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  • The Auditing Section
    A Model and Literature Review of Professional Skepticism in...
    research summary posted April 23, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind 
    Title:
    A Model and Literature Review of Professional Skepticism in Auditing
    Practical Implications:

    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. 

    Citation:

    Nelson, M. W. 2009. A Model and Literature Review of Professional Skepticism in Auditing.  Auditing: A Journal of Practice & Theory 28 (2): 1-34.

    Keywords:
    Auditing, Professional skepticism
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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. 

    Findings:
    • Knowledge: The author finds that audit experience and specialization can have both positive and negative effects on the level of professional skepticism exercised.  Auditors with more knowledge are better able to identify high-frequency errors and complex patterns of evidence that indicate error, but are also more likely to assume that non-error explanations are correct and that missing evidence is consistent with non-error explanations.  Auditors’ knowledge about complex professional standards provides auditors with an advantage when interacting with clients about contentious accounting issues.
    • Traits: The author finds that auditor problem-solving abilities, ethical predispositions, and traits such as self-confidence and the tendency to doubt are all related to the level of professional skepticism exercised in auditor judgments and actions.  
    • Incentives: The author finds that auditors’ incentives differ in the extent to which they affect the levels of professional skepticism exercised in auditor judgments and actions.  Auditors’ incentives can affect an auditor directly or indirectly, be immediate versus probabilistic, be financial versus social in nature, and affect an auditor in conscious and unconscious ways.  
    • Judgments: The author describes how audit evidence and pre-existing auditor knowledge, traits, and incentives all affect the level of professional skepticism in auditor judgments.  An example of a critical auditor judgment that is influenced by the level of applied professional skepticism is the overall audit risk assessment.  The author finds that much of the prior research draws upon work in psychology to identify how auditors’ cognitive limitations affect their levels of professional skepticism. Auditors’ cognitive limitations affect their levels of professional skepticism in predictable ways; therefore, practical changes can be made to increase the levels of professional skepticism applied in auditor judgments when these cognitive limitations are present.
    • Actions: The author describes how the level of professional skepticism applied in auditor judgments is a primary driver of the level of professional skepticism applied in auditor actions.  Some studies provide evidence that, given the level of professional skepticism of a particular auditor judgment, auditors’ traits and incentives influence whether or not an auditor takes an action that exhibits that level of professional skepticism.  The main auditor actions studied in prior research include auditors’ actions to modify the nature and extent of planned audit tests and auditors’ willingness to waive adjustments of identified misstatements.  
    • The author describes in detail how auditing firms can enhance levels of applied professional skepticism via changes in such areas as hiring, training, performance evaluation and promotion, review and consultation, decision aids, incentives, and tasks and institutions.
    Category:
    Auditor Judgment
    Sub-category:
    Prior Dispositions/Biases/Auditor state of mind
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  • Jennifer M Mueller-Phillips
    A Perspective on the PCAOB - Past and Future.
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 01.06 Impact of PCAOB 
    Title:
    A Perspective on the PCAOB - Past and Future.
    Practical Implications:

    The quality of the firm performing the audit is important but must be viewed through the perspective of a specific engagement team and a specific set of circumstances. Information supplied by the PCAOB is one component of the evaluation of the likelihood that an engagement team will perform a quality audit and of specific areas of audit practice where deficiencies have been identified. In the end, however, issues of independence, auditor rotation, industry competence, attention to the work, and all the other important aspects of audit quality must be monitored by the audit committee at the engagement level in the context of the specific engagement.

    Citation:

    Wedemeyer, P. D. 2014. A Perspective on the PCAOBPast and Future. Accounting Horizons 28 (4): 937-947.

    Keywords:
    internal auditing, auditing standards, PCAOB, Sarbanes-Oxley
    Purpose of the Study:

    The passage of Sarbanes-Oxley (SOX), the creation of the Public Company Accounting Oversight (PCAOB), and subsequent developments have substantially increased the political visibility of auditors and audits of financial statements. These same events have substantially decreased the role of the auditing profession in establishing audit standards and standards of audit performance; auditing is now an industry regulated primarily by persons who are not professional auditors. The perceived interest of each of the parties involved in the political process is often in conflict with those of any, or all, of the other parties.

    The author’s primary concern is the quality of the audit performed on a specific engagement.

    Design/Method/ Approach:

    This paper summarizes and synthesizes information on the PCAOB and its effect on the business model of an audit firm.

    Findings:

    SOX requirements for PCAOB inspections of audit firms substantially increased the possibility that an audit will be subsequently evaluated despite the absence of identified errors in audited financial statements. The SOX requirement for an auditor's opinion on internal controls over financial reporting (ICFR) immediately increased audit costs. The net effect of these changes has been to increase the cost of audits, particularly as a result of increased review, other quality control activities, and the performance of audits of ICFR, where required. In return, the quality of audits in terms of compliance with audit standards has improved significantly. However, the business models of audit firms and the processes for education and certification of accountants have remained substantially unchanged and are major influences on the quality of audits.

    Category:
    Standard Setting
    Sub-category:
    Impact of PCAOB, Impact of SOX
  • Jennifer M Mueller-Phillips
    A Post-SOX Examination of Factors Associated with the Size...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 05.0 Audit Team Composition, 05.04 Staff Hiring, Turnover and Morale, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    A Post-SOX Examination of Factors Associated with the Size of Internal Audit Functions
    Practical Implications:

    This study provides insights that should be useful for CAEs and boards of directors (or audit committees) in discussions related to (1) internal audit philosophy regarding its potential contributions to an organization, (2) alternative staffing models, (3) resource allocation, and (4) embracement of audit technology. The study could also help guide external auditors’ evaluation of client internal audit functions. The authors find that the mission of internal audit functions differs from organization to organization. Additionally, the results suggest that internal audit functions used for leadership development purposes (i.e., a rotational staffing strategy) are larger, presumably because the staff have less experience and staff are rotating in and out of the department more frequently. Finally, these findings help illustrate the importance of internal audit proving that it is ‘‘value added’’ to the organization. Management and audit committees are often looking for more than financial statement compliance, and those internal audit functions that have responded to these greater needs are rewarded with more resources, likely because they are perceived to deliver more value.

    For more information on this study, please contact Karla Johnstone.
     

    Citation:

    Anderson, U. L., M. H. Christ, K. M. Johnstone, and L. E. Rittenberg. 2012. A Post-SOX Examination of Factors Associated with the Size of Internal Audit Functions. Accounting Horizons 26(2): 167-191

    Keywords:
    Internal Audit; resource allocation; budgeting; staffing.
    Purpose of the Study:

    Internal auditing is a key element of an organization’s governance, risk management, and internal control structure. However, many organizations struggle to know if the investments they make in the internal audit function are appropriate and use size benchmarking data (e.g., firm assets, revenues, number of employees) to determine if internal audit is appropriately sized. However, benchmark data fails to incorporate other factors that influence internal audit size such as the effectiveness and efficiency of an internal audit function, the scope of the internal audit mission, or internal audit objectives and staffing strategies. Therefore, the objectives of the study include the following:

    • Develop and test a conceptual model that articulates the factors associated with internal audit size in the contemporary post-SOX era. The model includes four determinants of internal audit size: (1) audit committee characteristics, (2) internal audit characteristics and mission, (3) assurance activities performed by others (including internal audit outsourcing providers and assurance provided by other functions within the organization), and (4) organization characteristics.
    • Conduct an examination using contemporary post-SOX data in order to extend earlier related research on internal audit sizing by considering a variety of previously unexamined characteristics that differentiate internal audit functions from one another.
    • Examine the state of internal audit staffing in the post-SOX environment.
       
    Design/Method/ Approach:

    The authors collected data with which to test their model by first conducting field interviews with a variety of chief audit executives across a broad range of industries. The authors then distributed a survey to chief audit executives that are members of the Institute of Internal Auditors. The survey includes questions related to each of the four determinants of internal audit size (as mentioned above), as well as internal audit size based on number of internal audit personnel. The field interviews were conducted between August 2006 to November 2006 and the survey was conducted from August 2007 and October 2008.

    Findings:

    The authors find that internal audit size is positively associated with:

    Audit Committee Characteristics:

    • the size of the audit committee;
    • the frequency of audit committee meetings with the CAE
    • audit committee review and approval of the internal audit budget.

    Internal Audit Characteristics and Mission:

    • CAE tenure in the organization;
    • performance of IT auditing;
    • the use of a staffing model in which internal audit is used for rotational leadership development
    • the use of sophisticated audit technology.

    Organization Characteristics:

    • the total assets of the organization
    • the number of foreign subsidiaries that the organization possesses.


    Further, the authors find that internal audit size is inversely associated with:

    Internal Audit Characteristics and Mission:

    • the percent of audit staff designated as Certified Internal Auditors.

    Internal Audit Activities Performed by Others:

    • the extent of internal audit activities outsourced to a third party.
    Category:
    Audit Team Composition, Governance, Standard Setting
    Sub-category:
    Board/Audit Committee Composition, Impact of SOX, Staff Hiring - Turnover & Morale
  • Jennifer M Mueller-Phillips
    A Reexamination of Audit Fees for Initial Audit Engagements...
    research summary posted December 3, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 04.0 Independence and Ethics 
    Title:
    A Reexamination of Audit Fees for Initial Audit Engagements in the Post-SOX Period
    Practical Implications:

    The results of the study strongly suggest that initial-year audit discounts are quite common and substantial in the post-SOX period. Although the existence of lowballing seems to be a threat to independence, at least in appearance, the existing research on lowballing provides mixed results on its impact on audit quality. The findings will likely be of interest to the PCAOB as it searches for ways to bolster auditor independence and other regulators because many, including the GAO, believe that without non-audit service fees, auditors are less likely to offer ‘‘loss-leader’’ fees for audits.

    For more information on this study, please contact Rosemond Desir.

    Citation:

    Desir, R., J. R. Casterella, and J. Kokina. 2014. A Reexamination of Audit Fees for Initial Audit Engagements in the Post-SOX Period. Auditing: A Journal of Practice & Theory 33 (2):  59-78

    Keywords:
    Audit fees, auditor independence, lowballing, PCAOB
    Purpose of the Study:

    On August 16, 2011, the Public Company Accounting Oversight Board (PCAOB) issued a concept release seeking comments on ways to enhance auditor independence. The Board notes that higher failure rates in new audit engagements might be linked to unrealistic pricing. The Board’s concern is that a new auditor might be more susceptible to management pressure if initial-year audit fees are set artificially low.

    Prior to the passage of the Sarbanes-Oxley Act (SOX) of 2002, empirical evidence shows that auditors discounted their initial-year audit fees. This practice is known as lowballing and it occurs when auditors price initial-year audit fees lower for new clients with the expectation of increasing the fees substantially in later years in order to recoup their initial losses. Lowballing was expected to decrease significantly after the enactment of SOX.

    Indeed, findings of a study on audit pricing in initial-year audits seem to confirm that Big 4 auditors charged a fee premium on new auditor-client relationships in 2006. However, it is not clear if more recent post-SOX initial-year audits are free of lowballing. In the current study, the authors investigate whether lowballing exists in new auditor-client relationships in an ‘‘extended’’ post-SOX environment for the years 2007 to 2010. 

    Design/Method/ Approach:

    The authors analyze audit fee data for years 2006 through 2010 for publicly-traded companies that are Big 4 and non-Big 4 clients. The focus of the study is on initial audits following auditor dismissals as there are very few auditor resignations. The audit fee data were collected from Audit Analytics database and financial data – from Compustat.

    Findings:

    The results suggest that both Big 4 and non-Big 4 accounting firms discounted their initial-year audit fees during the sample period (2007–2010), with fee discounts ranging from 16 to 34 percent. In addition, the authors find no evidence of initial-year audit fee discounts (or premiums) in 2006. 

    Category:
    Auditor Selection and Auditor Changes, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc
  • The Auditing Section
    A Reexamination of Behavior in Experimental Audit Markets:...
    research summary posted May 4, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.04 Moral Development and Individual Ethics Decisions 
    Title:
    A Reexamination of Behavior in Experimental Audit Markets: The Effects of Moral Reasoning and Economic Incentives on Auditor Reporting and Fees
    Practical Implications:

    These findings suggest that auditors with lower moral reasoning scores (i.e., who tend to cooperate with close allies, but tend to be less cooperative with other parties) might in some cases better adhere to the profession’s duties.  Auditors with higher moral reasoning scores (i.e., who tend to view norms and rules as flexible and interpret them depending on a situation) are more likely to depart from auditing conventions and cooperate with others to their mutual benefit.  There have been similar findings, i.e. contrary to what we might expect in relation to moral reasoning, in other research settings.

    Citation:

    Schatzberg, J. W., G. R. Sevcik, B. P. Shapiro, L. Thorne, and R. S. O. Wallace. 2005. A reexamination of behavior in experimental audit markets: The effects of moral reasoning and economic incentives on auditor reporting and fees. Contemporary Accounting Research 22 (1): 229-264.

    Keywords:
    Audit fee, auditor reporting, cooperation, moral reasoning
    Purpose of the Study:

    In this study, the authors examine how “moral reasoning” (as measured by a commonly-used test) affects auditor reporting under different economic incentives, in an experimental setting.  In the audit of the financial statements process, cooperation between auditors and managers is important so that sufficient evidential matter can be obtained. The authors examine whether auditors are more or less likely to cooperate with management, based on the level of moral reasoning, and penalties for mis-reporting. 

    Design/Method/ Approach:

    The authors assign participants to either a “higher” or “lower” moral reasoning group based on each participant’s “higher” or “lower” score on a commonly-used moral reasoning test.  A lower score on the moral reasoning test indicates that the participant is focused on what is good for him or her whereas a higher score indicates the individual considers what is best for society.  Although not specifically stated in the study, the data appears to have been collected prior to 2005.  The participants used in this study were recruited from MBA classes.  Participants had to consider whether they would truthfully report a “low” outcome, or report “high” even though the outcome was low (i.e. cooperate with management), which would harm investors but economically benefit the participants.  The authors varied the level of penalty for misreporting to observe how this changes behavior. 

    Findings:
    • Moral reasoning and the economic penalty both significantly affected reporting behavior.  The smaller the economic penalty for misreporting the more frequently the participants tended to misreport.
    • As the economic penalty increased, truthful reporting increased.
    • When auditors engaged in “cooperative reporting behavior” (saying outcome was high when it was really low), managers tended to respond with cooperative contracting behavior (rewarding auditor participants).  Such cooperative contracting behavior was more frequent in higher moral reasoning groups, which is contrary to what we might expect (we would expect higher moral reasoning groups to report truthfully more often as opposed to less often). 
    Category:
    Independence & Ethics
    Sub-category:
    Impact of Fees on Decisions by Auditors & Managmeent, Moral Development and Individual Ethics Decisions
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  • The Auditing Section
    A Review and Integration of Empirical Research on...
    research summary posted April 13, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions 
    Title:
    A Review and Integration of Empirical Research on Materiality: Two Decades Later
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    Materiality, materiality bases, quantitative, qualitative materiality factors
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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).

    Findings:

    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)

    • There appear to be differences in the way firms establish planning materiality as well as differences in the extent of guidance provided by firms for setting planning materiality and tolerable misstatement.
    • Auditor judgment plays a significant role in setting planning materiality
    • Some version of income continues to be the major factor in determining the materiality of a misstatement (e.g., misstatement as a percent of net revenue). 

         Public Sources (i.e., financial statements, disclosures, and auditors’ reports)

    • Public sources also indicate that income continues to be the most significant factor in auditors’ materiality and disclosure decisions. This is the case regardless of the type of reporting item or disclosure in question.
    • Similarly, the choice to modify the auditor’s report seems consistent with traditional effects of the item on income. 

         Experimental Studies:

    • Experimental studies find that net income continues to be the most important factor in determining the materiality of misstatements, consistent with the findings of archival research. A number of studies find that the second most important materiality factor is the effect of the misstatement on a company’s earnings trend.
    • A number of qualitative factors were found to affect materiality decisions, including the auditors’ perceptions of management
      and management’s integrity, audit committee effectiveness, audit firm culture and whether a misstatement will be recognized in the financial statements or the footnotes.
    • Materiality judgments vary by experience and firm type. Experience appears to lead to greater consensus in materiality judgments and greater scrutiny of materiality judgments relating to discretionary, non-routine transactions.
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Materiality & Scope Decisions
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  • Jennifer M Mueller-Phillips
    A Review and Model of Auditor Judgments in Fraud-Related...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.02 Fraud Risk Models 
    Title:
    A Review and Model of Auditor Judgments in Fraud-Related Planning Tasks
    Practical Implications:

    The primary implication of the model based on the literature is that simply because auditors may assess fraud risk at a higher level due to the presence of risk factors, it does not necessarily mean that planned audit procedures designed to address these risks will be effective.  Although being aware of fraud risk is necessary to respond appropriately, being aware of only general risk factors makes it difficult for auditors to formulate possible fraud schemes that a client may perpetrate.  As a result, audit plans designed to respond to general fraud risks tend to increase the extent of testing, but do not alter the nature of the testing in a way that would be more likely to catch fraud.  If auditors identify specific situational cues and are able to generate a plausible fraud scheme as a result, more effective tests that alter the nature of the procedures can be identified and carried out.  Therefore, knowledge of fraud risks via experience or training, particularly for risks specific to a client or industry, will help to allow generation of plausible fraud schemes and the design of effective tests.

    For more information on this study, please contact Jacqueline Hammersley.
     

    Citation:

    Hammersley, J. S. 2011. A Review and Model of Auditor Judgments in Fraud-Related Planning Tasks. Auditing: A Journal of Practice & Theory 30 (4), 101-128.

    Keywords:
    fraud; risk assessment; hypothesis generation; audit planning.
    Purpose of the Study:

    The PCAOB has expressed concern regarding auditors’ frequent failure to properly adapt their audit plans for fraud risk factors and fraud cues.  Fraud is unique in the audit process in that auditors must plan their audits to address fraud risk, but most auditors have not been on engagements where fraud was discovered, reducing the likelihood that they will assess the risk of fraud effectively from experience.  Much research has been conducted to examine the various aspects of how auditors assess fraud risk and how they react to it.  This paper integrates this research into a qualitative model that shows the relationships between the identified activities of the fraud assessment process and how the related judgments are formed.

    This paper also summarizes auditing research that tests the links in the model, discussing the implications of their findings on these links.  The findings are then related to aspects of the client and situations where certain fraud risk factors may be present and how practitioners should consider these aspects, whether in the process of planning an audit or in training auditors.
     

    Design/Method/ Approach:

    The paper reviews and discusses a large number of research findings in the fraud assessment literature dating back to the early 1990s, synthesizing the results and discussing potential implications of their findings.

    Findings:

    The model can be summarized as follows:

    • Auditors’ knowledge of fraud is based on their experience, ability, and epistemic motivation (the extent to which they develop rich and accurate understandings of situations).
    • Auditors’ knowledge, combined with relevant risk factors identified for the audit, contributes to their ability to generate possible fraud schemes.
    • The generated schemes allow for the assessment of overall fraud risk, which the auditors then use to modify the audit program to detect fraud that may arise from the identified risks.

     

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Fraud Risk Models
  • 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
    A Summary of Research and Enforcement Release Evidence on...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.10 Confirmation – Process and Evaluation of Responses 
    Title:
    A Summary of Research and Enforcement Release Evidence on Confirmation Use and Effectiveness.
    Practical Implications:

    The review of AAERs identified failure to authenticate responses, collusion between auditee management and customers, and concealed side agreements and special terms as specific problem areas. These findings have several implications for standard setters, practitioners, and academic researchers. First is a need to improve response rates, as well as authenticate responses. Technology, perhaps involving third-party intermediaries, can help address these issues. Second, depending on the circumstances and identified risks, auditors may need to confirm the existence of side agreements and special terms. Auditors may also need to consider the possibility of collusion in their testing strategies. In addition, confirmation requirements may need to be extended to other accounts, at least in some circumstances.

    Citation:

    Caster, P., R. J. Elder, and D. J. Janvrin. 2008. A Summary of Research and Enforcement Release Evidence on Confirmation Use and Effectiveness. Auditing: A Journal of Practice & Theory 27 (2): 253-279.

    Keywords:
    AAER evidence, audit confirmations, audit evidence, confirmation reliability
    Purpose of the Study:

    Confirmations are extensively used and are often perceived by practitioners to be one of the most persuasive forms of audit evidence. Yet academic research has found limitations that restrict confirmation effectiveness for many management assertions. In addition, a number of problems with false and forged confirmations are identified in Accounting and Auditing Enforcement Releases (AAERs). The Public Company Accounting Oversight Board (PCAOB) and the International Auditing and Assurance Standards Board (IAASB) have put confirmation evidence on their respective agendas. Academic research indicates that receivable confirmations can be effective evidence for the existence assertion. Low response rates, as well as respondent errors and directional bias in detecting errors, are key barriers to confirmation effectiveness. This study provides a synthesis of academic and practitioner research on confirmation use and effectiveness.

    Design/Method/ Approach:

    The authors conducted a review of the academic literature on confirmations. They found few current papers examining confirmations. Most prior research addressed the effectiveness of confirmation of accounts receivable. To provide additional evidence relevant to questions in the SAG briefing paper involving confirmation of other accounts, they reviewed AAERs and practitioner literature. They identified 113 confirmation-related AAERs involving 51 auditees.

    Findings:

    The authors’ primary findings are:

    • Currently, some auditors choose not to confirm accounts receivable without justifying how they met one or more of the criteria in Statement on Auditing Standards (SAS) No. 67 for not confirming the accounts.
    • Generally, confirmations are relatively effective in testing the existence assertion for accounts receivable. However, low response rates have a negative impact on confirmation effectiveness.
    • Anecdotal evidence and some research suggest confirmation response rates are declining. Research has identified several methods to improve response rates.
    • Confirmations are also somewhat effective in examining the valuation assertion for accounts receivable. However, confirmees fail to detect many seeded errors in controlled experiments and are more likely to detect and report errors that are unfavorable to the confirmee rather than favorable errors.
    • Collusion between auditee management and the confirmee was a problem area in receivables confirmations identified from AAERs. The relationship between management and the confirmee calls into question the perception by auditors of confirmees as “independent” third parties.
    • Fictitious responses provided by auditee management were a problem area identified from a review of AAERs for accounts receivable and cash balance confirmations. Current auditing standards do not require auditors to authenticate responses.
    • Enforcement actions described in the AAERs indicated problems with bank confirmations. With the exception of accounts receivable, U.S. auditing standards related to confirmations do not provide explicit guidance for specific accounts, such as cash, marketable securities or other account balances, as well as confirmation of special terms or side agreements.
    • Considerable evidence exists that electronic confirmations and other forms of electronic database queries (i.e., defined views of supplier and/or customer databases) are becoming more prevalent. Technology offers alternatives to standard paper confirmations that may provide for authentication and improve confirmation effectiveness.
    Category:
    Auditing Procedures - Nature - Timing and Extent
    Sub-category:
    Impact of Technology on Audit Procedures Confirmation – Process and Evaluation of Responses
  • Jennifer M Mueller-Phillips
    A Summary of Research on External Auditor Reliance on the...
    research summary posted February 16, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control 
    Title:
    A Summary of Research on External Auditor Reliance on the Internal Audit Function
    Practical Implications:

    Regulators should draft regulations and oversee the profession in such a way that reflects an understanding of the complex environment in which practitioners are making reliance decisions. Standard setters, both domestic and international can learn from the cultural and jurisdictional nuances of different countries, which will facilitate appropriate internal audit reliance as corporations continue to have multi-national presences. Practitioners can benefit from the study by utilizing the review to improve upon their reliance decision frameworks.

    For more information on this study, please contact Chad Stefaniak.

    Citation:

    Bame-Aldred, C. W., D. M. Brandon, W. F. Messier, Jr., L. E. Rittenberg, and C. M. Stefaniak. 2013. A Summary of Research on External Auditor Reliance on the Internal Audit Function. Auditing: A Journal of Practice and Theory 32 (Supplement 1): 251-286

    Keywords:
    external audit; internal audit; reliance on the internal audit function; audit judgments.
    Purpose of the Study:

    The Public Company Accounting Oversight Board (PCAOB) requested a synthesis of existing research on the external auditor’s reliance of the internal audit function. Auditing Standard No. 5 (AS5) allows external auditors to rely on the internal audit function under certain criteria. This paper synthesizes post Sarbanes-Oxley research (2004 – 2012) that examines external auditor reliance of the internal audit function. The research reviewed pertains to:

    1. The influence of environmental factors on internal auditor reliance (i.e., Regulatory Environment and Governance and Client Management Characteristics),
    2. The impact of internal audit specific factors on reliance (i.e., Competence, Objectivity, and Work Quality),
    3. The nature and extent of the external auditor’s reliance, and
    4. The outcome effects of external auditor reliance on the internal auditor (i.e., Audit Efficiency, Fees, Financial Statement Quality, and Litigation).

    The research examined is limited and does not fully address the PCAOB’s inquiries, specifically jurisdictional limitations on internal audit reliance and overall threshold limitations on internal audit reliance. This paper identifies gaps in the research and proposes a series of research questions aimed at closing these gaps.

    Design/Method/ Approach:

    The review included current and proposed U.S. and international auditing standards, academic literature and selected practitioner research related to the nature of internal audit work, and the external auditor’s reliance on this work. Based on this review, the paper includes a proposed summation model and organizing framework to help capture the various factors in the reliance decision. This organizing framework is used to present the synthesis of the relevant research, identify gaps in the research and propose research questions aimed at closing these gaps. In addition, the relevant papers are summarized for ease of understanding. This summary includes the methodology, the objective of the research project, the sample (if applicable), the results of each study, and a cross-reference to the proposed research questions. 

    Findings:
    • The environment (i.e., the regulatory environment and governance and client characteristics) in which external auditors must make a reliance decision is complex – involving several factors that must be considered simultaneously. The evolving set of global auditing standards further complicates the reliance decision process.
    • Researchers have made some progress in understanding the influence of external auditors’ evaluations of internal auditor quality factors (i.e., competence, objectivity, and work performance); however, very little is known about how, and to what extent, external auditors are evaluating internal audit quality factors.
    • Research notes that the nature and extent of external auditors’ reliance on internal auditors is influenced by account risk, inherent risk, and internal audit sourcing (e.g., outsourced, co-sourced, or in-house). How the external auditors choose task environments (e.g., revenue recognition versus payroll) and the types of tests to rely upon within these task environments is not completely understood.
    • There are several unaddressed issues in the current research. These include:
      • Research examining the influence of continuous monitoring on the reliance decision
      • Research examining the reliance decision for integrated audits of public companies, specifically the audit of internal control over financial reporting.
      • Research examining the evolving nature of the internal audit function.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of SOX

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