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  • The Auditing Section
    Are the Reputations of the Large Accounting Firms Really...
    research summary posted April 23, 2012 by The Auditing Section, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
    Title:
    Are the Reputations of the Large Accounting Firms Really International?
    Practical Implications:

    This study provides an important implication for audit firms in maintaining their worldwide brand name reputation. The results suggest that, for global audit firms, the damage to auditor reputation in one country may spill over and cause concern among investors about the quality of their services in other countries. Further, the damage to reputation is greater where the demand for auditing and assurance is higher.

    Citation:

    Cahan, S. F., D. Emanuel, and J. Sun. 2009. Are the Reputations of the Large Accounting Firms Really International? Evidence from the Andersen-Enron Affair.  Auditing: A Journal of Practice and Theory 28 (2):  199-226. 

    Keywords:
    Auditor reputation, international audit markets, Arthur Andersen, Enron, auditor selection and auditor changes
    Purpose of the Study:

    The Big 4 accounting firms market themselves as global firms that deliver a uniform level of service across countries. While such a global reputation helps build worldwide demand for high-quality audits, it also creates risks if service quality becomes questionable in one of the countries in which a firm operates. Questionable audit practices in one of the countries, especially in the home jurisdiction, may  raise doubts as to whether sub-standard audits also occur in other countries. 

    This study examines whether the damage to the name brand of Arthur Andersen following the Andersen-Enron scandal in the U.S. spilled over into other countries. The study focuses on two key event dates leading up to Andersen’s demise: (1) January 10, 2002, when Andersen announced it had shredded documents related to the Enron audit, and (2) February 4, 2002, when Enron’s board released the Powers report that was critical of Andersen and when Andersen announced the establishment of an Independent Oversight Board (IOB) to investigate the firm’s audit policies and procedures. This study investigates the market reaction to Andersen’s clientele base around these two dates to determine whether: 

    • the events caused investors to reassess the reputation of Andersen’s non-U.S. audit units. 
    • investors’ reevaluation of Andersen’s reputation is more pronounced in cases where there is a higher demand for audit quality or credible financial statements. 
    • the effect is due to the perceived assurance or insurance value of an audit. The assurance value relates to an auditor’s ability to communicate with investors about the overall quality of client financial statements, while the insurance value relates to an auditor’s legal and financial liability for an audit failure.
    Design/Method/ Approach:

    The authors use data on publicly-traded companies audited by Arthur Andersen in 2001 to examine whether there is a negative market reaction to Andersen’s non-U.S. clients around the two event dates discussed above.

    Findings:
    • The authors document that an adverse market reaction to Andersen’s clients exists in non-U.S. countries, which suggests that the damage to Andersen’s reputation and audit quality in the U.S. spilled over to other countries.  
    • The market reaction is more negative in countries where there is a greater demand for high-quality auditing and credible financial reporting. More specifically, more-pronounced adverse market reactions are observed in common law (compared to code law) countries where investor protection is higher, ownership is more dispersed, and conflicts of interest between owners and managers are more likely to occur. 
    • The authors find that the market reaction for the shredding event is more negative for Andersen’s non-U.S., cross-listed clients than for Andersen’s non-U.S., non-cross-listed clients. This suggests that the shredding event may have been anticipated by the U.S. market as triggering lawsuits against Andersen and reducing its ability to pay for possible legal claims. 
    • The authors also report a similar market reaction for Andersen’s non-U.S., cross-listed clients and Andersen’s U.S. clients, suggesting similar levels of perceived audit quality across Andersen as a whole.
    Category:
    Auditor Selection and Auditor Changes, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Litigation Risk
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  • The Auditing Section
    The Impact of Roles of the Board on Auditors’ Risk A...
    research summary posted April 16, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    The Impact of Roles of the Board on Auditors’ Risk Assessments and Program Planning Decisions
    Practical Implications:

    The results of this study suggest that auditors do take into consideration board roles in their control risk assessments.  In addition, both dimensions of board structure are suggested to affect assigned audit hours. These findings provide additional insights into whether auditors are able to integrate adequately the board roles into their audit planning.  The results have implications for audit firms in better understanding how auditors incorporate the board roles into their risk assessments and audit planning.  Further, the results suggest that, in line with PCAOB AS 2, auditors rely on a more complex set of factors than simply the monitoring role of boards. 

    Citation:

    Cohen, J.C., G. Krishnamoorthy, and A.M. Wright. 2007.  The Impact of Roles of the Board on Auditors’ Risk Assessments and Program Planning Decisions.  Auditing: A Journal of Practice and Theory 26 (1): 91-112.

    Keywords:
    corporate governance; board role; resource dependence; risk assessment; audit planning judgments.
    Purpose of the Study:

    The current study expands our knowledge of the impact of governance structure, by focusing on how two attributes of boards influence the auditors’ risk assessment and program planning decisions. Specifically, the authors examine the influence of resource dependence and agency board roles, both defined below.  

    • A resource dependence role is described as one where the board member has specific experience with either the company or industry that is advantageous to their ability to provide relevant guidance. 
    • An agency role is described as one that provides a strong management monitoring function.  The current study examines whether inherent and control risk assessments are lower when these roles are stronger.  

    Below are the primary objectives that the authors address in this study: 

    • Examine the extent to which resource dependence and agency board roles affect auditors’ inherent risk assessment, control risk assessment, and planned audit hours (used as a proxy for extent of audit testing).
    Design/Method/ Approach:

    The investigation used an experimental questionnaire to obtain data. The questionnaire solicited voluntary responses from audit partners and managers at two large Northeast offices of one Big 4 auditing firm, prior to 2004.  Participants read a case-based experiment concerning a high-tech company, where the board related facts were varied between higher and lower resource dependence and higher and lower agency roles.  The participants then answered questions related to inherent and control risks, resource allocations and personal information.

    Findings:
    • Evidence suggests that auditors do respond to the roles of the board.  Specifically, auditors increase their control risk assessment when the board structure reflects weaker agency or resource dependence.
    • Evidence suggests that auditors do not respond to roles of the board when making inherent risk assessments. Specifically, the strength or weakness of either board characteristic has no impact on auditors’ inherent risk assessment. 
    • When auditors were presented with a board where resource dependence and agency roles were both higher, they decreased the amount of planned audit hours recommended.  Overall then, the evidence suggests that when both resource dependence and agency roles were higher, the control risk assessment and audit effort (i.e., planned audit hours) were lower. In all other combinations of the two board structure characteristics (i.e., high resource dependence-low agency, low resource dependence high agency, and low resource dependence-low agency), planned audit hours were higher.
    Category:
    Risk & Risk Management - Including Fraud Risk, Governance
    Sub-category:
    Assessing Risk of Material Misstatement, Board/Audit Committee Composition
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  • The Auditing Section
    CFO Intentions of Fraudulent Financial Reporting
    research summary posted April 13, 2012 by The Auditing Section, tagged 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.04 Management Integrity 
    Title:
    CFO Intentions of Fraudulent Financial Reporting
    Practical Implications:

    The results of this study call into question the legitimacy of compensation structure as a red flag for fraud risk and introduce company size as a new (and easily assessed) indicator of financial statement fraud. CFO attitude emerged as the most influential factor in the formation of intentions to misreport. This indicates that it is important that auditors attempt to assess client management’s attitude toward fraudulent financial reporting. Although directly assessing management’s attitude may not be possible, auditors can subjectively assess management attitude based on ongoing personal interactions with the client. More formal audit decision aids to assess management attitudes toward fraudulent financial reporting might also be valuable for successfully detecting fraud.

    Citation:

    Gillett, P.R. and N. Uddin. 2005. CFO Intentions of Fraudulent Financial Reporting. Auditing: A Journal of Practice and Theory 24 (1): 55-75.

    Keywords:
    Financial statement fraud, reasoned action model, company size, compensation
    Purpose of the Study:

    Many studies have examined whether the fraud risk factors or “red flags” listed in Statement on Auditing Standards (SAS) No. 99 are effective for predicting fraud. However, one limitation of this prior work is that it examines whether red flags were present after a fraud has already occurred. To address this limitation, this study identifies factors which influence the intentions of CFOs to report fraudulently and examines the predictive value of those factors. Thus, a CFO who expresses an intention to misreport will be more likely to actually do so. The following four factors are investigated to determine their respective influence on CFO intentions to fraudulently misreport: 

    •  Attitude: This refers to the CFO’s attitude toward fraudulent financial reporting. An attitude toward a behavior is formed based on the expected positive and negative consequences of the action. For example, if fraudulently overstating revenue will result in a management bonus, then the CFO’s attitude toward overstating revenue might be more positive.
    •  Subjective Norms: This refers to the CFO’s perception of the expectations of specific referents (e.g., coworkers, family, and friends) and the motivation to comply with those expectations. For example, a CFO who perceives that his/her coworkers, family and friends approve of fraudulent financial reporting will be more likely to misreport, especially if the CFO tends to comply with others’ expectations.
    •  Compensation Structure: When the compensation structure is highly contingent upon company performance, it is expected that managers are more likely to participate in fraudulent financial reporting. SAS No. 99 considers earnings-based compensation to be an incentive for fraud.
    •  Company Size: There is mixed evidence about the effect of company size on unethical or illegal activity. Therefore, the authors investigate whether company size influences CFO intentions of fraudulent financial reporting.
    Design/Method/ Approach:

    The authors collected their evidence by mailing surveys to the CFOs of domestic firms selected from the Compact Disclosure database as of July 1998. CFOs were provided with a fraud scenario, followed by questions measuring their intention to fraudulently misreport. The CFOs also answered questions measuring their attitude toward misreporting, subjective norms, their personal compensation structure, and the size of the firm for which they currently work. Once this data was collected, the authors used structural equation modeling (SEM) to determine the factors that influence CFO intentions of fraudulent financial reporting.

    Findings:
    • The authors find that a CFO’s attitude toward fraudulent financial reporting has the strongest influence on their intention to misreport. CFO attitudes toward fraudulent financial reporting appear to be driven primarily by the negative consequences expected if they misreport.
    • The authors find that larger firms are more likely to participate in fraudulent financial reporting.
    • Compensation structure and subjective norms did not influence CFO intentions to misreport in the manner expected by the authors. The finding that CFOs’ compensation structure does not influence intentions to misreport runs counter to SAS No. 99, which contends that earnings-based management compensation is a fraud red flag.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Management Integrity
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  • The Auditing Section
    Auditor Risk Assessment; Insights from the Academic...
    research summary posted April 12, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.05 Assessing Risk of Material Misstatement, 06.08 SAS No. 99 Brainstorming – effectiveness 
    Title:
    Auditor Risk Assessment; Insights from the Academic Literature
    Practical Implications:

    This article provides a very informative summary of current research related to the risk assessment process that supports the audit.  By outlining both general audit risk insights as well as fraud risk insights, the authors provide a clear and informative summary that should be of use to any audit firm attempting to better understand the current theoretical and practical research related to this emerging area.  Finally, by utilizing the PCAOB questions, the discussion also provides insights directly relevant to the current regulatory process.

    Citation:

    Allen, R.D., D.R. Hermanson, T.M. Kozloski, and R.J. Ramsay. 2006.  Auditor Risk Assessment: Insights from the Academic Literature.  Accounting Horizons 20(2): 157-177.

    Keywords:
    Risk assessment; PCAOB risk assessment project; industry specialization, fraud risk assessment; audit risk model.
    Purpose of the Study:

    This paper summarizes insights from academic literature related to risk assessment in financial statement audits project.  Using the February 16, 2005 PCAOB Standing Advisory Group (SAG) briefing paper on risk assessments as the organizing framework, the authors provide a literature review of topics related to: business risk, inherent risk, control risk, fraud risk, linking risk assessment to subsequent testing, and the audit risk model. 

    Design/Method/ Approach:

    The authors organize the auditor risk assessment literature review around the PCAOB briefing paper’s ten questions.  While cknowledging that fraud risk is integral to the overall audit risk, the uthors separate audit risk and fraud risk in their responses to further acknowledge he special problems in identifying, assessing, and responding to fraud isk.  Therefore, for each question, the authors discuss general audit risk assessment issues first, followed by those ssues specific to fraud risk assessments.

    Findings:
    • While using a business process focus in assessing client risks appears to be an advantage in the audit, additional guidance for using this approach may be helpful to address the diverse approaches utilized by the firms.  Decision aids and analytical procedures may increase effectiveness.
    • Industry expertise and specialization are critical to effective risk assessment.
    • Considering fraud risks separately from misstatements due to error, brainstorming and strategic thinking about management’s efforts to commit and conceal fraud all enhance fraud risk assessment effectiveness.
    • Systems dynamics, a methodology for studying and managing complex feedback systems, may provide auditors a framework to assess potential risk.  Authors suggest further examination of this and models in other fields for use in the audit process would be beneficial.
    • Auditor fraud risk assessments may not be well calibrated to the presence of risk factors.  Evidence on the effectiveness of fraud risk decision aids is mixed.
    • Inherent risk assessments (a) often are not meaningfully applied to each assertion; (b) may be decreasing over time, possibly to promote audit efficiency; and, (c) sometimes are combined with control risk into one risk factor.
    • While auditors may respond to global factors (e.g., management integrity, corporate governance) during micro-level risk assessments, proper weighting of global factors is challenging in a fraud context.
    • Testing of and reliance on internal controls have increased markedly in recent years.
    • Limited research suggests subsequent audit testing is weakly positively related to assessed risks, thus supporting efforts to improve linkages.
    • While the audit risk model appears to be sound as a conceptual tool, there are some significant limitations as a mathematical equation. In particular, it does not consider the blurring of inherent risk and control risk, the risk of incorrect rejection, the quality of evidence, or inconsistencies that may exist with actual auditor judgments.

     

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Assessing Risk of Material Misstatement, SAS No. 99 Brainstorming – effectiveness
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  • The Auditing Section
    The halo effect in business risk audits: Can strategic risk...
    research summary posted July 17, 2011 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    The halo effect in business risk audits: Can strategic risk assessment bias auditor judgment about accounting details?
    Practical Implications:

    The results of this study have an impact on the understanding strategic risk assessments.  Strategic risk assessments may reduce auditors’ sensitivity to inconsistent fluctuations in account balances.  This reduced sensitivity may cause auditors to underestimate the risks of financial misstatement when lower assessments of strategic risk are made in the early stages of an audit.    

    Citation:

    O’Donnell, E. and J.J. Schultz, Jr. 2005.  The halo effect in business risk audits: Can strategic risk assessment bias auditor judgment about accounting details?  The Accounting Review 80 (3): 921-939.

    Keywords:
    auditor judgment
    Purpose of the Study:

    Many audit firms have adopted a strategy of requiring auditors to conduct a strategic risk assessment that helps to develop a holistic perspective of the client’s business model at the beginning of an engagement.  The purpose of this assessment is to bring attention to the risks associated with the client’s strategy.  Implementing this strategy may have unintended consequences, as these judgments may create a halo effect on the later interpretation and analysis of audit evidence gathered.  The halo effect may lead auditors to discount account changes that are inconsistent with the client’s operations.  This study examines the following:

    • Will auditors that perform a strategic assessment prior to performing analytical procedures will have smaller variability in their risk assessment for consistent versus inconsistent fluctuations in account-level balances?
    • When auditors perform a strategic risk assessment, will the assessment of strategic risk be positively correlated with assessments of misstatement risk for accounts with inconsistent fluctuations?
    Design/Method/ Approach:

    The study used two experiments.  Each experiment used senior-level auditors from one Big 4 firm.  In experiment 1, participants were provided with background and financial information for a client.  They then analyzed information about company operations and assessed misstatement risk.  Participants completed a strategic risk analysis either before or after this analysis.

    In experiment 2, participants assessed account-level misstatement risk over 2 consecutive years.  In year 1, all participants received the same strategic risk analysis.  In year 2, participants received either a favorable or unfavorable strategic risk analysis.

    Findings:
    • Auditors who performed a strategic risk assessment prior to the performance of analytical procedures reacted less strongly to inconsistent fluctuations in the account-level balances.
    • There is a strong positive correlation between the strategic risk assessment and misstatement risk assessment when auditors perform a strategic risk assessment prior to performing analytical procedures when account-level balances have an inconsistent fluctuation.  There was no correlation in the other experimental conditions (consistent fluctuations or strategic risk assessment performed after analytical procedures were completed).
    • Auditors who are led to believe that strategic risk is low will rate misstatement risk lower for accounts with inconsistent fluctuations than will auditors who are led to believe that strategic risk is high.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement
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