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  • The Auditing Section
    The Impact of Management Integrity on Audit Planning and...
    research summary posted April 13, 2012 by The Auditing Section, tagged 02.02 Client Risk Assessment, 02.03 Management Integrity Assessments, 06.04 Management Integrity, 14.01 Earnings Management 
    Title:
    The Impact of Management Integrity on Audit Planning and Evidence
    Practical Implications:

    The results of this study are important because, while severe cases of low integrity may be weeded out during client acceptance, auditor firms tend to retain clients with a wide spectrum of integrity levels that must be managed throughout the audit process. Thus evidence regarding how the integrity of management influences auditors (1) assessment of risk, (2) planning of audit procedures, and (3) identification of misstatements may be useful for developing training materials or best practices for approaching audits on the lower end of the integrity spectrum.

    Citation:

    Kizirian, T.G., B.W. Mayhew, and L.D. Sneathen, Jr. 2005. The impact of management integrity on audit planning and evidence. Auditing: A Journal of Practice & Theory 24 (2): 49-67.

    Keywords:
    Audit risk model, management integrity, evidence
    Purpose of the Study:

    Management integrity (i.e., “tone at the top”) is a key determinant of the client’s risk structure and provides the foundation of internal control. As a result, it is important that auditors incorporate this risk component into their audit judgments. Furthermore, auditors rely on management to provide a great deal of audit evidence. Thus, auditors must carefully evaluate management integrity to assess the credibility of management-supplied evidence. To determine the extent to which auditor judgments are influenced by perceptions of management’s integrity, this study examines the effect of auditor-assessed management integrity on three aspects of the audit: (1) auditors’ assessments of risk of material misstatement (RMM), (2) audit planning, and (3) audit outcomes (i.e., identification of misstatements).

    Design/Method/ Approach:

     The authors collected their data from working papers of 60 clients of a U.S. Big 4 auditing firm. The working papers used were from engagements performed between 1996 and 1999. In all of the selected engagements, the auditors had documented an explicit assessment of management integrity as either “strong,” “moderate,” or “weak.”

    Findings:
    • Auditor-assessed management integrity is negatively related to the auditor’s assessment of RMM (i.e., high integrity is related to low risk assessments). However, the primary driver of auditors’ risk assessments appears to be whether or not the auditors identified a misstatement during the prior year audit (i.e., identification of a prior year error leads to higher assessments of RMM). In the case of a prior year misstatement, management integrity has no additional impact on assessments of RMM.
    • The auditor responds to low management integrity by requiring more persuasive evidence to support audit assertions. Additionally, management integrity was not related to the timing or extent of audit procedures. This suggests that when management integrity is low, the auditor goes outside the client for independent data verification rather than simply increasing the analysis of the client’s information.
    • When the auditor assesses that management is of low integrity, they are more likely to discover misstatements. Furthermore, the authors find that this is not just because the auditor tends to be more diligent in their testing when management is of low integrity. This suggests that management integrity is a good indicator of the likelihood that the financials are misstated.  
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Client Risk Assessment, Management Integrity, Assessing Risk of Material Misstatement, Earnings Management, Earnings Management
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  • The Auditing Section
    Financial Restatements, Audit Fees, and the Moderating...
    research summary posted April 23, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.03 Management Integrity Assessments, 06.06 Earnings Management, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Financial Restatements, Audit Fees, and the Moderating Effect of CFO Turnover
    Practical Implications:

    This study provides evidence that auditors consider a client restatement as an increase in the audit risk of a client for future periods.  This increase in audit risk is factored into the audit fee possibly through additional hours or higher hourly rates.  This study also provides evidence that when a company has a change in CFO, auditors view this positively. 

    Citation:

    Feldmann, D.A., W.J. Read, and M.J. Abdolmohammadi. 2009. Auditing: A Journal of Practice and Theory 28 (1): 205-223.

    Keywords:
    audit fees; financial restatements; executive turnover
    Purpose of the Study:

    Restatements increased in frequency throughout the period 2000-2005.  Companies who restate their financial statements face reputational costs. For example, extant literature has documented an association between restatements and higher costs of capital, stock price declines, and higher likelihood of litigation.  One strategy a company may employ to mitigate negative consequences of a restatement is through termination of the executive officers in place during the restated period (i.e. disassociate the firm from those perceived as responsible for the restatement).  The authors suggest that by replacing the CEO and/or CFO after a restatement the company is providing evidence to outside stakeholders (including auditors) that they are attempting to address the weaknesses that caused the restatement.

    This study examines the effect of restatements on future audit fees, which represent another cost associated with a restatement, and whether terminating executive officers after the restatement moderates an increase in audit fees.

    Design/Method/ Approach:

    The authors collect restatements of the fiscal year 2003 by searching the EDGAR online database during the period January 1, 2004 through March 31, 2005.  For the restating firms identified, the authors gather audit fee and executive turnover information from subsequent proxy statements. 

    Findings:
    • Companies that restate have significantly higher executive turnover after the restatement than firms who do not restate.
    • Companies who restate have significantly higher audit fees after the restatement relative to firms who do not restate
    • Companies who terminate the CFO after a restatement do not experience higher audit fees after the restatement.
    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit fee decisions, Client Risk Assessment, Management Integrity Assessments, Earnings Management, Earnings Management
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