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  • Jennifer M Mueller-Phillips
    The Interactive Effects of Internal Control Audits and...
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    The Interactive Effects of Internal Control Audits and Manager Legal Liability on Managers' Internal Controls Decisions, Investor Confidence, and Market Prices.
    Practical Implications:

    The results demonstrate a demand for IC audits such that, even in the presence of increased manager liability, the IC audit incrementally motivates managers to spend on improving IC and to provide more consistent and accurate ICFR disclosures. Unlike managers, investors react as though manager liability and IC audits are substitutes. This finding has implications for policymakers as it demonstrates the need to consider the possible differing effects of regulation on managers and investors. Moreover, with respect to regulatory actions to simultaneously implement both manager liability and an IC audit, the results suggest that both mechanisms may not be necessary to improve investors’ confidence and in turn market prices.

    Citation:

    Wu, Y., & Tuttle, B. 2014. The Interactive Effects of Internal Control Audits and Manager Legal Liability on Managers' Internal Controls Decisions, Investor Confidence, and Market Prices. Contemporary Accounting Research 31 (2): 444-468.

    Keywords:
    internal controls, internal auditing, investor confidence, Sarbanes-Oxley
    Purpose of the Study:

    This study investigates the effects of the audit of internal controls (IC audit) and manager liability for the company’s internal controls on investor confidence and market prices. This research is motivated by the substantial debate regarding the incremental effectiveness of IC audits and manager liability on investor confidence in financial disclosures. This debate came to the forefront with the Sarbanes-Oxley Act of 2002 (SOX) when the U.S. Congress simultaneously implemented both regulatory mechanisms. Section 302 requires that CEOs and CFOs personally attest, under penalty of perjury, that effective internal controls over financial reporting (ICFR) have been established, maintained, and evaluated on a timely basis. Section 404 requires that the auditors of publicly-traded companies provide assurance on the effectiveness of ICFR. However, direct empirical evidence remains limited regarding the individual versus joint effectiveness of these two regulatory mechanisms in (1) motivating managers to spend on improving ICFR and to provide more accurate ICFR disclosures and (2) improving investor confidence and market prices.

    Design/Method/ Approach:

    Seventy-six MBA students from a major public university participated in this study. The 76 participants resulted in a total of 19 sessions with four participants assigned to each. The experiment is programmed and conducted using ZTree software. Each session takes approximately 90 minutes and includes three practice rounds followed by 21 experimental rounds. The number of rounds is not known by participants. The evidence was collected prior to the summer of 2014.

    Findings:
    • Results suggest that the effects of manager liability and an IC audit are additive with respect to IC spending, with the IC audit having a stronger effect than manager liability.
    • Even after controlling for managers’ IC spending, results also demonstrate that IC audits improve the accuracy of managers’ ICFR disclosures.
    • Similar improvement is not associated with increased manager liability. In the presence of the IC audit, managers’ IC spending strategies are more constant over time and enable managers to provide accurate information more consistently regarding the effectiveness of ICFR.
    • Managers will spend more to improve ICFR when either liability or IC audits are present and that even in the presence of manager liability the IC audit incrementally increases managers IC spending.
    • The results demonstrate that investor confidence and stock price are no greater when both regulatory mechanisms are present than when only one is present.
    • Supplemental analyses suggest that manager reputation for accurate ICFR disclosures explains, at least in part, why investors perceive manager liability and IC audit to be substitutes.
    • The results suggest that when managers accrue a reputation for accurate ICFR disclosures, both regulatory mechanisms may not be necessary to improve investor confidence in managers’ earnings reports.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
  • Jennifer M Mueller-Phillips
    SOX after Ten Years: A Multidisciplinary Review.
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX 
    Title:
    SOX after Ten Years: A Multidisciplinary Review.
    Practical Implications:

    For researchers, the challenges are to develop methods that better specify and estimate the Act’s potential benefits, as well as its indirect costs. For policy-makers, the challenges are how to better design future regulatory (or de- or re-regulatory) interventions so as to permit more reliable inferences about their effects, to improve the quality of information about whether they have led to net benefits, and to reduce the risk that pure politics, untethered by fact or reason, will continue to generate unnecessarily costly oscillation in systemically important laws, regulations, and institutions that form the foundations of capitalism. These tasks are all the more important given ongoing efforts to legally mandate quantified cost-benefit analysis of financial regulation, which the findings here suggest remains aspirational, rather than feasible.

    Citation:

    Coates, J. C., & Srinivasan, S. 2014. SOX after Ten Years: A Multidisciplinary Review. Accounting Horizons 28 (3): 627-671.

    Keywords:
    audit, cost benefit analysis, PCAOB, regulation, Sarbanes-Oxley, SEC
    Purpose of the Study:

    The authors review and assess over 120 studies of the Sarbanes-Oxley Act. They describe major developments in its legal, regulatory, and institutional implementation; its effects on U.S. corporate law, disclosure practices, and other countries’ laws; and the propensity of companies to go or remain public in the U.S. The authors also note a puzzle regarding the Act’s reception in public debate. 

    Design/Method/ Approach:

    The authors review and assess research findings from more than 120 papers in accounting, finance, and law to evaluate the impact of the Sarbanes-Oxley Act after 2005. The authors sketch a research agenda in light of the literature review and assessment.

    Findings:

    On the one hand, the Sarbanes-Oxley continues to be fiercely and relentlessly attacked in the U.S., particularly in political election battles and during legislative debates, reflected in part in provisions of the Dodd-Frank Act and the JOBS Act, which can be seen as a partial legislative rollback of the Act. On the other hand, the authors discuss survey evidence that suggests that informed observers, including corporate officers and investors, do not believe that the Actas implemented, taking into account significant relaxations of its most criticized provision (section 404[b] internal control attestation)has been a significant problem, and may well have produced net benefits, and the law has been copied at least in part by other countries.

    The authors suggest that the puzzle of the Act’s reception may be explained in part by the inconclusive state of research on its costs and benefits, and so follows a two-part pattern that may be generalized to most types of regulation in the spheres of financial institutions, markets, and corporate governance. Firstas with most types of regulationthe Act had clear, non-trivial, and quantifiable direct costs. Second, the tasks of estimating either the benefits or the indirect costs of the Act are at least an order of magnitude more difficult than the task of estimating direct costs, and are possibly beyond the present capacity of researchers to achieve with much precision.

    Category:
    Standard Setting
    Sub-category:
    Impact of SOX
  • Jennifer M Mueller-Phillips
    A Perspective on the PCAOB - Past and Future.
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 01.06 Impact of PCAOB 
    Title:
    A Perspective on the PCAOB - Past and Future.
    Practical Implications:

    The quality of the firm performing the audit is important but must be viewed through the perspective of a specific engagement team and a specific set of circumstances. Information supplied by the PCAOB is one component of the evaluation of the likelihood that an engagement team will perform a quality audit and of specific areas of audit practice where deficiencies have been identified. In the end, however, issues of independence, auditor rotation, industry competence, attention to the work, and all the other important aspects of audit quality must be monitored by the audit committee at the engagement level in the context of the specific engagement.

    Citation:

    Wedemeyer, P. D. 2014. A Perspective on the PCAOBPast and Future. Accounting Horizons 28 (4): 937-947.

    Keywords:
    internal auditing, auditing standards, PCAOB, Sarbanes-Oxley
    Purpose of the Study:

    The passage of Sarbanes-Oxley (SOX), the creation of the Public Company Accounting Oversight (PCAOB), and subsequent developments have substantially increased the political visibility of auditors and audits of financial statements. These same events have substantially decreased the role of the auditing profession in establishing audit standards and standards of audit performance; auditing is now an industry regulated primarily by persons who are not professional auditors. The perceived interest of each of the parties involved in the political process is often in conflict with those of any, or all, of the other parties.

    The author’s primary concern is the quality of the audit performed on a specific engagement.

    Design/Method/ Approach:

    This paper summarizes and synthesizes information on the PCAOB and its effect on the business model of an audit firm.

    Findings:

    SOX requirements for PCAOB inspections of audit firms substantially increased the possibility that an audit will be subsequently evaluated despite the absence of identified errors in audited financial statements. The SOX requirement for an auditor's opinion on internal controls over financial reporting (ICFR) immediately increased audit costs. The net effect of these changes has been to increase the cost of audits, particularly as a result of increased review, other quality control activities, and the performance of audits of ICFR, where required. In return, the quality of audits in terms of compliance with audit standards has improved significantly. However, the business models of audit firms and the processes for education and certification of accountants have remained substantially unchanged and are major influences on the quality of audits.

    Category:
    Standard Setting
    Sub-category:
    Impact of PCAOB, Impact of SOX
  • Jennifer M Mueller-Phillips
    Auditor-provided nonaudit services and audit effectiveness...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    Title:
    Auditor-provided nonaudit services and audit effectiveness and efficiency: Evidence from pre-and post-SOX audit report lags
    Practical Implications:

    The results of this study have important implications for regulators, the accounting profession, and clients concerned with the escalating costs of the audit:

    • This study extends prior empirical evidence by showing that the joint provision of audit and nonaudit services does not reduce audit quality even when audit lags are shorter due to potential knowledge spillover
    • It also suggests that audit efficiencies may flow from the joint provision of audit and nonaudit services. The loss of potential synergies between audit and nonaudit services following the SOX ban on most auditor-provided nonaudit services will impose a greater cost burden on firms and may lead to lower audit quality.
    • The significance of audit lag as a determinant of reporting timelines is even more important in an era of accelerated SEC filing.

    For more information on this study, please contact Robert Knechel.

    Citation:

    Knechel, W. R., and D. S. Sharma. 2012. Auditor-provided nonaudit services and audit effectiveness and efficiency: Evidence from pre-and post-SOX audit report lags. Auditing: A Journal of Practice & Theory 31(4): 85-114.

    Keywords:
    audit quality; fee; lag; nonaudit; knowledge spillover; Sarbanes-Oxley
    Purpose of the Study:

    The debate about auditor-provided nonaudit services and whether they adversely affect audit quality or auditor independence has been a controversial topic in the profession for many years. The accounting profession generally disagreed with the prohibition against nonaudit services and argued that the joint provision of audit and nonaudit services improves the performance of the audit, claiming that knowledge spillover between the audit and nonaudit functions improves the quality of both. In academic area, empirical research has concentrated on the stream of the literature that focuses exclusively on audit effectiveness, because regulatory allegations pointed to auditors compromising their independence. Another stream of the literature that focuses on the association between nonaudit services and audit efficiency has received limited academic attention.  This study examines the relationship between nonaudit services and both audit effectiveness and efficiency using evidence from fees paid for nonaudit services and lags in audit reports.

    Design/Method/ Approach:

    The authors’ final sample consists of 5,004 firm-year observations of Big 5/Big 4 audit firms over the period 2000 to 2003 inclusive (data available in Compustat). The study used nonaudit service fees as a proxy for the extent of nonaudit services provided by the audit firm. 

    Findings:
    • Higher nonaudit service fees are associated with shorter audit report lags—a potential indicator of audit efficiency— prior to the passage of SOX, but such effects dissipate after SOX.
    • Audit quality, as measured by discretionary accruals and financial restatements, does not deteriorate when audit report lags are shorter for clients purchasing high levels of nonaudit services.
    • Discretionary accruals and financial restatements—potential indicators of audit effectiveness—do not increase when shorter audit lags occur in conjunction with high nonaudit service fees. This study also find that the firms with the highest levels of nonaudit service fees prior to SOX have the largest increase in audit lags after SOX.

    The authors claimed that taken together, the results are consistent with the concept of the auditor accumulating client-specific knowledge and expertise (i.e., knowledge spillovers) through the joint provision of audit and nonaudit services that can benefit both the audit and nonaudit services provided to clients. Additionally, the authors state the results imply that joint provision of audit and nonaudit services does not undermine the effectiveness of the audit but yields audit efficiency, and any gains in audit efficiency do not come at the loss of audit effectiveness.

    Category:
    Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of SOX, Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    Reflections on a Decade of SOX 404(b) Audit...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    Reflections on a Decade of SOX 404(b) Audit Production and Alternatives
    Practical Implications:

    Public interest demands more transparency and analysis about how control audits are conducted, how they might be improved, and what might be better alternatives for the future. Thus investors, auditors, standard setters, academics, auditing students and U.S. markets could all benefit in the long run, from more transparency about the current U.S. audit production process and from informed debate about the best mechanism design for balancing the needs of all parties interested in internal control quality disclosure.

    For more information on this study, please contact William R. Kinney Jr.

    Citation:

    Kinney Jr, W. R., R. D. Martin, and M. L. Shepardson. 2013. Reflections on a Decade of SOX 404 (b) Audit Production and Alternatives. Accounting Horizons 27(4): 799-813.

    Keywords:
    Sarbanes-Oxley Act of 2002; regulation alternatives; internal control audits; 404(b).
    Purpose of the Study:

    Since the passage Sarbanes-Oxley Act during July 2002, audit production in the U.S. has been substantially expanded by mandated internal control audits. The control audit mandate is unique to the U.S. and costly to apply, yet little is known about the conduct of control audits or the efficacy of lower-cost alternatives. Hence, this paper reflects the authors overall knowledge about control audit production and observation of a consistent message across public and limited non-public archival data. 

    Design/Method/ Approach:

    The authors have followed 404(b) audit implementation from perspectives as auditing educators, academic fellows at the Securities and Exchange Commission (SEC), advisor to the Public Company Accounting Oversight Board (PCAOB), standards setter as an International Auditing and Assurance Standards Board (IAASB) member, and a Big 4 audit manager applying 404(b).

    Other methods include: research projects; theoretical, archival, and behavioral research of others; and numerous control audit conversations regarding implementation with U.S. and foreign regulators, standards setters, practitioners, directors, corporate officers, and investors.

    Findings:

    Main observations

    • Audits of internal control processes are fundamentally different from audits of financial statements as to objective, value, and approach, although they share some attributes.
    • The three sources of control audit evidence required by PCAOB standards differ substantially in incremental costs, audit expertise required, and ability to identify material weaknesses so that:
      • Relative to design evaluation and implementation testing, auditors are effective and efficient at identifying control weaknesses that have resulted in known accounting misstatements—even if the misstatements are immaterial.
      • Absent knowledge of accounting misstatements, identification of weaknesses in control process design is difficult.
      • The appropriate scope of operating effectiveness testing remains unclear, as does when entity-level control tests can substitute for process-level control tests.

    Alternatives to mandated control audits:

    • No other country or auditing standards-setting body has adopted the U.S. control audit legislated mandate, even though it has been considered in multiple countries.
    • Some other countries have developed alternatives that partially apply the U.S. requirements and provide some control information to investors, but at less cost of production.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of SOX
  • Jennifer M Mueller-Phillips
    Audit Committee Director-Auditor Interlocking and...
    research summary posted March 2, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.02 Board/Financial Experts, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Audit Committee Director-Auditor Interlocking and Perceptions of Earnings Quality
    Practical Implications:

    This study is important to provide an insight into the personal relationships and familiarity between audit committee directors and external auditors in terms of auditor independence. Furthermore, our examination of AC director-auditor interlocking provides a more complete basis for understanding the effectiveness of corporate governance in guarding earnings quality. The results not only support the view that AC director-auditor interlocking positively affects investors’ perception of earnings quality, but also support the regulatory requirement that audit committees include at least one financial expert.

    For more information on this study, please contact Jeng-Fang Chen.

    Citation:

    Chen, J.-F., Y.-Y. Chou, R.-R. Duh, and Y.-C. Lin. 2014. Audit committee director-auditor interlocking and perceptions of earnings quality. Auditing: A Journal of Practice and Theory 33 (4): 41-70

    Keywords:
    Audit committee director-auditor interlocking, investor perceptions, earnings response coefficients, financial expert
    Purpose of the Study:

    In response to Enron and subsequent financial reporting scandals, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 (SOX, hereafter), which put particular emphasis on the role of audit committees in ensuring financial reporting quality. Although existing regulations stipulate the composition and qualifications of audit committee directors, audit committee director interlocking that arises when an audit committee director serves on more than one audit committee is allowed. Therefore, we analyze how investors perceive reported earnings when companies with interlocking audit committee directors are audited by the same audit firm (hereafter, AC director-auditor interlocking), using earnings response coefficients (ERCs) as a proxy for investor perceptions of earnings quality. The tendency of AC director-auditor interlocking could have positive or negative implications for the audit committee’s effectiveness in guarding earnings quality.

    • A positive influence may result insofar as closer personal relationships enhance the audit committee’s understanding and trust of auditors, thereby making interlocking audit committee directors more likely to support the auditor in accounting and auditing disputes.
    • An opposing argument is that economic incentives may compromise auditor independence. Also, interlocking audit committee directors may be less critical of auditor performance due to personal relationships with the interlocking auditor.

    Besides the relationship between AC director-auditor interlocking and ERCs, this study investigates whether the potential positive impact of AC director-auditor interlocking in improving earnings quality would be outweigh the potential negative influence in the post-SOX period, when shareholders and regulators have higher expectations and heighten liability concerns for both interlocking audit committee directors and auditors. In particular, this study examines if earnings quality is higher when interlocking audit committee directors are financial experts who are better placed to recommend streamlining of audit committee procedures on the financial reporting process.

    Design/Method/ Approach:

    We collect director information through the RiskMetrics database, which covers S&P 1500 companies, from fiscal years 1998 to 2010, while the impact of financial experts is examined by a sample from fiscal years 2003 to 2010. This study uses ERCs from returns-earnings regressions and designs three measures for the degree of a firm’s AC director-auditor interlocking to examine its impact on earnings quality. 

    Findings:
    • This study finds that a greater extent of AC director-auditor interlocking is perceived as associated with higher earnings quality.
    • This study finds that investors’ perceptions of earnings quality are more affected by the extent of AC director-auditor interlocking in the post-SOX era than before it, whatever we use the pre- and post-SOX subsamples or the interaction item of SOX for the test.
    • This study finds that investors perceive AC director-auditor interlocking especially positively when interlocked audit committee directors are financial experts. That is, the results document that the positive impact of AC director-auditor interlocking on the ERCs is more pronounced when interlocking audit committee directors are financial experts.
    Category:
    Corporate Matters, Governance, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Board/Financial Experts, Impact of SOX
  • Jennifer M Mueller-Phillips
    Did SOX Influence the Association between Fee Dependence and...
    research summary posted February 20, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 09.0 Auditor Judgment, 09.04 Going Concern Decisions 
    Title:
    Did SOX Influence the Association between Fee Dependence and Auditors’ Propensity to Issue Going-Concern Opinions?
    Practical Implications:

    This research note presents evidence that the question of whether new standards or regulations have achieved the objective of altering the behavior of their intended target cannot be adequately assessed shortly after they have come into effect, as the implementation often requires a steep learning curve and is frequently accompanied by intense public debates and media scrutiny. From the policy standpoint, it suggests that the concern expressed by the U.S, Treasury Department officials about auditors’ applying an overly strict approach in their audits to counter elevated liability after SOX may not be warranted.

    For more information on this study, please contact Wenjun Zhang.

    Citation:

    Kao, J. L., Y. Li., and W. Zhang. 2014. Did SOX influence the association between fee dependence and auditors’ propensity to issue going-concern opinions? Auditing: A Journal of Practice and Theory 33 (2): 165-185

    Keywords:
    Fee dependence, going-concern opinion, auditor independence, SOX
    Purpose of the Study:

    Li (2009) shows that the association between fee dependence (FEEDEP) and auditors’ likelihood to issue qualified going-concern audit opinions (GCO) changes from insignificant in 2001 to positive in 2003. Since then, several studies have quoted Li’s (2009) findings as evidence that SOX has led auditors to behave more conservatively with respect to going-concern reporting.

    This research note extends Li’s (2009) post-SOX sample period from 2003 to 2011 and demonstrates that her findings for 2003 do not hold over a much longer post-SOX period, implying that SOX has had little effect on auditors’ behavior with respect to going-concern reporting for their large financially distressed clients. These results call into question whether the positive FEEDEP-GCO association identified by Li (2009) indeed represents new audit practice in the post-SOX era.

    This research note is motivated by Feldmann and Read (2010), who showed that the incidence of qualified going-concern opinions issued to subsequently bankrupt companies reverted back to the pre-Enron level by 2006-2007 after a brief increase in 2002-2003, suggesting that the year right after the passage of SOX was not typical. Thus, by focusing on 2003, researchers merely capture a transitory reaction by the audit profession to intense public scrutiny following SOX.

     

    Reference: Li, C. 2009. Does client importance affect auditor independence at the office level? Empirical evidence from going-concern opinions. Contemporary Accounting Research 26 (1): 201-230.

    Design/Method/ Approach:

    The authors run ten annual regressions (2001; 2003-2011) of auditors’ propensity to issue qualified going-concern opinions to financially distressed audit clients (GCO) on a fee dependence measure (FEEDEP). Comparing the association between GCO and FEEDEP before versus after the passage of SOX, the authors draw inferences about whether the more conservative going-concern reporting documented by Li (2009) indeed represents a long-term equilibrium behavior in the post-SOX audit market. 

    Findings:
    • The authors find no association between auditors’ propensity to issue qualified going-concern opinions to financially distressed audit clients and the fee dependence measure over an extended post-SOX period (i.e., 2003-2011), implying that SOX has had no observable lasting effect on auditor conservatism with respect to going-concern reporting.
    • The authors find that while auditors were equally cautious in issuing qualified going-concern opinions to clients that eventually failed, both before and after SOX, they have made more Type I misclassifications in 2003 by issuing qualified going-concern opinions to clients that remained solvent within two years of financial statement dates. 
    Category:
    Auditor Judgment, Independence & Ethics, Standard Setting
    Sub-category:
    Going Concern Decisions, Impact of Fees on Decisions by Auditors & Management, Impact of SOX
  • Jennifer M Mueller-Phillips
    A Summary of Research on External Auditor Reliance on the...
    research summary posted February 16, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control 
    Title:
    A Summary of Research on External Auditor Reliance on the Internal Audit Function
    Practical Implications:

    Regulators should draft regulations and oversee the profession in such a way that reflects an understanding of the complex environment in which practitioners are making reliance decisions. Standard setters, both domestic and international can learn from the cultural and jurisdictional nuances of different countries, which will facilitate appropriate internal audit reliance as corporations continue to have multi-national presences. Practitioners can benefit from the study by utilizing the review to improve upon their reliance decision frameworks.

    For more information on this study, please contact Chad Stefaniak.

    Citation:

    Bame-Aldred, C. W., D. M. Brandon, W. F. Messier, Jr., L. E. Rittenberg, and C. M. Stefaniak. 2013. A Summary of Research on External Auditor Reliance on the Internal Audit Function. Auditing: A Journal of Practice and Theory 32 (Supplement 1): 251-286

    Keywords:
    external audit; internal audit; reliance on the internal audit function; audit judgments.
    Purpose of the Study:

    The Public Company Accounting Oversight Board (PCAOB) requested a synthesis of existing research on the external auditor’s reliance of the internal audit function. Auditing Standard No. 5 (AS5) allows external auditors to rely on the internal audit function under certain criteria. This paper synthesizes post Sarbanes-Oxley research (2004 – 2012) that examines external auditor reliance of the internal audit function. The research reviewed pertains to:

    1. The influence of environmental factors on internal auditor reliance (i.e., Regulatory Environment and Governance and Client Management Characteristics),
    2. The impact of internal audit specific factors on reliance (i.e., Competence, Objectivity, and Work Quality),
    3. The nature and extent of the external auditor’s reliance, and
    4. The outcome effects of external auditor reliance on the internal auditor (i.e., Audit Efficiency, Fees, Financial Statement Quality, and Litigation).

    The research examined is limited and does not fully address the PCAOB’s inquiries, specifically jurisdictional limitations on internal audit reliance and overall threshold limitations on internal audit reliance. This paper identifies gaps in the research and proposes a series of research questions aimed at closing these gaps.

    Design/Method/ Approach:

    The review included current and proposed U.S. and international auditing standards, academic literature and selected practitioner research related to the nature of internal audit work, and the external auditor’s reliance on this work. Based on this review, the paper includes a proposed summation model and organizing framework to help capture the various factors in the reliance decision. This organizing framework is used to present the synthesis of the relevant research, identify gaps in the research and propose research questions aimed at closing these gaps. In addition, the relevant papers are summarized for ease of understanding. This summary includes the methodology, the objective of the research project, the sample (if applicable), the results of each study, and a cross-reference to the proposed research questions. 

    Findings:
    • The environment (i.e., the regulatory environment and governance and client characteristics) in which external auditors must make a reliance decision is complex – involving several factors that must be considered simultaneously. The evolving set of global auditing standards further complicates the reliance decision process.
    • Researchers have made some progress in understanding the influence of external auditors’ evaluations of internal auditor quality factors (i.e., competence, objectivity, and work performance); however, very little is known about how, and to what extent, external auditors are evaluating internal audit quality factors.
    • Research notes that the nature and extent of external auditors’ reliance on internal auditors is influenced by account risk, inherent risk, and internal audit sourcing (e.g., outsourced, co-sourced, or in-house). How the external auditors choose task environments (e.g., revenue recognition versus payroll) and the types of tests to rely upon within these task environments is not completely understood.
    • There are several unaddressed issues in the current research. These include:
      • Research examining the influence of continuous monitoring on the reliance decision
      • Research examining the reliance decision for integrated audits of public companies, specifically the audit of internal control over financial reporting.
      • Research examining the evolving nature of the internal audit function.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of SOX
  • Jennifer M Mueller-Phillips
    Audit Partner Rotation and Financial Reporting Quality
    research summary posted February 15, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 11.0 Audit Quality and Quality Control, 11.01 Supervision and Review – Effectiveness 
    Title:
    Audit Partner Rotation and Financial Reporting Quality
    Practical Implications:

    This study informs the debates on costs and benefits of audit partner rotation. The results support concerns of the audit profession that audit partner rotation may impair the quality of audited financial information in the initial years of a new partner’s engagement with a client. This impairment appears to be more pronounced for larger clients and clients of non-Big 4 audit firms. Furthermore, the persistence of these quality consequences for non-Big 4 audit firms raises questions about the resource capacity of such firms to cope with imposing regulations. Given that partner rotation has both monetary and social costs, perhaps the decision to shorten partner engagement with a client from seven to five years is not in the best interests of auditors and investors. Ultimately, the costs of an audit will be passed onto investors, and as the study suggests, more frequent rotation may mean more periods of lower financial statement quality in the initial years of a partner’s engagement with a client. Additionally, the study’s city-level industry specialist and office size results suggest industry specialists and larger audit firm offices may have more capacity to absorb and manage partner rotation effects than non-specialists and smaller offices. Such findings support the audit profession’s concern over resource challenges brought on by more stringent partner rotation requirements. 

    For more information on this study, please contact Paul Tanyi.

    Citation:

    Litt, B., D. S. Sharma, T. Simpson and P. N. Tanyi. 2014. Audit Partner Rotation and Financial Reporting Quality. Auditing: A Journal of Practice and Theory 33 (3): 59-86

    Keywords:
    Audit quality, earnings management, financial reporting quality, discretionary accruals, meet or beat, partner rotation, partner change
    Purpose of the Study:

    Audit partner rotation has received considerable attention globally and in the U.S. since Section 203 of the Sarbanes-Oxley Act of 2002 accelerated the rotation period for lead and concurring engagement partners from seven to five years and expanded their cooling-off period from two to five years. Policymakers have rationalized these regulations based on enhanced partner independence and a fresh set of eyes examining the financial statements, thus increasing overall audit quality. However, the audit profession has argued that the loss of engagement partner continuity and client-specific knowledge brought on by increased rotation may actually hinder the quality of the audit. Despite such debate, there is a paucity of research on the effects of audit partner rotation in the U.S., largely due to the absence of publicly available information on audit partners. Using a novel approach to determine audit partner rotation, the authors are able to investigate the effect of rotation on financial reporting quality in the U.S. 

    Design/Method/ Approach:

    After performing procedures to obtain assurance on audit firm compliance with rotation regulations, the authors collect data from 2000 to 2010 for a sample of U.S. public clients that have changed audit firms. From this data, they are able to determine: (1) the first year of a partner’s engagement with a client (the year of audit firm change), (2) the year of audit partner rotation (five years later), and (3) the post-rotation year that a new audit partner leads the audit engagement (the sixth year post-audit firm change). The authors then examine whether financial reporting quality differs between the final two years with an outgoing partner and the first two years with a new partner post-rotation by evaluating discretionary accruals and going-concern reporting for these periods.

    Findings:
    • The authors find that financial reporting quality is lower during the first two years with a new audit partner as compared to the last two years with an outgoing partner. 
    • The authors find that partner rotation has a more adverse effect on financial reporting quality for larger clients of Big 4 auditors and across all clients of non-Big 4 auditors. 
    • The authors find the decline in financial reporting quality to be limited to the first year post-rotation for larger Big 4 clients, but persistent for up to three years post-rotation for non-Big 4 clients.
    • The authors find that non-specialist audit firms and audit firms with smaller offices at the city-level exhibit lower financial reporting quality as a result of rotation.
    • The authors find that financial reporting quality is less negatively affected during the first two years of an audit partner’s engagement with a client relative to the first two years of an audit firm’s engagement with a client.
    Category:
    Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of SOX, Supervision & Review – Effectiveness
  • Jennifer M Mueller-Phillips
    PCAOB Inspection Consequences, Processes, and Inspection...
    research summary posted October 22, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX 
    Title:
    PCAOB Inspection Consequences, Processes, and Inspection Team Performance: Perspectives of Triennially Inspected Firms
    Practical Implications:

    The results of this study are important to practitioners, regulators, legislators, academicians, and other market participants as many aspects of SOX and PCAOB inspections have been criticized. Oversight bodies have modified SOX in response to concerns of oversight groups (Advisory Committee on Smaller Public Companies). Researchers and practitioners have called for research to study the impact of SOX on audit quality and the public interest. The Government Accountability Office (GAO), required by SOX to study the potential effects of further mandates, chose to wait several years to monitor and evaluate the effectiveness of SOX and the PCAOB on auditor independence and audit quality before proposing any further modifications (GAO 2004). We interpret our findings as suggesting the efficacy of PCAOB inspections may be enhanced by focusing on potential unintended consequences and inspection process modifications rather than on inspectors’ qualifications and actions.

     

    For more information on this study, please contact Brian Daugherty at University of Wisconsin-Milwaukee.

    Citation:

    Daugherty, B., and W. Tervo. 2010. PCAOB Inspection Consequences, Processes, and Inspection Team Performance: Perspectives of Triennially Inspected Firms. Accounting Horizons 24 (2):189-219.

    Keywords:
    PCAOB inspections: registered auditing firms: Sarbanes-Oxley; peer review
    Purpose of the Study:

    We solicit perceptions of the Public Company Accounting Oversight Board’s (PCAOB) inspection process from the leadership of triennial firms (100 or fewer publicly-traded audit clients, inspected triennially) receiving their initial inspection through the use of a survey. Our research is motivated by a growing stream of research related to triennial firms. Practitioners have called for research to determine if the performance of audits in the Sarbanes-Oxley era may fail to attain the stated objective of enhancing investor confidence in the capital markets. 

    Design/Method/ Approach:
    • Through December 2007, over 1,800 firms and affiliates were registered with and approved by the PCAOB to conduct audits of U.S. registrants, and 467 triennial firms had their initial inspection report posted on the PCAOB’s website. Instruments were mailed from 9/2007 to 1/2008.
    • We asked that the research instrument be completed by the person in each firm most closely involved with PCAOB inspections. 
    • A number of statements were designed to have participants evaluate consequences resulting from initial PCAOB inspections (Consequences), evaluate the inspection process (Process), and rate the performance of their PCAOB inspection team (Team). Consequence statements seek perceptions related to the influence of PCAOB inspections on overall audit quality, the ability to accept and retain public audit clients, public confidence in the audit profession, personnel time incurred in anticipation of inspection, incremental fees billed to clients as a result of inspection, recruitment and retention matters, and litigation risk. Process statements cover inspectors’ criticisms, engagement selection, time devoted to inspection, and confidentiality of findings related to firms’ QC systems and also gauge firms’ level of agreement with inspectors’ findings and evaluations of PCAOB inspections relative to the prior peer-review process. Team statements include those related to the technical knowledge and professional conduct of inspectors as well as the appropriateness of their focus on workpaper documentation, substantive procedures, and internal control audits.
    Findings:
    • Smaller respondents reported initial PCAOB inspections resulted in a negative impact on many aspects of their audit practices while medium and larger firms reported more favorable consequences.
    • Firms with reports released earlier in the initial inspection cycle reported negative consequences that appear to diminish as the process matures.
    • Results suggest very small triennial firms may be ceasing the performance of audits of public enterprises as a result of PCAOB inspections.
    • Smaller triennial firms disagree the PCAOB inspection process increases overall audit quality (contrary to the stated intentions of SOX) and both smaller and medium firms do not view PCAOB inspections as positively impacting their audit business.
    • Respondents generally evaluated inspectors’ performance in favorable terms but were much more critical of the inspection process itself.
    • An overriding concern of many inspected firms is the perception that inspectors are, in many cases, substituting their own judgment for the auditor’s professional judgment in determining whether audit engagements comply with applicable professional standards. This possibility is particularly troubling given the auditors’ direct interaction with client personnel and audit committee members in an ex-ante setting while PCAOB inspections are, by definition, conducted in an ex-post setting with minimal or no audit client contact.
    • Firms evaluated their initial inspection team’s performance favorably, but were more critical of the inspection process itself. Levels of satisfaction with nearly all aspects of PCAOB inspections appear to increase with firm size and the passage of time. 
    Category:
    Standard Setting
    Sub-category:
    Impact of PCAOB, Impact of SOX

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