The finding that higher decision authority can have negative audit quality implications is relevant to audit firm policies, which often vest substantial authority in consultants, and to the ongoing debate over standards for the use of specialists. This and other findings also suggest that it may be beneficial to advocate lower decision authority. Finally, the findings can inform audit firm policies that require consultation with knowledgeable persons, as well as standard-setters and regulators whose responsibilities to provide guidance on using consultation to conduct more effective audits of financial statement estimates.
Knechel, W. R. and J. Leiby. 2016. If You Want My Advice: Status Motives and Audit Consultations About Accounting Estimates. Journal of Accounting Research 54 (5): 1331 – 1364.
Financial reports contain many complex accounting estimates that require significant auditor judgment and can increase the risk of material misstatements. Auditors often struggle to maintain the requisite knowledge and questioning mindset necessary to effectively assess these estimates. Little is known about how the efficacy of consultation and the conditions under which consultants provide advice that might improve the audit of estimates. Consultation in auditing is pervasive and has substantial potential benefits, thus the availability of useful advice is often a necessary condition to improve the audit of estimates. In this study, the authors examine two properties of advice that are likely to help improve auditor judgment on accounting estimates: contrariness and precision. Contrariness refers to the degree to which a consultant’s advice differs from the advice-seeker’s own opinion, and precision refers to the narrowness of the range of options presented by a consultant to an advice seeker, that is, reducing the range of possible outcomes to be considered.
The authors conduct an experiment with a number of audit managers and senior managers from a U.S. accounting firm. The authors manipulate status motives by priming auditors with a brief story prior to the task in which they act as a consultant to another auditor regarding the discount rate a client uses to estimate the fair value of a securitized asset.
Valuators’ judgment and decision making is currently unexplored. This study provides preliminary evidence on how valuators act in the presence of conflict of interest, and the need for conflict disclosures. The results of this study have implications for public accounting firms to the extent that they provide either fairness opinions and associated valuation judgments or are involved in some audit aspects related to mergers/acquisitions. This study contributes to accounting and psychology literature on conflict of interest disclosures and is the first study to test the biasing effects of conflict disclosure specifically targeting professionals performing familiar tasks. Further, this study extends existing literature of the topic by documenting that bias arising from disclosure of conflict of interest depends on whether the conflict of interest is aligned or misaligned with the client’s interest. This study provides the first evidence that disclosure of conflict of interest causes bias in Client-Aligned, but not in a Client-Misaligned, conflict of interest setting.
Jamal, K., E. Marshall and H. Tan. 2016. Does Disclosure of Conflict of Interest Increase or Decrease Bias? Auditing: A Journal of Practice and Theory 35 (2): 89-99.
Professional valuators are increasingly called upon to supply inputs that form part of the financial statements and the audit report. However, criticisms of potential conflicts of interest relating to valuators’ reports abound. One concern is that professional valuators provide expert opinions in circumstances where they are required to act in the public interest, yet are hired and paid by a client who has self interest in the outcome of the valuator’s report. This study seeks to investigate, in a valuation setting involving professional valuators, the efficacy of disclosure in curbing biases stemming from conflict of interest. Further, this study investigates whether the effect of disclosure of conflict of interest depends on the nature of the conflict of interest—specifically, whether the conflict of interest is aligned with or threatens the current client’s (seller or auditor’s) interest.
The authors recruited 90 experts with business valuation experience and sent these participants research instruments via courier mail. On average, participants had 13.3 years of work experience, 6.7 years of work experience in business valuation, and had worked on 38 valuation engagements. These individuals were asked to make a valuation judgment in the context of a larger fairness opinion engagement on the sale of a subsidiary. Conflict of interest was manipulated as either Client-Aligned (valuators’ interest aligned with auditors) or Client-Misaligned (valuators’ interest aligned with audit client). The results were also examined in the presence and absence of disclosure (No Disclosure, Disclosure).
The study resulted in the following conclusions. • In a Client-Aligned conflict situation, disclosure of conflict of interest induces bias toward the current client (auditor), and does not produce the intended result of reducing or preventing bias. • In a Client-Misaligned conflict of interest setting where the valuator has potential future business opportunities with the buyer (audit client), the authors found evidence that valuation estimates are still biased toward the current client (auditor), regardless of disclosure. • In the Client-Aligned conflict situation, disclosure magnified bias. In contrast, in the client-misaligned conflict setting, disclosure of conflict of interest did not cause any incremental bias.
This study has implications for public accounting firms engaging in GHG engagements. Team training that establishes an understanding of the knowledge and role of the team members from differing disciplines might help to alleviate over-reliance on peer-provided evidence. In the context of multidisciplinary assurance teams, establishing and adhering to audit firm quality control mechanisms relating to evidence collection, evaluation, and review are of particular importance. Accounting firms may also need to pay particular attention in fostering an assurance environment that encourages objective evidence processing.
Kim, S., W. J. Green, and K. M. Johnstone. 2016. Biased Evidence Processing by Multidisciplinary Greenhouse Gas Assurance Teams. Auditing: A Journal of Practice and Theory 35 (3): 119-139.
Due to the increased attention being paid to the environment as well as how humans are impacting the environment, there exists growing demand for a range of corporate social responsibility information. In order to be most efficient, assurors conduct greenhouse gas (GHG) assurance engagements using multidisciplinary teams containing varying technical expertise, with some possessing financial audit-related expertise and others possessing science or combined science/financial-related expertise. The purpose of this study is to investigate how auditors respond to the discipline-specific expertise of other team members in undertaking GHG assurance.
The authors test this by conducting an experiment in which traditional auditor participants respond to a simulated multidisciplinary team and examine whether the auditors bias their weighting of evidence based on if the senior assuror has a science background as opposed to a financial background.
The authors believe that when armed with knowledge of how management may intentionally or unintentionally introduce error into their FVMs, auditors will be better able to take steps to adjust for this error. Currently, professional skepticism is the best way to combat this problem. Researchers and policy makers within firms need to grapple with the possibility that existing audit team structure and incentives may not be compatible with audits that require more and more specialized valuation knowledge.
Martin, R. D., J. S. Rich, and T. J. Wilks. 2006. Auditing Fair Value Measurements: A Synthesis of Relevant Research. Accounting Horizons 20 (3): 287-303.
In order to contribute to the PCAOB project on auditing fair value measurements (FVMs), the authors synthesize and discuss the implications of academic research that should be relevant to auditors, standard-setters, and academics who increasingly deal with the complexities of auditing FVMs. The authors structure their synthesis of prior research along two dimensions:
Structuring the synthesis along the aforementioned dimensions, the authors first focus on the generation of FVMs because they believe auditors cannot exercise due care in the audits of FVMs without a thorough understanding of the underlying valuation techniques and inputs used in assessing FVMs. They focus second on research related to verification and attestation procedures for FVMs, even though very little research directly examines the auditing of FVMs.
Based on the interviews and problems identified, the authors conjecture that potentially suboptimal auditing methods are being used to evaluate complex estimates which are an important and growing part of the financial statements. This may be negatively impacting audit quality. More specifically, auditors over-rely on management estimates because they lack the knowledge and incentives to behave otherwise. This possibility has direct consequences for auditor professional skepticism because increasing professional skepticism may be less effective unless auditors are also given the requisite knowledge to properly use it. These problems are reinforced by auditing standards and regulators which generally outline/criticize the current auditing methods without suggesting new or better ones.
Griffith, E., J. Hammersley, and K. Kadous. 2015. Audits of Complex Estimates as Verification of Management Numbers: How Institutional Pressures Shape Practice. Contemporary Accounting Research 32 (3): 833-863.
Complex estimates are increasingly important to financial statements and of growing concern to both regulators and investors. While auditors have well-established procedures for auditing more objective account balances (i.e., valued at historical cost), little is known about the process auditors use to evaluate more subjective, complex estimates. This article conducts interviews with experienced audit personnel to determine how auditors evaluate such estimates, determines the problems with such approaches, and uses “institutional theory” to theorize the reason such problems exist and persist. The authors consider the influence of both audit firms themselves and regulators (i.e., information from PCAOB inspection reports) on auditors’ complex estimate audit procedures.
The authors conducted semi-structured phone interviews with experienced audit personnel. Participants are from 6 large accounting firms with at least manager level experience. Interviews were conducted between October and November 2010. The authors analyzed the audit process steps discussed by participants for complex estimates and coded these steps according to the PCAOB auditing standards related to accounting estimates (AU 342 and 328). For steps that could not be appropriately classified into ones discussed by the auditing standards, the authors developed additional classifications.
While auditing standards allow for different approaches to evaluating complex estimates (e.g., testing management process, preparing independent estimate, etc.), the authors find that auditors usually just test management’s process (i.e., verifying inputs such as historical cost, understanding who and how estimate is generated, testing controls surrounding process, and testing sensitivity of assumptions used).
Based on institutional theory, the authors theorize two key reasons that auditors mainly use management process verification when auditing complex estimates instead of other (potentially more creative and skeptical) approaches. The reasons are:
The results have implications on two fronts. First, the findings indicate that auditors pursue different production and pricing strategies in different segments of the market, suggesting that the Big 4 audit firms respond to the competitive pressures in each submarket. Second, the evidence raises questions about the construct validity of market share-based measures of industry specialization, which have been used extensively in the literature. The evidence suggests that auditors who obtain a large market share by auditing a large proportion of the industry sector may actually do so by producing lower quality, lower cost audits. As such, these auditors are not acting as true specialists in the sense of using specialized training and knowledge to raise the quality of the audit performed.
Cahan, S. F., D. C. Jeter, and V. Naiker. 2011. Are All Industry Specialist Auditors the Same? Auditing: A Journal of Practice & Theory 30 (4): 191-222.
Auditor industry specialization continues to attract considerable attention in the literature. This may reflect the importance that clients place on industry specialization, e.g., 80 percent of companies viewed industry expertise or specialization as being an important factor in choosing an auditor. Most commonly, archival studies identify industry specialist auditors using a market share-based measure where a significant share, or an industry leading share, of the industry’s audit fees is used to designate specialists. However, a market share-based measure is problematic because market share depends jointly on the proportion of clients audited and the average size of those clients. For example, it is possible to attain a large industry market share by auditing a few relatively large clients in an industry or many relatively small ones. The question the authors examine is as follows: Are industry specialists who obtain a high market share in disparate ways similar in terms of product (audit) quality and price (audit fees)?
The authors begin with all client-years from 2003 through 2007 with requisite data available from Compustat and Audit Analytics. For the audit fee sample, the data requirement to compute the control variables results in a final sample of 9,565 client-year observations. For the discretionary accruals model, the additional data requirements needed to estimate discretionary accruals and the control variables for Equation (3) result in a final sample of 9,396 client-year observations. Sixty-one industries are represented by observations in both the audit fee and discretionary accruals samples.
The authors find evidence of higher (lower) audit quality when the auditor attains a high market share by auditing a lower (higher) proportion of clients in the industry. Combined, the findings suggest that industry specialists who gain market share by auditing a small proportion of clients in an industry pursue a product differentiation strategy, offering a higher quality, but more costly, audit. On the other hand, those specialists who gain market share by auditing a large proportion of clients follow a cost minimization strategy, competing on price and sacrificing quality. The authors do not find any evidence that the Big 4 operates as a tight oligopoly either in the overall audit market or within industry markets, whether defined at the national or local level. In summary, the results suggest that not all industry specialists are the same.
Involving two service providers, rather than one, conveys potential benefits similar to those argued for joint audits. Auditor independence is enhanced because each firm provides a reciprocal check on the diligence of the other, and the allocation of fees between providers reduces economic bonding between the client and any one firm. Regulators might consider requiring disclosure of the recipient of NAS payments for both the audit firm and other consultants to allow a more complete examination of the influence of NAS on audit quality in other settings.
Gaver, J. J., and J.S. Paterson. 2014. The Association between Actuarial Services and Audit Quality. Auditing: A Journal of Practice & Theory 33 (1): 139-159.
A challenge facing the accounting profession is the creation and maintenance of auditor independence from clients, both in fact and in appearance. The authors examine the association between non-audit services and audit quality among firms in the property-casualty insurance industry. Limiting the sample to insurance firms conveys benefits that provide a more powerful test of the audit quality-NAS relation than has been possible in prior studies. This setting allows the authors to focus on a specific non-audit service that is purchased by almost all firms in the industry. The insurance setting is unique because the non-audit service that the authors examine is purchased by all firms in the sample, and they can identify both the audit and non-audit service provider. This allows the authors to directly address the NAS separation issue while holding NAS quality constant.
Since 1990, the National Association of Insurance Commissioners (NAIC) has required a "Statement of Actuarial Opinion" regarding the adequacy of the company's loss reserve to be submitted with the insurer's Annual Statement. Although auditing standards and SOX both prohibit the audit firm from determining insurance company policy reserves (the audit client must use its own actuaries or third-party actuaries to provide management with primary actuarial capabilities), it is acceptable for actuaries from the audit firm to review and certify reserves established by the client and to sign the Statement of Actuarial Opinion. The loss reserve is the largest liability on insurer balance sheets, and establishing comfort on reserve levels is a crucial aspect of an insurance company audit.
The sample consists of 3,261 insurer-year observations where both audit and actuarial services are provided by a Big N firm. The sample was derived from a property-casualty database of the NAIC during the years 1993 through 2006. In 2,977 cases, the services are obtained from the same Big N firm; in the remaining 284 cases, one Big N firm conducts the audit and a different Big N firm certifies the reserves.
The authors find that when actuarial work is obtained only from Big N firms (NAS quality is constant), audit quality is higher when separate Big N firms provide audit and actuarial services. The implication is that separating audit and NAS functions between two quality providers is beneficial, compared to allowing one quality firm to provide both services.
The results indicate that joint provision of services is related to significantly more over-reserving by healthy insurers, compared to the case where audit and actuarial services are obtained from two independent firms. Although over-reserving by financially secure insurance clients does not present the same risk of audit failure as does under-reserving by weak insurers, both findings suggest that reserves are more likely to be biased in the client's favor when multiple services are consolidated in one provider. Specifically, jointly provided audit and actuarial services are associated with a greater tendency for weak insurers to under-reserve and strong insurers to over-reserve.
This study examines the value of non-financial specialist assurance in the capital markets setting. While similar to existing audit literature, this study offers new research by examining a setting in which disclosure of non-financial information is mandatory. To the extent the findings are generalizable to other non-financial assurance settings, they suggest caution in adopting a mandatory approach owing to cost/benefit considerations.
Ferguson, A., and G. Pündrich. 2015. Does Industry Specialist Assurance of Non-Financial Information Matter to Investors? AUDITING: A Journal of Practice & Theory 34 (2):121-146.
The information environment of Mining Development Stage Entities in Australia (MDSEs) is characterized by the reality that the utility of nonfinancial technical information supersedes financial statement information in firm valuation. Previous studies have highlighted the value of non-financial information in settings where disclosure and assurance of non-financial information is voluntary. This study examines the value of assurance of non-financial information where the assurance of public resource disclosures is mandatory. The authors seek to prove the hypothesis that reserve disclosures assured by specialist mining consulting firms have larger market reactions than disclosures assured by non-specialist mining consulting firms.
To ensure accurate classification and measurement of reserve changes, the authors developed a hand-collected proprietary database of project-level reserve disclosure data. After removing problematic data, a sample was collected of 1,467 reserve disclosures, released by 404 MDSEs over the period 1996 to 2012. Data collection consists of reserve figures, the length and tone of the announcement, firm-level financial information, and commodity and security price data. Using the reserve data, the authors specified a multivariate model controlling for deposit properties, firm-level economic properties, and announcement disclosure characteristics.
Overall, the study found weak evidence of specialist assurance being positively related to market reactions around reserve disclosures. The specific findings were as follows:
Ultimately, the study provides evidence demonstrating that changes in share prices around non-financial disclosures are driven by specialist assurers. This finding is supportive of the insurance hypothesis in that specialist assurance does not matter in the absence of litigation risk.
Although both auditors and fraud specialists added non-standard procedures to the audit program, auditors cut the budgets for some standard procedures, making room in the overall audit budget for non-standard additional procedures. In contrast, fraud specialists added standard procedures, but they were not more effective than those selected by auditors, and also provided less budget room for those procedures. The involvement of fraud specialists in planning an audit engagement where fraud risk is present is likely to lead to additional audit effort and cost, possibly without commensurate benefit. However, considering the potential consequences to the auditor of undiscovered fraud, it may be cost-effective to include additional non-standard procedures in an audit program if they improve the probability of discovering a fraud.
Boritz, J. E., Kochetova-Kozloski, N., & Robinson, L. 2015. Are Fraud Specialists Relatively More Effective than Auditors at Modifying Audit Programs in the Presence of Fraud Risk? Accounting Review 90 (3): 881-915.
Since the passage of Statement on Auditing Standards (SAS) 99 and the Sarbanes-Oxley Act of 2002, policy-makers and regulators have promulgated additional guidance aimed at improving auditors’ performance in assessing and responding to fraud risks of audit clients. Auditors are expected to address fraud risk through the design of their audit methods and programs and by involving specialists. The authors study whether fraud specialists are relatively more effective than auditors in designing an audit program that will address elevated fraud risk. The goal is to examine whether the expertise of fraud specialists can directly contribute to planning the nature and extent of audit procedures, and whether the mix of procedures that such specialists recommend is likely to be more effective and efficient than the procedures proposed by auditors in a setting where ex ante fraud risk is rated at above a low level. By directly examining fraud specialists’ recommendations for an audit plan under conditions of an elevated fraud risk, the authors seek to clarify whether there are benefits in requesting fraud specialists to participate in audit program design.
Participants completed an audit case based on an actual company that had issued fraudulent financial statements. Thirty-two fraud specialists and sixteen auditors completed the case On average, the fraud specialists were 41 years old, had 12 years of specialized fraud-related experience, and six years of auditing experience. The auditors were, on average, 36 years old, had 13.25 years of auditing experience, but no specialized fraud experience. The evidence was gathered prior to November 2010.
The results suggest that auditors’ AIS expertise can play a significant role in complex AIS settings and in their ability to compensate for CAS competence deficiencies. The authors note that it may be prudent for firms to consider the combined capabilities of individuals when assigning auditors and CAS to engagements with complex AIS.
Brazel, J. F. and C. P. Agoglia. 2007. An examination of auditor planning judgments in a complex accounting information system environment. Contemporary Accounting Research 24 (4): 1059-83.
This study examines auditor judgments in a complex accounting information system (AIS) environment. Auditing standards recommend that a computer assurance specialist (CAS) be assigned to assist in the audit of computer-intensive environments.
CAS (also known as information systems audit specialists and IT auditors) provide auditors with control-testing evidence relating to their client’s AIS. Auditors use this information when making control risk assessments and planning substantive audit procedures. This study examines how the auditors’ own level of AIS expertise and the competence of the CAS affect the assessed control risk and scope of substantive testing.
Participants included practicing auditors from four international and two national public accounting firms. Participants were audit seniors with an average of 3.7 years of experience. The experiment was conducted before 2007.
Participants were provided a case that included background information for a hypothetical client, relevant authoritative audit guidance, and prior year workpapers. After reviewing this information, participants assessed and documented inherent risk. Participants then received information about the CAS competence (high or low) and CAS control tests. Participants were then asked to evaluate the strength of CAS testing, assess control risk, and plan the substantive audit procedures.