proxies: cumulative abnormal returns, earnings response coefficients, discretionary accruals, and audit fees.

• The authors find that cumulative abnormal returns are significantly negative in the one, two, and three days after the public disclosure of a participating auditor for the experimental sample. For the control sample, the cumulative abnormal returns are not significantly different from zero. This finding shows that the initial disclosure of the participating auditor is informative to the market.
• In the earnings response coefficient analysis, the market valuation of earnings surprises decreases in the quarters subsequent to the public disclosure of the participating auditor. 
• When evaluating discretionary accruals, the authors find that performance-adjusted discretionary accruals are higher for the experimental sample issuers when compared to the control sample. 
• Using audit fees as a measure of audit quality, the results did not show a reduction in audit fees for the experimental sample issuers compared to the control sample.
• Overall, the results show that the public disclosure of SEC issuer engagements with participating auditors provides the market with information that is beneficial in assessing audit quality.  
   

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