This study provides a more complete examination of auditor-client pre-negotiation decisions and negotiation tactics when confronted with an ambiguous accounting issue. Because auditors and clients approach conflict resolution and make negotiation decisions in very different ways, the results should be of interest to auditors.
Bame-Aldred, C. W. and T. Kida. 2007. A Comparison of Auditor and Client Initial Negotiation Positions and Tactics. Accounting, Organizations, and Society 32 (6): 497-511.
Auditors must work with clients when forming their financial reporting decisions and the two parties may encounter situations where their reporting goals are different. This conflict can compel the auditor and client to enter into formal or informal negotiations. Various studies have previously examined auditor-client negotiation behavior, but none have directly compared the negotiation decisions of auditors and clients when faced with the same negotiation context. As such, the overall purpose of the study is to further examine the negotiation behavior of auditors and clients when facing an ambiguous revenue recognition issue. Negotiation behavior will ultimately have an impact on the firm’s financial reporting decisions. Below are the objectives that the authors address in their study:
The authors collected their evidence via research questionnaires mailed to auditors at national CPA firms and experienced financial managers at various companies during the Spring and Summer of 2002. The auditor participants included partners, senior managers, and managers. The financial managers included CFOs, controllers, accounting managers, and analysts from 38 different companies. Participants read summary financial information, a description of the auditor-client relationship, and a scenario about the proper amount of revenue recognition in a specific conflict scenario. Participants were asked questions about their initial negotiation positions, their range of acceptable amounts, their perceptions of the other party’s positions and limits, the importance of certain revenue recognition issues, and the likelihood of using specific types of negotiation tactics.
Professional skepticism is an integral component of auditing and audit quality, as evidenced by standards such as SAS 1 and SAS 109. Regulators often refer to professional skepticism as something that was missing when audit failures occur. Thus, understanding what factors influence auditors’ levels of professional skepticism is important. The author contends that this study facilitates an understanding of how audit firms can influence professional skepticism in practice via changes in such practices as hiring, training, performance appraisal, review, decision aids, incentives, and changes in tasks and institutions.
Nelson, M. W. 2009. A Model and Literature Review of Professional Skepticism in Auditing. Auditing: A Journal of Practice & Theory 28 (2): 1-34.
The purpose of this study is to review research that examines professional skepticism in auditing. Consistent with other research and recent regulatory concerns, the author defines professional skepticism as “indicated by auditor judgments and decisions that reflect a heightened assessment of the risk that an assertion is incorrect, conditional on the information available to the auditor.” Unlike the professional standards, this definition reflects more of a “presumptive doubt” view rather than a “neutral” view of professional skepticism, implying that auditors who exhibit higher levels of professional skepticism are auditors who need relatively more persuasive evidence (in terms of quality and/or quantity) to be convinced that an assertion is correct. In other words, such auditors are more likely to doubt evidence that an assertion is true than they are to doubt evidence than an assertion is false.
Drawing from prior studies, the author describes how audit evidence combines auditor knowledge, traits, and incentives to affect the level of professional skepticism exercised in auditor judgments. Further, the author describes how, given a judgment with some level of professional skepticism, the judgment combines with auditor knowledge, traits, and incentives to affect auditor actions that reflect relatively more or less degrees of professional skepticism.
The study reviews research that examines professional skepticism in auditing. The author discusses the various definitions of professional skepticism both in professional standards and academic research. The author draws on prior relevant research to explain how auditor knowledge, traits, and incentives combine to affect the level of professional skepticism in auditor judgments and auditor actions.
The results of the studies documented in this review suggest that there is a great deal of variability in the approaches taken by firms for establishing materiality. Such differences in materiality methods can affect both the effectiveness and efficiency of audits. For example, if firms differ in how they allocate materiality to financial statement accounts, then the scope of the work could differ across audits with similar characteristics. Auditors also appear to differ in terms of the factors they consider for determining the materiality of internal control weaknesses, suggesting that auditors may need more structured criteria to make materiality judgments about internal control weaknesses. Materiality judgments are influenced by authoritative guidance, suggesting that standard setters and audit firms have the ability to influence auditors’ materiality judgments by providing auditors with specific guidance.
Messier, Jr., W.F., N. Martinov-Bennie, and A. Eilifsen. 2005. A review and integration of empirical research on materiality: Two decades later. Auditing: A Journal of Practice and Theory 24 (2): 153-187.
Materiality has been and continues to be a topic of importance for auditors. There has recently been renewed interest in the concept of materiality, motivated by concerns at the Securities and Exchange Commission, and the Auditing Standards Board and as evidenced by the Sarbanes-Oxley Act and the issuance of proposed standards on materiality by the International Auditing and Assurance Standards Board. Additionally, new guidance has been issued recently in response to some of the materiality concerns, including Staff Accounting Bulletin (SAB) No. 99, Statements on Auditing Standards (SAS) No. 89, and SAS No. 90. Due to the continued importance of understanding the concept of materiality, this paper reviews and integrates the empirical research on materiality since 1982. Based on the review of the literature, the authors suggest some implications of this research for audit practice and research.
This paper reviews the literature related to materiality that has been published since 1982. The authors divide their discussion of the research into archival studies and experimental studies. Archival studies use audit firm manuals, data from auditor working papers, or published financial statement data and auditor reports to examine materiality decisions. Experimental studies examine materiality judgments and decision-making of financial statement users, auditors and others (e.g., judges/lawyers).
Archival Studies: The primary findings from archival studies are categorized based on whether they were obtained from auditor-related sources (e.g., auditor working papers) or public sources (e.g., financial statements).
Auditor Related Sources (i.e., firm manuals and working papers)
Public Sources (i.e., financial statements, disclosures, and auditors’ reports)
Experimental Studies:
The results of this study are important for audit firms to consider providing decision aids and/or on job training. The results suggest that considerable practical experience is necessary to achieve good judgment performance. In addition, the evidence indicates that auditing firms may wish to concentrate their training earlier to more quickly create a basis for high-quality auditor judgments.
Wright, William F. 2007. Academic Instruction as a Determinant of Judgment Performance. Behavioral Research in Accounting 19: 247-259.
Knowledge and personal involvement are important factors that affect auditor judgment quality. It is generally believed that sufficient knowledge can lead to good auditor judgment. Two sources of relevant knowledge are academic instruction and practical experience. Yet the relative benefits of the two sources remain unclear. The primary purpose of the study is to test for the benefit of task-specific academic instruction and practice relative to task-specific CPA training and experience in making auditor judgments.
The research evidence is collected during 1991. Three groups of people participated in the experiment: (1) graduate business students, (2) inexperienced financial institution audit seniors, and (3) experienced financial institution auditors (managers, senior managers, and junior partners). Participants were asked to complete a simulated case involving evaluating the collectability of commercial loans to a fictitious manufacturer of microcomputers.
Firms should consider the levels of accountability pressure and situations where they use them and consider how different levels of pressure may impact performance. Higher levels of accountability pressure may increase effectiveness and increase the likelihood of finding material misstatements.
On the other hand, increased effectiveness and time spent due to higher levels of accountability pressure may cause inefficiencies and result in unnecessary effort. Firms should evaluate the costs and benefits for their situations.
The authors note that this study only looks at the effect of accountability pressure from an unknown partner. In the real world, auditors have accountability pressures from many levels such as other superiors, clients, regulators, and audit committees.
Further, the auditor may have assessed things differently if they knew the partner that was performing their review.
DeZoort, T., P. Harrison, and M. Taylor. 2006. Accountability and auditors’ materiality judgments: The effects of differential pressure strength on conservatism, variability, and effort. Accounting, Organizations, and Society 31 (4-5): 373-390.
The purpose of this study is to look at how four different levels of accountability pressure (i.e. how their decisions would be reviewed) affect auditor conservatism, variability, and effort in tasks related to materiality.
The authors performed a computerized experiment using a final sample of auditors from five public accounting firms. Participants were managers, staff and senior associates. Participants were asked to review client background information, financial information, and a proposed audit adjustment for the Allowance for Doubtful Accounts balance. Participants were asked to provide a planning materiality amount for the engagement and a materiality judgment regarding the proposed audit adjustment. The auditors were put into one of four levels of accountability pressure:
In addition, about half of the participants received a “planning materiality decision aid,” which provided a range of planning materiality values.
Professional Commitment has been found to impact work behaviors. Theory indicates the three dimensions of PC can impact these behaviors in varying ways (positive or negative). Firms can influence some precursors to PC including training, organizational culture, requiring employees to complete a professional qualification, and participation in professional organizations.
Smith, D. and Hall, M. 2008. An Empirical Examination of a Three-Component Model of Professional Commitment among Public Accountants. Behavioral Research in Accounting 20 (1): 75-92.
Professional commitment (PC) refers to the attachments that individuals form to their profession. Those with strong professional commitment have been found to be less likely to leave their job and more likely to observe rules, to be involved in professional organizations, and to mentor. Three aspects of PC have been identified:
The purpose of this study is to confirm whether these three aspects of PC apply to public accountants as well as to determine whether the professional commitment questionnaire (PCQ) used in the majority of prior PC research measures only APC or all three aspects of PC.
Accountants from one big-four and six middle-tier Australian accounting firms participated in this study. Participants filled out a survey designed to assess the participants’ level of PC, and specifically their levels of APC, CPC, and NPC.
At its core, the theory proposed by the authors assumes that auditors are economic agents who provide a valuable service and can be expected to behave rationally to maximize their profits. Strategic behaviors such as under-auditing, over-auditing, or overbilling would be unobservable by an auditee in many instances. The possibility of such behaviors has important implications for the level of assurance over financial reports and can potentially affect the efficient allocation of capital resources. One of the goals of this study was to analyze how the credence aspect of audits could influence important policy decisions. Regulation may play a powerful role in mitigating the credence nature of auditing, e.g., PCAOB inspections. However, regulation can be a double-edged sword if it increases the incentive or opportunity for auditors to behave strategically. Therefore, auditors can take the theories and models presented in this study to evaluate their firms for potential profit maximizing biases that may negatively impact audit quality and efficiency. Policy makers could also use these theories and models to evaluate how new auditing policies might influence auditors’ incentives and behaviors.
For more information on this study, please contact W. Robert Knechel.
Causholli, M., and W. R. Knechel. 2012. An Examination of the Credence Attributes of an Audit. Accounting Horizons 26(4): 631-656.
The purpose of this study was to expand the understanding of the economics of auditing and audit markets by using the theory of credence goods as the basis for explaining auditors’ incentives. The idea of a credence good or service is that (1) the seller of the good or service is an expert who both recommends and provides a level of service to the buyer; (2) buyers of credence goods or services cannot assess how a service is a delivered and must rely on a seller’s recommendation; and (3) buyers cannot assess how well the service was performed. The authors suggest that the external audit is a credence good which provides auditors with incentives to under-audit, over-audit or overcharge their clients.
The authors take a purely theoretical approach to study the perspective of an audit as a credence good. The authors rely on prior research of credence goods and on the principles of Game Theory to help explain auditors’ incentives to under-audit, over-audit or overcharge clients and predict auditors’ behaviors under certain scenarios. The authors use theoretical decision trees to describe an auditor’s possible strategies for bidding for an audit, and for executing the audit. The authors also describe examples of prior auditing research that present results that support the author’s credence theory.
The authors propose that if an audit is a credence good, the auditee cannot determine any of the levels of audit effort that define the auditor’s decisions. This creates information asymmetry between the auditor and auditee both before and after the audit because the auditee cannot be sure of the true level of assurance that is necessary before the audit, and the auditee cannot be sure of the true level of assurance that is gained as a consequence of the audit. The information asymmetry goes in favor of the auditor, who can act strategically to under-audit and earn greater profits because the auditee has imperfect information about the auditor’s work and the level of assurance gained by the auditor’s efforts.
The authors also propose that there are disciplining mechanisms in the market for audit services that are in place to mitigate an auditor’s incentive to behave strategically such as an auditee’s direct knowledge, audit firm reputation and size, professional regulation, legal liability, and competition between audit firms. However, while these mechanisms may be in place, an auditor facing low penalties or risk of detection may be more likely to consider strategic actions. In environments with weak courts or regulation, auditors have more incentives to act strategically and expect to reap superior profits as a result. Similarly, changes in regulations or other structural changes in the audit market can induce changes in the incentives for auditors to behave strategically. Overall, disciplining mechanisms facilitate the operation of audit markets even though they may not completely resolve the information (credence) problem.
This study provides evidence that there were significant differences in the pre-negotiation judgments of partners and managers. Since an outcome of an auditor-client negotiation of a contentious issue may have a significant impact on financial reporting quality, the findings of the study suggest that the using partners in the negotiation process is likely to lead to improved reporting quality. The results have implications for audit firms in allocating manager and partner time to handle negotiation.
Trotman, K. T., A. M. Wright, and S.Wright. (2009). An Examination of the Effects of Auditor Rank on Pre-Negotiation Judgments. Auditing: A Journal of Practice & Theory 28(1): 191-203
Negotiations are pervasive in the auditing environment. In general, audit firms have choices over what level of staff are involved in the process of negotiation. An important issue is that differences may exist between partner and manager negotiation judgments and strategies. This study focuses on the expectations and assessments that partners and managers take into the negotiation process, specifically the pre-negotiation stage. The authors use negotiation theory as well as other general psychology findings to investigate how rank (partner versus manager) affects the pre-negotiation judgments made by auditors. The authors suggest and test the following assertions:
The research evidence was collected prior to September 2007. The authors used responses collected from a computerized case about inventory write-downs, administered to partners and managers at three Big 4 firms in Australia and the U.S.
The results should be of interest to auditing standard setters who provide guidance on the evaluation of control deficiencies as part of an integrated audit. Further, regulators inspecting public company audits may want to further review settings where control deficiencies were not evaluated as material weaknesses and assess whether the presence/absence of a financial statement misstatement was appropriately considered. The findings provide a more complete understanding of how the factors that auditors encounter during the audit engagement influence their judgment about whether identified deficiencies in ICFR are such that there is a reasonable possibility that a material misstatement of the company’s financial statements will not be prevented or detected on a timely basis (i.e., material weakness).
Gramling, A. A., E. F. O'Donnell, and S. D. Vandervelde. 2013. An Experimental Examination of Factors That Influence Auditor Assessments of a Deficiency in Internal Control over Financial Reporting. Accounting Horizons 27 (2): 249-269.
Beginning in 2004, public company auditors who opine on client financial statements also express an opinion about whether the client’s internal control over financial reporting (ICFR) is effective at year-end. In forming the ICFR opinion, auditors evaluate the severity of each identified control deficiency to determine whether the deficiency is a material weakness. When auditors conclude there is a reasonable possibility that ICFR will fail to prevent or detect a material financial misstatement (i.e., a material weakness exists), they issue an adverse opinion on the effectiveness of ICFR. This study examines how different types of audit evidence accumulated during the audit influence auditor judgment of ICFR operating effectiveness and about whether an identified control deficiency is a material weakness in ICFR.
The study is motivated by a recognition that many stakeholders, including financial statement users, company management, audit committee members, regulators, researchers, and other auditors, would benefit from an enhanced understanding of the factors an auditor considers when evaluating the effectiveness of ICFR and concluding whether identified control deficiencies represent material weaknesses.
The authors analyze responses from the submitted case materials of 138 participants, which include 44 partners, 47 senior managers, and 47 managers. On average, the participants had worked on 4.0 integrated audit engagements and had issued 1.1 adverse opinions on ICFR. For the integrated audit engagements on which the participants had worked, they reported an average of 4.1 potential material weaknesses that were ultimately deemed to be significant deficiencies. The evidence was gathered prior to June 2013.
Based on experimental results from audit managers and partners, the authors provide evidence regarding whether the following factors are significant determinants of assessed operating effectiveness of an identified control deficiency: (1) whether the client has a material weakness unrelated to the deficiency being assessed (i.e., unrelated material weakness), and (2) whether there is a known misstatement associated with the identified control deficiency (i.e., failure of the specific control to prevent a misstatement). Further, they examine whether these two factors influence the likelihood of assessing a control deficiency as a material weakness. The authors find that the presence of either an unrelated material weakness or a known misstatement influences the assessed operating effectiveness of an internal control, in addition to the likelihood of a material weakness assessment. The presence of either an unrelated material weakness or a known misstatement warrants a decreased operating effectiveness assessment and an increased likelihood of a material weakness assessment. The combination of the two factors together does not further influence those assessments.
Auditors should recognize that an implicit tradeoff exists between the availability of subsequent event evidence and timelier reporting. However, the net effect is not well understood because prior research has only focused on quantifying the benefits of timely reporting, not the costs associated with obtaining less subsequent event evidence. The low evidence discovery rate reported by participants suggests that the current audit methodology might suffer from inefficiencies. Further research should establish relative frequency information to help auditors generate hypotheses and guide audit planning.
Janvrin, D. J. and C. G. Jeffrey. 2007. An Investigation of Auditor Perceptions about Subsequent Events and Factors That Influence This Audit Task. Accounting Horizons 21 (3): 295-312
Generally accepted auditing standards require auditors to consider subsequent events by examining transactions that occur after the balance sheet date. In light of the Securities and Exchange Commission’s (SEC) decision to shorten the time between the balance sheet and report dates, this study seeks to better understand how auditors search for and discover subsequent event evidence in this new reporting environment. Prior literature on this subject is sparse. The Canadian Institute of Chartered Accountants (CICA) and the American Institute of Certified Public Accountants (AICPA) are concerned that audit quality will suffer because auditors now have less time to discover evidence of subsequent events. For example, earnings management behavior is difficult to detect without persuasive evidence. Specific study goals are as follows:
A field-based experiential questionnaire was issued to U.S. auditors from each of the Big-4 firms and one national firm over a one-year period prior to November 2004. Participants had an average of 9.6 years of experience. Participants were asked to rate how often they search for and discover subsequent event evidence both in general, and using the ten procedures found in auditing standards.