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.

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

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.

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

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.

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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.

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

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. 

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.

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. 

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The results of the studies documented in this review suggest that there is a great deal of variability in the approaches taken by firms for establishing materiality. Such differences in materiality methods can affect both the effectiveness and efficiency of audits. For example, if firms differ in how they allocate materiality to financial statement accounts, then the scope of the work could differ across audits with similar characteristics. Auditors also appear to differ in terms of the factors they consider for determining the materiality of internal control weaknesses, suggesting that auditors may need more structured criteria to make materiality judgments about internal control weaknesses. Materiality judgments are influenced by authoritative guidance, suggesting that standard setters and audit firms have the ability to influence auditors’ materiality judgments by providing auditors with specific guidance.

Messier, Jr., W.F., N. Martinov-Bennie, and A. Eilifsen. 2005. A review and integration of empirical research on materiality: Two decades later. Auditing: A Journal of Practice and Theory 24 (2): 153-187.

Materiality has been and continues to be a topic of importance for auditors. There has recently been renewed interest in the concept of materiality, motivated by concerns at the Securities and Exchange Commission, and the Auditing Standards Board and as evidenced by the Sarbanes-Oxley Act and the issuance of proposed standards on materiality by the International Auditing and Assurance Standards Board. Additionally, new guidance has been issued recently in response to some of the materiality concerns, including Staff Accounting Bulletin (SAB) No. 99, Statements on Auditing Standards (SAS) No. 89, and SAS No. 90.  Due to the continued importance of understanding the concept of materiality, this paper reviews and integrates the empirical research on materiality since 1982. Based on the review of the literature, the authors suggest some implications of this research for audit practice and research.

This paper reviews the literature related to materiality that has been published since 1982. The authors divide their discussion of the research into archival studies and experimental studies. Archival studies use audit firm manuals, data from auditor working papers, or published financial statement data and auditor reports to examine materiality decisions. Experimental studies examine materiality judgments and decision-making of financial statement users, auditors and others (e.g., judges/lawyers).

Archival Studies: The primary findings from archival studies are categorized based on whether they were obtained from auditor-related sources (e.g., auditor working papers) or public sources (e.g., financial statements).  

     Auditor Related Sources (i.e., firm manuals and working papers)

• 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.

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.

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

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.

This article is a commentary.

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?

http://www.auditingresearchsummaries.org

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.

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

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.

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. 

• 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.

http://www.auditingresearchsummaries.org