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  • The Auditing Section
    Analysis of Diagnostic Tasks in Accounting Research Using...
    research summary posted May 9, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.11 Auditor judgment in the workpaper review process 
    Title:
    Analysis of Diagnostic Tasks in Accounting Research Using Signal Detection Theory
    Practical Implications:

    The results of this study provide insights into the decision-making process of auditors.  It suggests that accountants’ decisions may reflect an unconscious bias based on the potential cost or impact of the decision. The study provides information regarding  assignment of workpaper review responsibilities.  Managers have greater accuracy than seniors in detecting conceptual errors, but are equally accurate in detecting mechanical errors. 

    The study also provides information regarding the efficacy of audit committees.  Auditors are better able to discriminate between bankrupt and nonbankrupt companies when the audit committee consists of independent directors. 

    Citation:

    Ramsay, R. J. and R. M. Tubbs. 2005. Analysis of diagnostic tasks in accounting research using signal detection theory. Behavioral Research in Accounting 17 (1): 149-173.

    Keywords:
    Diagnostic tasks, signal detection theory, accuracy, response bias, confidence, auditor judgment
    Purpose of the Study:

    Many accounting judgments are diagnostic tasks in which accountants, auditors, managers, or investors discriminate among possible states and decide which one exists.   When evaluating decisions, we often assess the accuracy of a decision by asking the question “Did the accountant make the correct decision?”  Signal Detection Theory provides an alternative way to evaluate decisions that recognizes that decisions are made in the presence of uncertainty.  A task can involve two independent cognitive processes:  discrimination (the capability of recognizing the discriminating stimuli) and decision (the effect of decision factors).  An individual must first determine whether a signal is present (e.g., signal or noise) and then determine whether or not to report the factor as present (e.g., yes or no).  Many accounting decisions (e.g., bankruptcy, material misstatement, fraud) involve this two-step process where an individual must make a determination about how strong the evidence is before responding.  The authors of this paper utilize Signal Detection Theory to re-evaluate two previous studies to determine if this new technique allows existing researchers to draw updated conclusions about previous research. The methods and measures used by Signal Detection Theory have been widely adopted in studies of a variety of diagnostic tasks (e.g., information retrieval, weather forecasting, medical diagnosis, recognition memory, aptitude testing, and polygraph lie detection).  The purpose of this study is to provide evidence that Signal Detection Theory offers  valuable information into the decision-making process of accountants as well.

    Design/Method/ Approach:

    The authors re-examine data from two existing studies using the measures and methods of Signal Detection Theory.  The first study (Ramsay, R. J. Senior/Manager Differences in Audit Review Performance.  Journal of Accounting Research 32 (1): 127-135.)  conducted pre-1994, asked auditors (seniors and managers) from an international accounting firm to review a set of simulated working papers to determine if working paper errors existed.  As originally published, the study found senior auditors were more likely to find mechanical (objective, concrete, and verifiable) errors such as an account balance not agreeing with the workpapers. The original study also found that managers were more likely to find conceptual (subjective, unverifiable, and imprecise) errors such as an inadequate level of support for a particular account balance. 

    The authors also re-evaluate data from a study) conducted on public companies (excluding financial institutions) experiencing financial distress during 1994 (Carcello, J. V. and T. L. Neal. Audit Committee Composition and Auditor Reporting.  The Accounting Review 75 (4): 453-467).  As originally published, the study found auditors are more likely to issue a going-concern opinion for firms with independent audit committees than for firms with affiliated audit committees which include members of management or gray directors (i.e., former employees, relatives of management, or others with significant business relationships with the company).

    Findings:

    After applying Signal Detection Theory, the authors were able to gather additional insight from the original data. 

    Ramsay (1994)

    • Auditors exhibited greater bias toward saying “yes” (i.e., “error is present”) for conceptual errors which the authors believe is reasonable since the cost of missing a conceptual error is likely to be higher than the cost of missing a mechanical error. 
    • Auditors also exhibited greater confidence in their assessment of conceptual errors, which the authors theorize is due to the greater amount of time spent reviewing conceptual errors. 
    •  Original conclusions from the study were modified.  While managers had greater accuracy (of moderate significance) in assessing conceptual errors, there was no difference in the accuracy of assessing mechanical errors based on level of experience. 

    Carcello and Neal (2000)

    • Consistent with original findings, the authors find auditors are biased toward issuing a going concern opinion for firms with independent audit committees.  Auditors of firms with independent audit committees are better able to discriminate between bankrupt and nonbankrupt companies.  However, the cause of this finding is worthy of future investigation.
    Category:
    Auditor Judgment
    Sub-category:
    Auditor judgment in the workpaper review process
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  • Jennifer M Mueller-Phillips
    Are Auditors Professionally Skeptical? Evidence from...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Are Auditors Professionally Skeptical? Evidence from Auditors’ Going-Concern Opinions and Management Earnings Forecasts.
    Practical Implications:

    The decision process concerning a firm’s going-concern status is a crucial component of the overall audit. The authors provide new empirical evidence showing how auditors use potentially biased management forecasts in their going-concern decision process. Auditor professional skepticism is an important concept in audit practice as evidenced by its prominence throughout auditing standards. The authors show that auditors do not significantly overweight management forecasts on average, and even underweight management forecasts they perceive as being suspicious, indicating that auditors exercise professional skepticism when using management earnings forecasts. Thus, this paper is informative to regulators who are mainly concerned about auditors relying too heavily on what their clients tell them and failing to sufficiently test or challenge the forecasts, views, or representations of management.

    Citation:

    Feng, M., & Li, C. 2014. Are Auditors Professionally Skeptical? Evidence from Auditors' Going-Concern Opinions and Management Earnings Forecasts. Journal Of Accounting Research 52 (5): 1061-1085.

    Keywords:
    going-concern, management forecast, professional skepticism
    Purpose of the Study:

    This paper investigates whether auditors exercise professional skepticism about management earnings forecasts when assessing a client firm’s going-concern status. Professional skepticism is “an attitude that includes a questioning mind and a critical assessment of audit evidence”. Regulators have long been concerned that auditors rely too much on what their clients tell them rather than applying professional skepticism. For example, a lack of professional skepticism is one primary cause of SEC actions against audit firms.

    This paper sheds light on auditor professional skepticism due to the joint effect of three important factors.

    • Prospective financial information provided by managers is an important input to auditors when they evaluate the client’s going-concern status. Among this information, management earnings forecasts are particularly important because, if a financially distressed firm is expected to continue generating losses, the losses are likely to drain the firm’s limited cash resources and increase the firm’s likelihood of going bankrupt.
    • Financially distressed firms tend to issue optimistically biased forecasts. Because the firms to which auditors consider issuing a going-concern opinion are generally financially distressed, professional skepticism could be especially important in this setting.
    • Auditors could obtain management earnings forecasts through private communication with managers and/or public earnings forecasts.
    Design/Method/ Approach:

    The authors obtain data from financially distressed firms that have auditor reports available on Audit Analytics and are covered by the Compustat and First Call database for fiscal years 2000 through 2010. This results in final sample of 1,054 firm-year observations with 39 observations receiving going-concern opinions, and 33 filing for bankruptcy in the 12 months subsequent to the auditor opinion issuance date.

    Findings:

    The authors find that, when management earnings forecasts are higher, the firms are less likely to receive going-concern opinions and to subsequently go bankrupt. Moreover, the coefficient on management forecasts in the going-concern model is not significantly different from the coefficient in the bankruptcy model. Hence, there is no significant evidence showing that auditors, on average, overweight management earnings forecasts and thus fail to apply professional skepticism when evaluating the firms’ going-concern status.

    The authors find that auditors’ going concern decisions are not associated with management earnings forecasts with lower perceived credibility, but significantly and negatively associated with the other management earnings forecasts. In contrast, the likelihood of bankruptcy is significantly related to management earnings forecasts, regardless of auditor-perceived credibility. More importantly, the weight that auditors assign to management forecasts with low perceived credibility is significantly lower than the weight implied in the bankruptcy model. In other words, auditors’ underweight management earnings forecasts that are issued by managers who previously missed their own forecasts and management forecasts that predict high earnings increases or high earnings.

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Are PCAOB-Identified Audit Deficiencies Associated with a...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 09.0 Auditor Judgment, 09.04 Going Concern Decisions 
    Title:
    Are PCAOB-Identified Audit Deficiencies Associated with a Change in Reporting Decisions of Triennially Inspected Audit Firms?
    Practical Implications:

    Our findings seem to support statements made by the PCAOB regarding the usefulness of the inspection process in changing audit firm behavior.

    The change in GC reporting decisions that we find suggests either (1) an increased conservatism following a PCAOB inspection, of the audit firm on important reporting issues, and/or (2) an increased level of competence brought to the reporting decision.

    It is important to note that we find no change in the accuracy of the GC opinions, as measured by the future bankruptcy (or not) for clients that received a GC opinion.

    For more information on this study, please contact Jayanthi Krishnan.

    Citation:

    Gramling, A.A., J. Krishnan and Y. Zhang. 2011. Are PCAOB-Identified Audit Deficiencies Associated with a Change in Reporting Decisions of Triennially Inspected Audit Firms? Auditing: A Journal of Practice and Theory 30 (3): 59-79.

    Keywords:
    PCAOB inspection reports; going-concern; audit deficiencies.
    Purpose of the Study:

    At a broad level, we are obtaining evidence on whether the PCAOB inspection process is associated with changes in auditor behavior. More specifically, we examine whether PCAOB-identified audit deficiencies are associated with a change in triennially inspected audit firms’ going concern (GC) reporting decisions for their financially distressed clients. 

    Design/Method/ Approach:

    We obtained PCAOB inspection reports, dated between 01/01/2005 and 12/31/2007, from the PCAOB website. These reports covered PCAOB inspections of audits completed by the audit firms during 2004-2007. For the audit firms included in the sample, we read the inspection reports to identify those that indicated audit deficiencies. Data on GC opinions were obtained from Audit Analytics. The final sample on which we base our results consists of 202 audit firms and 1,648 client-year observations. The sample clients are distributed across a wide spectrum of industries, with over 50 two-digit SIC industries represented.

    Findings:
    • Firms with PCAOB-identified audit deficiencies were more likely to issue GC opinions for financially distressed clients subsequent to their PCAOB inspection than prior to their inspections.
    • While there was a change in behavior, the change does not suggest an improvement in reducing Type I errors (i.e., issuing a GC opinion to clients that subsequently remain viable) or Type II errors (i.e., failure to issue a GC opinion to a client that subsequently declares bankruptcy). Additional analysis indicates no systematic change in Type I and Type II errors following the issuance of a PCAOB report.
    • We find limited evidence of a change in the likelihood of issuing a GC opinion for audit firms that had no PCAOB-identified audit deficiencies. This finding suggests that the inspection reports without identified audit deficiencies have some, but limited, impact on changing audit firm behavior.
    Category:
    Auditor Judgment, Standard Setting
    Sub-category:
    Going Concern Decisions, Going Concern Decisions, Impact of PCAOB
  • Jennifer M Mueller-Phillips
    Assurance worlds: Consumers, experts and independence
    research summary posted April 1, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 09.0 Auditor Judgment 
    Title:
    Assurance worlds: Consumers, experts and independence
    Practical Implications:

    The author provides a commentary analyzing audit principles as they relate to studies chosen by the author. The analysis is helpful in understanding practical implications of audit principles in other assurance industries. The studies analyzed by the author provide real world examples of how audit independence, audit process, and assurance services can be viewed in a different light. The commentary provides these examples in order to examine criticisms that have been leveled against the industry relating to the principles mentioned above.

    For more information on this study, please contact Michael Power (m.k.power@lse.ac.uk).

    Citation:

    Power, M. 2011. Assurance worlds: Consumers, experts and independence. Accounting, Organizations and Society 36 (4-5):324-326.

    Purpose of the Study:

    The author describes the findings in three key studies on audit principles. The principles include:

    • Auditor Independence
    • Audit Expertise
    • Audit Process
    • To whom assurance is provided

    The author summarizes the findings to address the criticisms of the accounting profession as they relate to the principles mentioned above.

    Design/Method/ Approach:

    The author obtained three studies and provides analysis of the studies in the form of a commentary. The author addresses economic factors from 2010 and 2011. 

    Findings:
    • The author finds that a study conducted by Jamal and Sunder (2011) provides an example on how a market creates a demand for certification and grading services. The study analyzes the baseball card industry and it is observed that authenticated cards generate more value in the industry. As confidence grows in the grading services, so does the market and value of the products. However, the author notes that independence is not valued as highly as in the audit industry. The authors notes that independence is a product of the market dynamic itself. The author emphasizes that independence may be valued improperly according to the market value that is associated with it.
    • The author finds that a study conducted by Jeacle and Carter (2011) provides another concept for assurance services. By examining the TripAdviser model, the author examines how the majority provides assurance about the minority. In this case the majority are the hotel users and the minority represents the hotels themselves. The assurance is provided by ratings issued by the users. Besides the monopoly power and potential issues for misuse, the auditor believes that this particular model may provide more markets for assurance services.
    • The author finds that a study conducted by Downer (2011) provides a relationship between aircraft design safety and the approach that could be used by auditors providing assurance for banks. High reliability technology environments are subject to non-redundantly structured information technology. The overall audit takeaway is that historical information provides assurance in this area by accumulating knowledge over time. Auditor judgment plays a role in this type of environment.
    Category:
    Auditor Judgment, Independence & Ethics
  • The Auditing Section
    Attention to Evidence of Aggressive Financial Reporting and...
    research summary posted May 7, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind 
    Title:
    Attention to Evidence of Aggressive Financial Reporting and Intentional Misstatement Judgments: Effects of Experience and Trust
    Practical Implications:

    The results of this study are important for audit firms to consider when making audit personnel assignments in order to take advantage of individual traits and experiences.  Audit firms may benefit from audit team structures that include members with varying levels of trust and varying levels of prior fraud experience.  Diversifying audit team composition may improve fraud detection while maintaining audit efficiency. 

    Citation:

    Rose, J.M. 2007. Attention to evidence of aggressive financial reporting and intentional misstatement judgments: Effects of experience and trust. Behavioral Research in Accounting 19(1): 215-229.

    Keywords:
    aggressive reporting; experience; fraud; skepticism; trust
    Purpose of the Study:

    Auditors face increased pressure to detect and prevent fraud and increased responsibilities to maintain professional skepticism as a result of SAS No. 99.  Yet their ability to do so may be constrained by their individual traits or experiences.  Previous research has not sufficiently addressed auditors’ ability to detect potentially fraudulent reporting or auditors’ judgment concerning misstatements and has not evaluated auditor characteristics that can influence attention to evidence of aggressive reporting. 
    This paper investigates the following factors:  

    • Whether professional skepticism increases auditors’ attention to evidence of aggressive reporting. 
    • Whether dispositional trust affects auditor’s critical evaluation of audit evidence.  Dispositional trust is a personality trait which affects professional behavior by influencing the degree to which an individual believes that people are typically trustworthy or that they will personally benefit by trusting others.
    • Whether fraud-specific audit experience results in the development of knowledge structures that are useful for the detection of potentially fraudulent and aggressive reporting practices. 
    Design/Method/ Approach:

    The authors collected their evidence using a simulated task completed by practicing auditors from Big 4 and national accounting firms with an average of 3.6 years of experience.  Participants were given background information along with 45 pieces of audit evidence for a hypothetical audit client, and told that they were performing workpaper reviews for the client. Then, participants were asked to perform a surprise free recall of the information. Finally, participants were asked to make a judgment on the likelihood that the client’s financial statements were intentionally misstated.  Participants were assigned to either a higher or lower level of client-related skepticism and aggressive or non aggressive individual audit evidence items.

    Findings:
    • The authors find that increased skepticism is associated with increased attention to aggressive reporting, and as a result, increased belief that intentional misstatement has occurred.
    • Less trusting auditors appear to pay more attention to evidence of aggressive reporting than do more trusting auditors.  
    • The authors find that prior fraud-specific experience positively influences auditor’s judgments of intentional misstatement.  Prior fraud experience may allow auditors to develop fraud-based explanations for aggressive reporting and develop knowledge structures that include potential indicators of fraud. 
    Category:
    Risk & Risk Management - Including Fraud Risk, Auditing Procedures - Nature - Timing and Extent, Auditor Judgment
    Sub-category:
    Fraud Risk Assessment, Auditors’ Professional Skepticism, Prior Dispositions/Biases/Auditor state of mind
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  • The Auditing Section
    Audit Documentation Methods: A Path Model of Cognitive...
    research summary posted April 16, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.02 Documentation Specificity, 11.0 Audit Quality and Quality Control, 11.09 Evaluation of Evidence 
    Title:
    Audit Documentation Methods: A Path Model of Cognitive Processing
    Practical Implications:

    The results of this study are important for audit firms to consider when evaluating documentation protocol.  The results suggest that the preparation of detailed workpapers resulted in better pattern recognition and also a greater identification of exceptions.  Both of these would increase audit effectiveness.  Even though detailed workpapers are associated with greater detection rates and pattern recognition, the auditors did not perform as well on memory tests.  Therefore, audit teams may enhance the memory of auditors by encouraging team members to examine evidence a greater number of times.  The results also indicated that self-review of documentation could also increase pattern recognition, which would have a beneficial impact on audit effectiveness. 

    Citation:

    Payne, E. A. and R. J. Ramsay. 2008. Audit Documentation Methods: A Path Model of Cognitive Processing, Memory, and Performance. Auditing: A Journal of Practice and Theory 27 (1): 151-168

    Keywords:
    Audit documentation, memory, fraud, pattern recognition, error detection.
    Purpose of the Study:

    In recent years, public accounting firms have increased the use of detailed audit workpapers and are using fewer summary memos.  Summary memos were previously popular because they often provided increased efficiency (by a reduction of time to complete documentation) and reduced litigation risk.  However, the adoption of PCAOB’s Auditing Standard #3 increased the amount of documentation of auditing procedures that should be maintained by firms.  A contrast of the two types of memos is provided below: 

    • Summary memos: include an explanation of the overall procedures performed (i.e. sample selection and selection criteria) and a description of exceptions of the audit tests
    • Detailed workpapers: include the specifics of all items examined (which can include names, dates, amounts, etc.), procedures performed on each item, and the results associated with each of those items. 

    The authors consider whether the type of documentation can impact the efficiency and effectiveness of evidence gathering procedures.  Specifically, the authors consider if the type of audit documentation affects cognitive processing (i.e. how information is processed within an individual’s brain) and if these differences in cognitive processing are associated with better memory and performance measures.  The performance measures can include recognition of patterns that might suggest fraud and the identification of internal controls exceptions.

    Design/Method/ Approach:

    The research evidence is collected prior to 2005, before AS No. 3 was issued.  The authors use a group of staff and senior auditors from three of the (then) Big 5 accounting firms.  The computerized experiment was conducted at firm training sessions. Each participant completed a case study which involved testing internal controls for write-offs of accounts receivable. After reading the client background information, the subjects were presented a sample of A/R write-offs and related evidence which allowed them to  determine if the write-offs were approved in accordance with the client’s policy.  Participants were asked to complete their documentation using either a summary memo, or to prepare detailed workpapers.  The case materials included errors (i.e., a posting error and an authorization error).  Additionally, the materials were constructed to include a pattern suggestive of fraud (i.e., 5 of the 20 write-offs were just under the client’s threshold for authorization).

    Findings:
    • The two methods of documentation (detailed workpapers versus summary memos) both enhance the cognitive process, but they have different effects on memory and performance.
    • The preparation of summary memos requires auditors to view each piece of audit evidence a greater numbers of times; viewing evidence more results in better pattern recognition (i.e. recognizing a combination of factors that together suggest fraud) and increased memory.
    • The use of detailed workpapers increases the amount of time auditors spend reviewing  each of the evidence items; the increased preparation time improves auditors’ ability to identify internal control exceptions and to detect an underlying pattern in the information.
    • While both documentation methods enhance the identification of patterns in the data, the use of detailed workpapers also improves the ability to identify exceptions in internal controls while the use of summary memos enhances memory/recall.
    • Thorough self-review by a preparer of detailed workpapers further enhanced the ability to detect patterns.
    • Preparation of detailed workpapers was more efficient.
    Category:
    Auditor Judgment, Audit Quality & Quality Control
    Sub-category:
    Documentation Specificity, Evaluation of Evidence
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  • Jennifer M Mueller-Phillips
    Audit Fees and Investor Perceptions of Audit...
    research summary posted September 9, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 09.0 Auditor Judgment, 09.06 Adequacy of Disclosure 
    Title:
    Audit Fees and Investor Perceptions of Audit Characteristics.
    Practical Implications:

    These findings provide important insight into investors’ current perceptions of auditor independence, particularly in the absence of relative or comparative information, and suggests that it might be useful for regulators, when contemplating additional disclosure requirements, to allocate some attention to disclosures that have the potential to enhance investor perceptions of auditor independence. The findings of this study contribute to the forum of debate concerning the current state of audit-related disclosures and their value for investors.

    Citation:

    Beck, A. K., R. M. Fuller, L. Muriel, and C. D. Reid. 2013. Audit Fees and Investor Perceptions of Audit Characteristics. Behavioral Research in Accounting 25 (2): 71-95.

    Keywords:
    audit fees, disclosure, investor perception
    Purpose of the Study:

    Very little information is provided to the investor about the audits performed or the nature of the relationship between the auditor and client. It is difficult for investors and other external constituents to observe important qualitative aspects of an audit engagement such as the experience level, technical competence, conscientiousness, or objectivity of audit personnel.

    The objectives of this research are two-fold. First, the authors investigate whether the provision of additional referent information about audit fees (percentile rank data relative to other firms in the industry that establish a comparative benchmark) alters user perceptions of audit characteristics. This enables them to determine what investors perceive, based on audit fees, about the audit characteristics, and whether their perceptions coincide with the audit feeaudit characteristic relationships identified in previous archival research. Second, the authors contrast the perceptions of investors who are merely supplied with the total dollar amount of the audit fees with the perceptions of investors who are told that a company’s audit fee is approximately average in comparison to the audit fees of other companies within the same industry. Making this latter comparison offers insights as to how investors perceive audit and company characteristics when lacking additional information, consistent with the current state of audit fee disclosures.

    Design/Method/ Approach:

    One hundred and fourteen accounting students were recruited to participate in the experiment. These students were enrolled in an undergraduate auditing course. The instrument was administered in two different semesters, but in the same course. The participants were randomly assigned to groups, and an initial ANOVA verified that there were no differences between the four groups in terms of age, gender, or investing experience. Participants were incented to participate via bonus points in the course. The evidence was gathered prior to January 2013.

    Findings:

    The results of the study suggest that investors do develop perceptions about a company and its audit based on audit fees, as the authors find that providing supplemental audit fee disclosures indicating the relative magnitude of a company’s audit fees significantly influences investor perceptions of auditor independence, auditor effort, and audit quality. Specifically, the authors present evidence that when fees are presented to investors as low, average, or high (as compared to industry averages), investors commensurately perceive audit quality and auditor effort as being low, average, or high, respectively. When not provided with any additional information concerning the audit fee (similar to the present state of disclosures), investors assess audit quality and auditor effort as being average. However, they find that while investors perceive auditor independence as low, average, and high when fees are presented as high, average, or low, respectively, investors not provided with any relative fee information assess auditor independence as low.

    Category:
    Auditor Judgment, Client Acceptance and Continuance
    Sub-category:
    Adequacy of Disclosure, Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    Audit Partner Evaluation of Compensating Controls: A Focus...
    research summary posted February 16, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 09.0 Auditor Judgment, 09.02 Documentation Specificity 
    Title:
    Audit Partner Evaluation of Compensating Controls: A Focus on Design Effectiveness and Extent of Auditor Testing
    Practical Implications:

    The results of this study are important for audit firms to consider when audit partners are evaluating the level of precision in a compensating control. The evidence indicates that the partner’s knowledge of the existence of a material weakness unrelated to a compensating control being evaluated results in partners preferring a more precise compensating control and requiring more audit testing. Furthermore, this has implications for the efficiency of the audits as control-related decisions are potentially being influenced by inappropriate factors.

    For more information on this study, please contact Audrey Gramling, Ed O’Donnell, or Scott D. Vandervelde. 

    Citation:

    Gramling, A., E. O’Donnell, and S.D. Vandervelde. 2010. Audit Partner Evaluation of Compensating Controls: A Focus on Design Effectiveness and Extent of Auditor Testing. Auditing: A Journal of Practice & Theory 29 (2): 175-187.

    Keywords:
    audit partner judgments, compensating controls, halo effects, internal control over financial reporting, material weakness
    Purpose of the Study:

    The assessment of internal control over financial reporting is a mandatory requirement of auditors for large publicly traded companies. The assessment made by the auditors on the severity of any identified control deficiencies has a significant impact on external reporting. To assess the severity of a deficiency, auditors should consider the effect of any compensating controls. However, auditors’ prior knowledge has been a primary influence on their subsequent judgments during the assessment of this severity. Also knowledge of risk factors not directly related to the compensating control influences audit partner judgments’.

    This paper addresses the concern of the influence of this prior knowledge on the evaluation of compensating controls by investigating two factors:

    • Level of precision needed in a compensating control for it to be assessed as effectively designed
    • Extent of evidence needed for auditor testing of the operating effectiveness of the compensating control

                The authors motivate their expectations based on the psychology literature discussing halo effects. Halo effects occur when knowledge that has no diagnostic implications for a specific judgment still influences that judgment. In an audit setting, halo effects can result in auditors interpreting judgment-specific evidence to be consistent with global knowledge about the client, instead of evaluating that evidence based on its diagnostic implications relative to the judgment at hand.

    Design/Method/ Approach:

    The research evidence was collected in June 2007. The authors use a simulated task to examine whether information about overall risks influences audit partners’ judgments related to a compensating control that has been implemented within a specific client process. Participants have an average experience level of 20.91 years. The minimum number of years of experience is 10 and maximum number of years of experience is 35. Participating audit partners were asked to assume the role of an engagement partner on an integrated audit. 

    Findings:
    • Audit partners who knew of an unrelated material weakness required testing of a greater percentage of the revenue subject to the compensating control than partners who knew there were no other material weaknesses.
    • Differences in inherent risk did not significantly influence any of the dependent variables (assessment of the control design effectiveness, and the extent of evidence necessary for testing the operating effectiveness of that compensating control).
    Category:
    Auditor Judgment, Internal Control
    Sub-category:
    Assessing Material Weaknesses, Documentation Specificity
  • Jennifer M Mueller-Phillips
    Audit Partner Perceptions of Post-Audit Review Mechanisms:...
    research summary posted April 28, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.12 Impact of potential post-audit review - e.g., PCAOB, internal firm inspections, 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    Audit Partner Perceptions of Post-Audit Review Mechanisms: An Examination of Internal Quality Reviews and PCAOB Inspections
    Practical Implications:

    The results of this study make several contributions. It is beneficial to researchers interested in furthering our understanding of the effects and effectiveness of IQRs and PCAOB inspections, as well as to practitioners and regulators. While many opportunities for further research exist, results indicating a large portion of partners try to predict the engagements that will be selected for either PAR can serve as a foundation to investigate further the effects of PAR salience on audit planning and reporting decisions.

    For more information on this study, please contact Richard W. Houston
     

    Citation:

    Houston, R. W., and C. M. Stefaniak. 2013. Audit Partner Perceptions of Post-Audit Review Mechanisms: An Examination of Internal Quality Reviews and PCAOB Inspections. Accounting Horizons 27 (1).

    Keywords:
    audit quality; internal quality reviews; PCAOB inspections
    Purpose of the Study:

    Tis study attempts to examine audit partner perceptions of the two primary post-audit review (PAR) mechanisms intended to help maintain and improve the quality of public company audits (PCAOB inspections and firms’ internal quality reviews [IQRs]). Using a survey of audit partners, the authors investigate and compare partners’ perceptions of each review’s predictability, conduct, inspector qualifications and behavior, and effects. This study extends upon prior research by reporting perceptions of experienced partners from large firms, providing detailed evidence concerning IQRs, and examining partners’ perceptions of both PCAOB inspections and IQRs. Finally, the authors are also the first to study PAR perceptions to consider the effects of partner experience, complementing research suggesting that partner experience affects audit performance. 
     
     

    Design/Method/ Approach:

    To learn more about PCAOB inspections and IQRs, the authors investigate and compare partners’ perceptions of each PAR. The research questions concern perceptions of each PAR’s (1) predictability, (2) conduct, (3) inspector qualifications and behavior, and (4) effects, as well as whether results differ based on partner experience. To examine the research questions, the authors distributed a survey to large-firm audit partners. Survey participants were obtained via a mailing list obtained through the AICPA. The list included U.S. professionals who were (1) partners, shareholders, or owners; (2) audit focused; (3) employed by U.S. public accounting firms with over 100 employees. The packets were mailed to 1,400 auditors who met the above criteria. 125 partners responded resulting in approximately a 9 percent response rate.

    Findings:
    • Partners can or try to predict the engagements that will be selected for either an IQR or PCAOB inspections.
    • While partner believe they can more easily predict the specific year of an IQR, no difference was found in their abilities to select which specific engagements will be selected for IQRs or PCAOB inspections.
    • Partners perceive both PARs to be very detailed.
    • Partners believe that IQRs are more likely to cover all audit areas and that IQR reviewers have a better understanding of their firms’ audit methodologies than do PCAOB inspectors.
    • Partners believe that both IQRs and PCAOB inspections affect their professional reputation.
    • IQRs provide more timely feedback than do PCAOB inspections, and partners perceive IQR feedback to be more beneficial.
       
    Category:
    Audit Quality & Quality Control, Auditor Judgment
    Sub-category:
    Impact of Firm & External Inspection Programs, Impact of potential post-audit review (e.g. PCAOB - internal firm inspections)
  • Jennifer M Mueller-Phillips
    Audit Reporting for Going-Concern Uncertainty: A Research...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Audit Reporting for Going-Concern Uncertainty: A Research Synthesis
    Practical Implications:

    This study provides a summary of the literature examining the auditor’s GCO decisions. Determinants of GCOs include client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), auditor factors (e.g. audit firm size), auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and environmental factors (e.g. changes in regulations, auditing standards and audit market structure). Important findings are that auditors will change the likelihood of issuing GCOs in response to changes in the environment (whether due to changes in regulation or changes in the economy) and that the majority of companies that receive GCOs do not subsequently file for bankruptcy.

    For more information on this study, please contact Elizabeth Carson.

    Citation:

    Carson, E., N. L. Fargher, M. A. Geiger, C. S. Lennox, K. Raghunandan, and M. Willekens. 2013. Audit reporting for going-concern uncertainty: A research synthesis. Auditing: A Journal of Practice & Theory 32 (Supp): 353-384.

    Keywords:
    going-concern; audit reporting; bankruptcy
    Purpose of the Study:

    The global financial crisis in 2007 has resulted in an increased incidence of company failures. This led to renewed interest from regulators, standard setters and investors in the auditor’s assessment and reporting on a company’s ability to continue as a going concern. In order to facilitate the understanding of the role and effectiveness of independent audit, this study conducts a comprehensive review to synthesize and discuss the extant academic literature on auditors’ decisions to issue a modified opinion based on going concern uncertainty (hereafter, GCO).

    Design/Method/ Approach:

    This study synthesizes major findings from audit research since the 1970s. Most of the research reviewed is archival; however, a few studies using experimental designs are also cited. A framework is developed to structure the categorization of the extant GCO literature. Three main themes are identified: (1) Determinants of GCOs, (2) Accuracy of GCOs, and (3) Consequences of GCOs. This study also provides a discussion on issues related to research methodology and identifies areas for further research.

    Findings:

    Under the category of “Determinant of GCOs”, the synthesis shows that:

    • Auditors are more likely to issue GCOs after December 2001, which is in response to the accounting and auditing scandals in early 2000s (e.g. collapse of Enron). Also, smaller companies more likely to receive GCOs.
    • In the ten-year period between 2000 and 2010, 60.10% of bankruptcy filings are preceded by GCOs.
    • Determinants of GCOs include: (1) client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), (2) auditor factors (e.g. audit firm size), (3) auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and (4) environmental factors (e.g. changes in regulations, auditing standards and audit market structure).

    Under the category of “Accuracy of GCOs”, the synthesis shows that:

    • Since the adoption of SAS No.59, 40-50% of bankruptcy firms did not receive a prior GCO.
    • 80-90% of companies receiving a GCO do not file for bankruptcy in the subsequent year.

    Under the category of “Consequences of GCOs”, the synthesis shows that:

    • Issuance of GCOs is associated with negative excess returns, and the reaction is more negative when problems with obtaining financing are cited.
    • In the U.S., the issuance of GCO can be a “self-fulfilling prophecy” and cause the financial demise of company that would have survived if it had not received a GCO.

    With regards to issues in research methods, this study cautions the use of small samples in analysis and the interpretation of interaction variables in the statistical models. The study also finds general limitations in extant research due to the varying sample selection criteria for identifying financial stressed firms and the exclusion of private companies from samples examined.

    This study suggests further research could (1) examine the relations between auditor independence and GCO decisions, (2) investigate auditor’s GCO decisions and the related issues for financial institutions, non-profit organisations and government entities, (3) replicate research on GCO accuracy in different time periods with different samples, (4) examine the information usefulness of GCOs to a wide set of market participants, and (5) properly distinguish between the roles of management, audit committee and auditor in the disclosure and discussion of going-concern. 

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions

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