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  • Jennifer M Mueller-Phillips
    Auditors’ Risk Assessments: The Effects of Elicitation A...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Auditors’ Risk Assessments: The Effects of Elicitation Approach and Assertion Framing
    Practical Implications:

    These results imply that risk assessment approach can have a significant effect on the assessed risk of material misstatement and, thus, on audit program decisions that influence audit effectiveness and efficiency. The existence of assertion framing effects may directly affect the level of professional skepticism and audit effectiveness and efficiency. Both studies indicate that when belief-based assessments are transformed into probabilities, the difference from the direct probability assessments of risk is not significant; thus, obtaining belief-based assessments might make obtaining probability assessments redundant and also has the advantage of providing explicit assessments of ambiguity. 

    Citation:

    Mock, T. J. and H. Fukukawa. 2016. Auditors’ Risk Assessments: The Effects of Elicitation Approach and Assertion Framing. Behavioral Research in Accounting 28 (2): 75 – 84. 

    Keywords:
    auditors’ risk assessment, belief functions, probability, assertion framing, and skepticism.
    Purpose of the Study:

    The primary purpose of this experimental study is to replicate a previous study conducted by the authors, who examine the effects of “risk assessment elicitation approach” and “assertion framing” on auditors’ risk assessments. They find that auditors’ risk assessments differ in some important ways and that auditors’ risk assessments are influenced by assertion framing. However, the generalizability of these findings may be limited due to the use of Japanese practitioners as subjects. This study investigates U.S. practitioners in an attempt to corroborate the previous findings.

                The study focuses on two important factors that are found to affect auditors’ risk assessment judgments in the prior study: the risk assessment elicitation approach and the framing of financial statement assertions being audited. 

    Design/Method/ Approach:

    This study is an experimental replication of Fukukawa and Mock 2011. The risk assessment elicitation approach is manipulated by using scales based on either probability theory or the theory of belief functions. 

    Findings:
    • The authors find that both experimental results show significant “risk assessment approach” effects in the expected directions.
    • The authors find considerable evidence of significant “assertion framing” effects.
    • The authors find that the two risk elicitation approaches result in significantly different risk assessments.
    • The authors find that auditors’ assessed risks are higher; they seem to be more risk-sensitive and exhibit a higher level of professional skepticism when an assertion is stated in a negative way than in a positive way.
    • The authors find that while probability-based risk assessments are higher than belief-based assessments and lower than plausibility assessments, the differences between the two approaches are not significant when the belief-based assessments are transformed into probabilities using a newly proposed method. 
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement
  • Jennifer M Mueller-Phillips
    Client business models, process business risks and the risk...
    research summary posted November 14, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Client business models, process business risks and the risk of material misstatement of revenue
    Practical Implications:

    The importance of understanding the operation of a client’s business and its competitive environment to achieve an effective audit is well-known. More specifically, the PCAOB requires that an auditor understand the company’s objectives and strategies and those related business risks that might reasonably be expected to result in risks of material misstatement. Valid understanding also is necessary to both interpret results from analytical procedures and to engage in effective professional skepticism for management’s assertions. The author’s results reveal a previously unreported level of understanding of process-oriented business risks and their association with the RMM of revenue for essentially new staff auditors. 

    Citation:

    Wright, W. F. 2016. Client business, models, process business risks and the risk of material misstatement of revenue. Accounting, Organizations and Society 48: 43-55. 

    Keywords:
    business risk auditing, risk-based auditing, risk assessment, analytical procedures, strategic management, and business models.
    Purpose of the Study:

    There are undeniable benefits for financial auditors to understand a client’s business strategy, strategic objectives and critical business processes, as well as understanding the business risks of a client’s business model during the reporting period. In fact, an inadequate understanding of business risks can result in an audit failure. While business risk auditing continues to be a central framework for auditing, whether auditors can achieve the necessary in-depth understanding of the business risks generated by different strategies and business models remains unclear.  Current research tests for understanding of the theory of business risk auditing, but this author tests the premise that informed graduate students acting as surrogates for staff auditors will understand and implement in their judgments the process risk implications of different business strategies and business models. This should prove important because the existing literature indicates inconsistent results on auditor’s ability to conduct an effective strategic analysis. 

    Design/Method/ Approach:

    The author conducted a 2x2 randomized between subjects design. The participants were all accounting Masters students who were a few weeks from their graduation. These participants were presented with an array of facts, until ultimately deciding which business strategy applied and assessing the performance and the associated business risk of each of the five processes of the case. 

    Findings:
    • The author finds that, with a few exceptions, surrogates for entry-level auditors made the subtle yet important distinctions among process-level business risks given the requirements of two different business strategies.
    • The author finds that the participants were able to report risk assessments for the critical Production process such that the indirect effect of process-specific business risk mediated the direct relationship between judgments of process performance and the RMM of revenue.
    • The author finds that the participants were able to make the distinction between the two different business strategies and could correctly indicate that there is no significant difference in the RMM of revenue for the two strategies when product generation performance was relatively high and business risk was relatively low. 
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Business Risk Assessment (e.g. industry - IPO - complexity)
  • Jennifer M Mueller-Phillips
    The Role of Account Subjectivity and Risk of Material...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors 
    Title:
    The Role of Account Subjectivity and Risk of Material Misstatement on Auditors’ Internal Audit Reliance Judgments
    Practical Implications:

    This paper suggests that the relationship between account subjectivity and usage of internal audit depends on the relative risk of misstatement.  This complex relationship has not been shown in academic literature, nor is it highlighted in audit standards.  More specifically, at lower levels of risk of misstatement, increases in subjectivity have no influence on the reliance of internal audit.  At moderate risk levels the extent of internal audit reliance increases with subjectivity of the account.  At high levels of misstatement internal audit reliance decreases with account subjectivity.  This study provides insight into the decision criteria for internal audit reliance and highlight where internal audit usage maybe more prevalent, as well as were further audit guidance may be beneficial.

    Citation:

    Bhattacharjee, S., M.J. Maletta, K.K. Moreno. 2016. The Role of Account Subjectivity and Risk of Material Misstatement on Auditors’ Internal Audit Reliance Judgments. Accounting Horizons 30 (2): 225-238.

    Keywords:
    Internal audit; account subjectivity; material misstatement risk
    Purpose of the Study:

    Reliance on Internal Audit has become an important element of the external audit.  Use of Internal Audit can play a significant role in reducing audit costs without sacrificing audit quality.  However, the extent of usage of Internal Audit has been shown to be influenced by inherent risk, control risk, and the subjectivity of audit tasks.  This paper looks at the interaction between risk assessment and subjectivity to provide insight into the complexities associated with the usage of internal audit.  The authors aim to dive deeper into the analysis of internal audit usage, expanding on the dichotomous “low or high risk” assessment by investigating moderate risk scenarios.  By analyzing these relationships with a field-based questionnaire, the authors present documentation of how real decisions are based on a complex assessment of the role of internal auditors.

    Design/Method/ Approach:

    The authors conducted a field-based questionnaire using 68 auditors from a Big 4 firm.  These auditors were located in the U.S., but came from different geographic areas.  They have an average experience of 46 months and represented 15 different industry specializations.  The auditors were asked to choose one public company client and respond to questions regarding demographic information, client characteristics, external audit team characteristics, client misstatement risk, account subjectivity, client internal audit structure, and external audit assessment of internal audit usage.

    Findings:
    • The authors find that auditors’ reliance decisions involve an interaction between material misstatement risk and account area subjectivity. 
    • The authors find that incremental increases in account subjectivity have no effect on extent of internal audit reliance when misstatement risk is assessed at lower levels.  At moderate levels of misstatement risk, however, account subjectivity is positively associated with use of internal auditors.  This suggests that moderate misstatement risk creates opportunities for auditors to benefit from increasing internal audit utilization without offsetting impairments to audit effectiveness.  At higher levels of misstatement risk, incremental increases in account subjectivity have a negative association with external audit usage.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Reliance on Internal Auditors
  • Jennifer M Mueller-Phillips
    Client business models, process business risks and the risk...
    research summary posted March 22, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Client business models, process business risks and the risk of material misstatement of revenue.
    Practical Implications:

    The study provides evidence on the extent to which auditors can implement the theory of business risk auditing, including the linkages between business strategies, business models, assessment of process-level business risks and the RMM of revenue. The study provides new insights on the ability of auditors to use non-financial information effectively to assess process-level business risks and relate them to RMM of revenue. The study also provides evidence that staff auditors can distinguish between many of the subtle and important business risk implications of the two different types of business strategies  product differentiation and operational excellence.

    Citation:

    Wright, W. F. 2016. Client business models, process business risks and the risk of material misstatement of revenue. Accounting, Organizations and Society 48: 43-55.

    Keywords:
    Business risk auditing, risk-based auditing, risk assessment, analytic procedures, strategic management, business models
    Purpose of the Study:

    This study examines the theory of business risk auditing. Regulators, researchers, and practitioners indicate the importance of understanding the operation of a client’s business and its competitive environment to achieve an effective audit. A valid understanding of a company’s objectives and strategies and those related to the business risks is necessary to interpret results from analytical procedures and engage in effective professional skepticism for management’s assertions. The author focuses process-level (instead of entity-level) business risk assessment and tests for relationships between risk assessments given differing business strategies (product differentiation versus operational excellence) and the fundamental operating processes of a manufacturing firm. Process-specific business risks are important because they can cause misstatements and can cause entity-level business risks.

    Design/Method/ Approach:

    Experimental data was collected from accounting Masters students, a few weeks prior to their graduation. Evidence was collected prior to August 15, 2014. The participants read an introduction on auditor’s risk assessment context then a case describing a client’s strategic orientation, prevailing conditions and competition in the industry, details on the operation of each of the client’s five primary business processes, and the client’s current unaudited financial results with audited results from prior years. Participants provided judgments on which business strategy applied, assessed the performed and associated business risk of each of the five processes, and reported three risk of material misstatement (RMM) assessments.

    Findings:

    Overall, participants indicate business risk and RMM judgments that reflect significant understanding of the subtleties of business risk assessment. Specifically:

    • Participants provided process-specific business risk judgments consistent with RMM judgments for the critical processes of the product differentiation strategy.  
    • The process-specific judgments of business risk link the judgments related to the production process performance and the RMM of revenue.
    • When the three product generation processes were performing less well, participants correctly assessed the highest RMM of revenue.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement
  • Jennifer M Mueller-Phillips
    Construal instructions and professional skepticism in...
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism, 09.0 Auditor Judgment, 09.02 Documentation Specificity, 11.0 Audit Quality and Quality Control, 11.09 Evaluation of Evidence 
    Title:
    Construal instructions and professional skepticism in evaluating complex estimates.
    Practical Implications:

    The findings of this study have important implications for practice. Given the concern from the PCAOB regarding auditors’ lack of professional skepticism, this paper finds a mechanism to increase and improve the level of professional skepticism. In addition, the technique the author finds (providing high-level construal instructions) to auditors is “simple to use, inexpensive, and can easily be tailored for a firm’s specific needs or language

    Citation:

    Rasso, J.T. 2015. Construal instructions and professional skepticism in evaluating complex estimates. Accounting, Organizations and Society 46: 44-55.

    Keywords:
    professional skepticism, material misstatement, auditor judgment
    Purpose of the Study:

    The purpose of this study is to examine whether instructing auditors to create summaries of their audit findings during evidence evaluation in a broad/abstract manner (creating high-level construals) increases professional skepticism. Theoretical research suggests that using these high-level construals (or interpretations) helps individuals to process and understand numerous pieces information. The author suggests that this method could help auditors to ‘see the big picture’, which could help identify patterns in the evidence or possible material misstatements. Then, auditors may be more willing to gather and evaluate additional evidence to test for these potential problems.

    Design/Method/ Approach:

    Data for this paper was collected prior to April 2015 by using a computerized experiment. Auditors were used as participants in the study, and they averaged 5.4 years of audit experience (ranging from staff auditor to partner). In addition, ninety percent of the auditors had audited fair value estimates in the past.

    Findings:

    Auditors that were given documentation instructions to create high-level construals were more likely to exert professional skepticism compared to auditors given low-level construals (identifying specifically how an estimate could be fairly stated or misstated) or auditors given no instructions. Specifically, they spent more time collecting and evaluating audit evidence, collected more evidence, and rated the risk of the fair value estimate higher. These findings suggest that auditors using the high-level construal instructions process the information from their findings better and recognize a need to gather more evidence when given an incomplete amount of evidence. In addition, when evidence suggests that the fair value is overstated, auditors given the high-level construal instructions are more likely to realize the high risk.

    Category:
    Audit Quality & Quality Control, Auditing Procedures - Nature - Timing and Extent, Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Auditors’ Professional Skepticism, Documentation Specificity, Evaluation of Evidence
  • Jennifer M Mueller-Phillips
    A Risk Model to Opine on Internal Control.
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.02 Fraud Risk Models, 06.05 Assessing Risk of Material Misstatement, 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses 
    Title:
    A Risk Model to Opine on Internal Control.
    Practical Implications:

    The auditor needs a different model for audits of internal control. The auditor needs to apply two different models in an integrated audit, the original model for the opinion on the financial statements and a different model for the opinion on internal controls.

    The author believes standard setters should sponsor research on an appropriate risk model for audits of internal control. Even before the research is completed, the standards could be enhanced in the following ways:
    • indicate that the original audit risk model is intended for use only in financial statement audits, not internal control audits;
    • write standards that consistently use risk terminology and are clear as to which risk they are discussing; and
    • provide guidance on the use of models in integrated audits.

    Citation:

    Akresh, A. D. 2010. A Risk Model to Opine on Internal Control. Accounting Horizons 24 (1): 65-78.

    Keywords:
    audit risk model, inherent risk, integrated audit, internal control, opinion, risk of material misstatement, risk of material weakness
    Purpose of the Study:

    The audit risk model has provided a conceptual framework for audits of financial statements for more than 40 years. Despite practical difficulties in implementation and criticisms of its theoretical foundation, the model has been fairly effective in helping auditors analyze risks and use that analysis to determine the nature, timing, and extent of audit procedures in audits of financial statements. In recent years, some auditors have tried to apply the audit risk model to audits of internal control, usually performed as parts of integrated audits. An integrated audit is an engagement where the auditor provides an opinion on the financial statements and an opinion on the effectiveness of internal control over financial reporting. It is integrated in the sense that the auditor tries to use some of the same procedures to meet both objectives.

    While the audit risk model was designed for audits of financial statements, it was not designed for audits of internal control. Audits of internal control are audits of processes rather than audits of outputs (financial statements). In addition, opinions on internal control do not rely on analytical procedures or on substantive tests of details. Because of this conceptual difference, the author asserts that audit risk model, as originally formulated, does not work as a coherent conceptual framework for audits of internal control. The need for a different risk model for internal control audits is not currently recognized in the auditing standards or in the auditing literature.

    Design/Method/ Approach:

    This article is a commentary.

    Findings:

    For an integrated audit, the auditor would use the two models sequentially. The auditor would use the internal control risk model as a framework to determine the extent of control tests. Then the auditor would use the financial statement audit risk model as a framework to determine the extent of substantive testing.

    Future research could determine a more specific model based on how auditors perform these audits. Some research questions include, for example:

    • What models and approaches are currently used in practice? How does current practice compare with the model proposed and other models?
    • Are models useful in providing a conceptual framework for integrated audits?
    • What are the current practices for the auditor’s evaluation of inherent risk? How do those practices compare with risk models?  
    • How do auditors assess design and implementation of internal controls in light of inherent risk without considering operating effectiveness?
    • What are the current practices for the auditor’s evaluation of design, implementation, and operating effectiveness of the control environment? Are those practices adequate to effectively use in a risk model?
    Category:
    Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Material Weaknesses, Assessing Risk of Material Misstatement, Fraud Risk Models, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    How Do Audit Workpaper Reviewers Cope with the Conflicting...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 11.0 Audit Quality and Quality Control, 11.01 Supervision and Review – Effectiveness, 11.06 Working Paper Review – Conduct, Biases and Predispositions 
    Title:
    How Do Audit Workpaper Reviewers Cope with the Conflicting Pressures of Detecting Misstatements and Balancing Client Workloads?
    Practical Implications:

    These findings have implications for both practice and future research. For example, the PCAOB has raised questions about (1) the thoroughness with which engagement managers and partners review audit documentation, and (2) the extent to which their attention to engagements reflects audit-related risks. Further, the IFAC has acknowledged that reviewers in today’s audit environment have alternative ways in which to conduct their reviews, and prior research suggests that the choice of review format has implications for audit. The results presented here advance the understanding of the factors that influence this choice. The findings provide insight to firms, regulators, and inspectors regarding the impact of workload pressure and misstatement risk on how audit managers and partners conduct their reviews. These issues are increasingly relevant given recent changes to the regulatory environment.

    Citation:

    Agoglia, C. P., J. F. Brazel, R. C. Hatfield, and S. B. Jackson. 2010. How Do Audit Workpaper Reviewers Cope with the Conflicting Pressures of Detecting Misstatements and Balancing Client Workloads? Auditing: A Journal of Practice & Theory 29 (2): 27-43.

    Keywords:
    audit quality, electronic communication, face-to-face interaction, misstatement risk, review process, workload pressure
    Purpose of the Study:

    This study examines how risk of misstatement and workload pressure affect audit workpaper reviewers’ choice of review format. Recently, auditors have witnessed a number of changes in their regulatory environment that have increased their workloads. The advent of electronic communication and electronic workpapers has provided auditors with the means to alleviate certain pressures on firm resources. Electronically reviewing workpapers and transmitting review notes can ease scheduling issues and reduce reviewer travel time as it permits reviewers to review multiple jobs concurrently and from a remote location. However, prior research suggests that face-to-face communication during review has the potential to improve audit quality. Concerns over the effectiveness of reviews are highlighted by recent PCAOB inspections which raise questions about how engagement risk impacts the thoroughness of the review process. Further, the International Federation of Accountants (IFAC) acknowledges current alternatives available to reviewers and advises that explicit consideration be given to the review format choice during the audit planning process. While prior research has concentrated on the impact and extent of review, the study contributes to the literature by focusing on the choice between alternative review formats.

    Design/Method/ Approach:

    The authors surveyed twenty-three practicing auditor managers and partners to learn their beliefs about in-person and electronic communication during review. Seventy-eight percent of survey participants were from international firms, while 22 percent were from large regional firms. For the authors experiment participants were 60 practicing auditors from international, national, and large regional firms. They were primarily managers (43 percent) and partners (50 percent) with an average of 14.5 years of experience. Evidence was gathered prior to July 2009.

    Findings:

    Results of the survey suggest that reviewers view in-person interaction during review as more effective and electronic interaction as more convenient. In addition, reviewers report that they use electronic and in-person communication for roughly an equal proportion of their reviews. Results of the experiment indicate that risk of misstatement and workload pressure interact to affect participants’ review mode choices. Misstatement risk moderates the effect of workload pressure such that, when risk is high, the effect of workload pressure is effectively eliminated. These findings suggest that reviewers perceive reviews involving face-to-face interaction to be more appropriate when effectiveness of procedures is essential to ensure an acceptable level of audit quality and, when risk conditions allow, consider electronic review to be a practicable way to cope with workload pressures associated with a hectic client schedule.

    Given the survey and experimental results, the authors conclude that reviewers will choose to sacrifice convenience when higher risk calls for employing a more effective review format. They document a relationship between risk and review format. Therefore, the authors are able to shed light on how auditors are concurrently reacting to the pressures of client risk and balancing a portfolio of clients while maintaining audit quality.

    Category:
    Audit Quality & Quality Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Engagement Quality Review – Processes & Effectiveness, Working Paper Review – Conduct - Biases & Predispositions
  • Jennifer M Mueller-Phillips
    Materiality Judgments and the Resolution of Detected...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees.
    Practical Implications:

    The results of this study shed light on the complex interplay between analyst following, the pressure that managers face to manage earnings, the pressure that auditors face to protect their reputations in the post-SOX environment, and the important role that audit committees can play in settings in which managers may act strategically to achieve desired financial reporting outcomes.

    Citation:

    Keune, M. B., and K. M. Johnstone. 2012. Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees. Accounting Review 87 (5): 1641-1677.

    Keywords:
    audit committees, audit fees, error correction, materiality, stock analysts
    Purpose of the Study:

    Auditors detect and inform client managers and audit committees of misstatements, and these agents must reach agreement about whether managers will correct the misstatements prior to issuing the financial statements. Managers may waive correcting misstatements if auditors and audit committees conclude that the misstatements do not render the financial statements materially incorrect. Yet, the Securities and Exchange Commission (SEC) and others have asked the rhetorical question: If a misstatement is immaterial, then why not correct it? Given the absence of bright-line criteria for assessing materiality, judgments about resolving misstatements may be strategic to achieve desired financial reporting outcomes. Analysis of the role of managers, auditors, and audit committees in misstatement materiality judgments is therefore important because it can aid understanding of observed audit and financial reporting outcomes that can affect users.

    In this study the authors make use of regulation concerning the resolution of detected misstatements contained in Staff Accounting Bulletin No. 108 (SAB 108). The implementation of SAB 108 provides disclosure data on detected misstatements that were previously judged immaterial and were not corrected in the financial statements until the release of the new guidance. The authors use the SAB 108 disclosures to measure both the qualitative and the quantitative materiality of misstatements during the periods in which they remained uncorrected.

    Design/Method/ Approach:

    The data-collection period covers 10-Qs filed from November 15, 2006 to February 28, 2007 and 10-Ks filed from November 15, 2006 to February 15, 2008, and the analyses examine waived misstatements that existed in the financial statements during the period January 1, 2003 to September 30, 2006. To identify these misstatements, the authors read SAB 108 disclosures to find companies that corrected misstatements under SAB 108. 

    Findings:
    • The authors find that managers are generally more likely to waive qualitatively material misstatements as analyst following increases, but this effect is primarily present when audit fees are relatively low.
    • They find auditors are less likely to allow managers to waive quantitatively material misstatements as audit fees increase.
    • The authors also find a negative interaction between audit fees and analyst pressure on the likelihood that auditors will allow managers to waive qualitatively material misstatements.
    • Specifically, auditors’ incentives to protect their reputations weaken the effect of managerial incentives associated with the pressure created by analyst following; auditors are less likely to allow managers to waive qualitatively material misstatements as audit fees increase.
    • The authors find that audit committees with greater financial expertise are less likely to allow managers to waive qualitatively or quantitatively material misstatements than are audit committees with less expertise.
    Category:
    Corporate Matters, Governance, Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Board/Audit Committee Oversight, Earnings Management, Earnings Management, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Managing Audits to Manage Earnings: The Impact of Diversions...
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 06.06 Earnings Management 
    Title:
    Managing Audits to Manage Earnings: The Impact of Diversions on an Auditor’s Detection of Earnings Management.
    Practical Implications:

    Diversions can have important practical implications beyond the setting of deliberate earnings management. Managers may divert auditors from higher risk areas to accounts that they believe are not at risk of misstatement. The findings suggest that auditors would be susceptible to these diversions as well. However, to the extent that errors can occur anywhere, managers might mistakenly direct auditors’ attention to an area with errors, which could backfire on managers. Even more broadly, managers may inadvertently direct auditors’ attention from an account that materially misstates earnings to another account that does not. No matter the cause of the diversion, the results demonstrate that such diversions significantly influence an auditor’s detection of a material misstatement of earnings elsewhere in the financial statements. 

    Citation:

    Luippold, B. L., Kida, T., Piercey, M. D., & Smith, J. F. 2015. Managing audits to manage earnings: The impact of diversions on an auditor’s detection of earnings management. Accounting, Organizations & Society (41):39-54.

    Keywords:
    earnings management, audit management, decision making, material misstatements
    Purpose of the Study:

    This study discusses an aspect of earnings management called audit management. The authors define audit management as a client’s strategic use of diversions to decrease the likelihood of auditors discovering managed earnings during the audit. Evidence from prior studies suggests that managers strategically attempt to conceal earnings management. This study investigates whether managers who manipulate earnings can successfully employ diversions to influence auditors’ detection of unusual fluctuations during analytical review. That is, the authors investigate whether diversionary statements made by the client (i.e., identifying areas of risk in the financial statements to lure the auditor away from managed earnings) affect an auditor’s detection of managed earnings contained elsewhere in the financial statements.

    Managers may be motivated to divert auditors to areas that contain, or do not contain, other errors. If managers point auditors to ostensibly risky areas that are clean, auditors may conclude that the client’s accounts are likely to be accurate in other areas as well. Conversely, management may want to direct auditors to areas that contain other errors, thinking that these other errors may occupy their attention, leading auditors to feel satisfied that they are detecting misstatements, resulting in auditors feeling less compelled to discover other errors. However, auditors are also trained to practice professional skepticism, and the diversion to the other errors should elevate their sensitivity to the risk of material misstatement in the remainder of the financial statements, resulting in greater overall audit effort and a greater likelihood that they would find the earnings manipulation. The authors therefore investigate the impact of management intentionally directing auditors to both clean accounts and accounts containing errors.

    Design/Method/ Approach:

    A representative from each of the Big Four and other audit firms identified auditors with sufficient knowledge to perform the task. Seventy-six auditors, with an average of four years of audit experience, took part in the study. The experiment required that auditors complete analytical review procedures on the financials statements of a hypothetical client. The study employed a 2x2 experimental design. The evidence was collected prior to February 2015.

    Findings:

    The results suggest that diversions to clean accounts and diversions to accounts containing other errors have different effects on auditors’ detection of earnings management. The authors find that auditors’ detection of earnings management was worst when they were diverted to clean financial statement accounts, and best when they were diverted to accounts containing other errors, with earnings management detection in between these levels when no diversions were used (whether other errors were present or not). Overall, these results suggest that if management directs auditors to accounts that contain errors, the discovery of those errors heightens their sensitivity to errors in other areas of the audit. However, if auditors are directed to clean accounts, the use of diversionary statements can deter auditors from finding earnings management. Managers can potentially exploit an audit management tactic as simple as a diversion to a clean area because such a diversion reduces auditors’ effectiveness at detecting earnings management elsewhere in the financial statements.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Earnings Management
  • Jennifer M Mueller-Phillips
    Materiality Guidance of the Major Public Accounting Firms
    research summary posted July 19, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments 
    Title:
    Materiality Guidance of the Major Public Accounting Firms
    Practical Implications:

    Knowledge of how materiality guidance is integrated into a firm’s methodology is important for accounting and auditing researchers as well as for practitioners, regulators, and educators. The last published research that examined the major firms’ policies on materiality occurred in 1998.The results of this study provide important insights into implementation of materiality standards and valuable information for future research and education.

    For more information on this study, please contact Aasmund Eilifsen, aasmund.eilifsen@nhh.no.

    Citation:

    Eilifsen, A., and W. F. Messier Jr. 2015. Materiality Guidance of the Major Public Accounting Firms. AUDITING: A Journal of Practice & Theory 34 (2):3-26.

    Keywords:
    Materiality, tolerable misstatement, misstatements, group audits
    Purpose of the Study:

    Materiality is a key concept for both auditors and managers, as well as for users of financial statements. Audit standard setters have recently issued standards related to materiality. Firms translate such auditing standards into their methodologies. This paper provides evidence on the relative consistency of the materiality guidance among the top eight firms. More specifically, it shows how firms determine multiple levels of quantitative materiality, the firms’ guidance on the incorporation of qualitative factors in determining and evaluating materiality, their guidance on handling detected and undetected misstatements and, finally, how the firms’ guidance determines materiality levels in group audits. The authors aim to provide possible answers to concerns raised by prior researchers and information helpful in designing future research.

    Design/Method/ Approach:

    The materiality guidance for profit-oriented entities of eight of the largest U.S. public accounting firms was analyzed along six dimensions:

    • Benchmarks for determining overall materiality
    • Percentages applied to benchmarks for determining overall materiality
    • Determination of tolerable misstatement
    • Amounts used to determine "clearly trivial" misstatements
    • Use of materiality to evaluate misstatements
    • Use of materiality on group audits.

    Each firm reviewed the coding of its guidance for accuracy and completeness. The firms’ guidance was provided to the researchers through a partner contact who held a senior position in each firm’s assurance/audit group. Firm contacts were sent a research proposal that provided the motivation for the study, the research questions, and the deliverables. The proposals were sent out in Fall 2011 with approval and completion in Spring 2012; coding and firm review occurred in Summer and Fall 2012. At the time of the study, these were the eight firms subject to annual inspections by the PCAOB.

    Findings:
    Overall, the findings indicated relative consistency of the materiality guidance among the eight firms. Specifically:
    • Quantitative benchmarks (e.g., income before taxes, total assets or revenues, and total equity) used to determine overall materiality and the related percentages applied to those benchmarks are reasonably consistent across the eight firms.
    • Seven firms use a percentage of overall materiality for determining tolerable misstatement that fits in a 50 to 75 percent range; one firm uses a range of 70 to 90percent.
    • Seven of the firms establish a clearly trivial misstatement to be 3 to 5 percent of overall materiality; one firm uses a range of 5 to 8 percent.
    • All of the firms provide detailed guidance on the evaluation of detected misstatements including consideration of qualitative factors.
    • Applying materiality on group audits closely parallels the guidance provided in the standards.
    • There are differences in how the firms consider the possibility of undetected misstatements when evaluating uncorrected detected misstatements.
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Audit Scope & Materiality Judgements

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