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  • The Auditing Section
    Effects of Technical Department’s Advice, Quality A...
    research summary posted May 7, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.09 Impact of Consultation on Judgments 
    Title:
    Effects of Technical Department’s Advice, Quality Assessment Standards, and Client Justifications on Auditors’ Propensity to Accept Client-Preferred Accounting Methods
    Practical Implications:

    The results of this study are important for audit firms to consider when outlining best practices for their technical department.  They highlight the role and limitations of in-house consultation and advice in enhancing auditors’ decisions, and suggest that the nature of advice sought by, and presented to, auditors matters. Technical advice that merely reduces ambiguity may not be sufficient to counteract auditors’ bias toward accepting client-preferred methods. In fact, such advice could lead to an unintended consequence of bolstering auditors’ support for client-preferred methods. Explicit recommendations to use the most appropriate methods and reference to QAS should be included as well.

    Citation:

    Ng, T.B. and P. G. Shankar. 2010. Effects of Technical Department’s Advice, Quality Assessment Standards, and Client Justification on Auditors’ Propensity to Accept Client-Preferred Accounting Methods. The Accounting Review 85 (5): 1743-1761.

    Keywords:
    Advice, quality assessment, justification, auditor judgment
    Purpose of the Study:

    Current standards require auditors to discuss with listed companies’ audit committees their judgments about the appropriateness or quality, not just acceptability, of the accounting principles and estimates in audited financial statements. The spirit of such standards advocates for the use of the most appropriate accounting method. However, prior research suggests that auditors continue to accept client-preferred methods, even when they may not be the most appropriate. This paper investigates whether the effectiveness of quality assessment standards (QAS) is weakened or strengthened by: 

    • Advice from the audit firm’s technical department. Both the presence and type of advice should impose reasonableness constraints on auditors’ tendency to accept client-preferred accounting methods.
    • The strength of client justification for their preferred accounting methods. Strong client justifications are more likely to persuade auditors, so the combined effect of QAS and advice from the audit firm’s technical department should be higher in these circumstances. 

    The authors derive their expectations from the psychology literature pertaining to motivated reasoning. The theory of motivated reasoning suggests that auditors with pro-client directional goals are likely to support their client-preferred method within reasonableness constraints, (i.e., as long as it is justifiable).

    Design/Method/ Approach:

    The research evidence was collected in the mid-2000s. Audit seniors, supervisors, and managers from two Big 4 firms in Singapore participated in the experiment. Auditors completed a simulated task involving the decision to accept the client-preferred method of accounting for an ambiguous sales contract. In the first stage, the authors randomly assign participants to one of four possible conditions, where QAS is present or absent, and client justification strength is strong or weak.  In the second stage, participants within each of these four conditions were randomly provided with two types of technical advice, with an explicit recommendation or without. At the end of both stages, participants made several judgments about the case, including whether to accept the client-preferred method.

    Findings:
    • The authors find that auditors’ propensity to accept the client-preferred method in the absence of technical advice (stage 1) is significantly influenced by client justification strength, but not by the presence of QAS.
    • The authors find that auditors’ propensity to accept the client-preferred method is reduced by the presence of QAS only when client justification is strong and explicit technical advice is provided (stage 2).
    • Subsequent analysis suggests that auditors strategically use technical advice to increase support for the client-preferred method unless QAS is present, explicit technical advice is provided, and client justification is strong.
    Category:
    Auditor Judgment
    Sub-category:
    Impact of Consultation on Judgments
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  • The Auditing Section
    Covariation Assessments with Costly Information Collection...
    research summary posted April 16, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.03 Adequacy of Evidence 
    Title:
    Covariation Assessments with Costly Information Collection in Audit Planning: An Experimental Study
    Practical Implications:

    The study has significant implications for situations where auditors must make decisions based on preliminary analyses (i.e. analytical procedures). From this analysis they either pass or extend testing on the accounts under review. In the absence of guidance on the importance of subjecting all accounts and transactions to testing, auditors may tend to over (under) test in response to greater (lesser) sensitivity of an account to error (based on the preliminary testing). The ineffectiveness and inefficiencies that may result are potentially greater when transactions to be tested are chosen judgmentally. 

    Citation:

    Ganguly, A.R. and J. S. Hammersley. 2009. Covariation Assessments with Costly Information Collection in Audit Planning: An Experimental Study. Auditing: A Journal of Practice and Theory 28(1):1-27.

    Keywords:
    auditing; audit planning; covariation; correlation; costly information.
    Purpose of the Study:

    Auditors often must estimate the potential that the presence of observable clues and could lead to or provide some insight into the actual presence of material misstatements in financial reporting. For example, while studying the internal control system during audit planning, the auditor may discover a weakness in internal control (clue). The auditor must then assess how this weakness may affect the risk of material misstatement and assign resources to testing accordingly. If the assessment is too high (or too low) the auditor will likely overemphasize (or underemphasize) the necessary substantive testing. 

    Prior auditing research has consistently demonstrated that people tend to place much more emphasis on presence, rather than absence, of clues. In this study, the authors study covariation and define it loosely as a measure of how much two variables change together (e.g. an internal control clue and an actual material misstatement). The purpose of this study is to explore how auditors assess the relationship between clues (specifically internal control clues) and resulting conditions (e.g. a material misstatement). In this setting the auditors have incentive to make accurate assessments; however, the cost of obtaining sufficient evidence to support the assessment is high.

    Design/Method/ Approach:

    The authors conducted two experiments during which students (surrogates for auditors) chose which costly information to obtain in order to assess the relationship between an observable clue and its associated condition. The experiments were conducted in the early 2000’s time period.

    Findings:
    • The authors find evidence suggesting that when people are simultaneously incentivized to be both effective and efficient, they collect insufficient information in specifically predictable patterns.
    • The authors find evidence suggesting that when participants were biased in their estimation assessments, the biases occurred more due to the type of information collected rather than improper processing of collected information.
    • The authors find evidence suggesting that collecting information randomly from all available populations can potentially      improve understanding of the relationship between clues and resulting conditions. However, it can lead to a stronger revision of initial beliefs based upon some perceived or real standard rather than collecting information only from judgmentally-selected populations.  
    • The authors find that when collecting information is costly and auditors are allowed to select populations from which to sample they are more likely to collect sufficient information if they have been instructed that sampling from all populations of interest is important.
    Category:
    Auditor Judgment
    Sub-category:
    Adequacy of Evidence
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  • The Auditing Section
    Development of a Scale to Measure Professional Skepticism
    research summary posted May 2, 2012 by The Auditing Section, tagged 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:
    Development of a Scale to Measure Professional Skepticism
    Practical Implications:

    This study provides accounting firms with the first instrument theoretically designed to measure professional skepticism in auditors.  Objective measures of professional skepticism may be helpful to firms looking to increase audit efficiency or effectiveness, specifically in critical areas such as hypothesis generation, risk identification and fraud detection.

    Citation:

    Hurtt, R. K. (2010). Development of a Scale to Measure Professional Skepticism. Auditing: A Journal of Practice & Theory 29(1): 149-171.

    Keywords:
    Professional skepticism, scale development, trait skepticism
    Purpose of the Study:

    Professional standards have stressed the importance of individual auditor professional skepticism from the earliest codification. Although the concept of professional skepticism is widely accepted, there has been little research on exactly what comprises skepticism and how it can be measured. Professional skepticism is a complex characteristic; scales previously used to measure skepticism were not developed with the multi-dimensionality of professional skepticism in mind.  It can therefore, become difficult to draw appropriate conclusions or make comparisons with these measures. The study identifies two distinct types of professional skepticism: 1) trait skepticism, (defined as: relatively stable, an enduring quality of an individual) and 2) state skepticism (defined as: a temporary condition aroused by a given situation).  This particular study focuses only on the former and further delineates six character components of trait skepticism.  These characteristics are drawn from a careful review of the auditing standards as well as research in auditing, psychology, philosophy, and consumer behavior. The six characteristics are as follows:

    • A questioning mind
    • A suspension of judgment
    • A search for knowledge
    • Interpersonal understanding
    • Self-esteem
    • Autonomy      

    The author considers each of these component characteristics and develops a scale to more adequately and appropriately measure the trait skepticism of auditors. 

    Design/Method/ Approach:

    The author gathers 220 potential questions measuring each of the component characteristics identified. This large group of questions was further reduced based on several pre-tests performed on groups of varying size of undergraduate and graduate level business students. Once the scale had been reduced to a 30-item test, it was administered to 200 auditors from a major international accounting firm. To ensure that the scale was reliable, the test was re-administered to 88 auditors from the same international firm.  It is important to note that the scale was validated using auditors from only one major firm and was validated prior to the passage of the Sarbanes-Oxley Act of 2002.

    Findings:
    • The results provide preliminary evidence that the skepticism scale developed here is an instrument with appropriate reliability and validity.  
    Category:
    Auditing Procedures - Nature - Timing and Extent, Auditor Judgment
    Sub-category:
    Auditors’ Professional Skepticism, Prior Dispositions/Biases/Auditor state of mind
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  • The Auditing Section
    Auditors’ Assessment and Incorporation of Expectation P...
    research summary posted April 16, 2012 by The Auditing Section, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 09.0 Auditor Judgment, 09.03 Adequacy of Evidence 
    Title:
    Auditors’ Assessment and Incorporation of Expectation Precision in Evidential Analytical Procedures
    Practical Implications:

    The results of this study suggest that auditors’ precision assessments may not be well calibrated for relevant precision factors. Thus, auditors may benefit from additional guidance indicating the factors that should be considered for assessing the precision of analytical
    procedures.  Furthermore, audit firms might want to consider integrating some of the findings of this study into future training sessions and/or decision aids that would assist auditors in improving their precision calibration. An insensitivity to important precision factors may lead to over-reliance on analytical procedures, negatively affecting audit effectiveness. Because the allowance for loan losses is an estimate, the results of this study provide insight into factors that could influence the potential effectiveness of audits of estimates. Understanding how auditors evaluate analytical procedure precision for estimates is particularly critical in that analytical procedures may be the only source of assurance for testing these accounts.

    Citation:

    McDaniel, L.S. and L.E. Simmons. 2007. Auditors’ assessment and incorporation of expectation precision in evidential analytical
    procedures. Auditing: A Journal of Practice & Theory 26(1): 1-18.

    Keywords:
    Analytical procedures, precision, expectations, substantive test, audit evidence
    Purpose of the Study:

    The precision with which auditors form expectations during analytical procedures is important. The precision of an expectation is a measure of the closeness of the developed expectation to the actual amount and refers to the quality of the expectation, and thus, the quality of the analytical procedure. Professional standards clearly indicate that auditors should be able to form more precise expectations for accounts that are more predictable (income statement relationships generally are more predictable than balance sheet relationships) and when the information related to the account is more disaggregated (i.e., detailed). However, the Public Oversight Board’s (POB) Panel on Audit Effectiveness has found evidence that auditors rely on analytical procedures that do not provide the desired level of assurance, suggesting possible difficulty in assessing precision. To address this finding by the POB, this study investigates auditors’ abilities to assess expectation precision and incorporate their assessments into judgments related to substantive analytical procedures, as required by professional standards. A first step toward developing more effective guidance is obtaining a better understanding of why auditors sometimes fail to effectively apply analytical procedures. As such, the authors aim to answer the following two questions: 

    • To what extent do auditors’ precision assessments reflect the level of account predictability and the level of detail of the data used to form expectations? 
    • To what extent are auditors’ judgments consistent with their precision assessments? According to professional standards, the following judgments should be consistent with auditors’ precision assessments:

    (1)   The level of assurance expected by auditors to be provided by the analytical procedure.

    (2)   The range of the difference between the expected and recorded amount.

    (3)   The likelihood that the difference between the expected and recorded amount is due to misstatement versus non-isstatement causes.

    Design/Method/ Approach:

    The authors gathered their data experimentally at a firm training event for audit seniors and above (the training event occurred sometime during or prior to 2005). The participants were asked to review workpapers which included analytical procedures for two different accounts – the allowance for loan losses (a less predictable account) and interest income (a more predictable account). The expectations for the analytical procedures documented in the workpapers were either based on more or less detailed information. After reviewing the analytical procedures, auditors were asked to assess the precision and the level of assurance provided, provide an expectation range for the account balance, and judge the amount of difference between the expected and recorded amount due to misstatement.

    Findings:
    • Overall, auditors assess precision higher when the data forming the expectation are disaggregated (i.e., more detailed) versus aggregated (i.e., less detailed). 
    • Auditors also assess precision higher for the more predictable account (interest income) versus the less predictable account (the allowance for loan losses). 
    • Auditors’ precision assessments for the allowance for loan losses are not significantly different between the disaggregated and aggregated analytical procedures. This finding suggests that in assessing the precision of analytical procedures for less predictable accounts, auditors do not consider the effects of data aggregation. 
    • The results also show that for both accounts auditors judge the level of assurance obtained from the analytical procedures consistent with their precision assessments (i.e., higher assessed precision corresponds with a higher level of assurance).  
    • Counter to the authors’ expectations, auditors’ precision assessments were not related to their judgments of the range of differences between the expected and recorded amounts or the likelihood of misstatement.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Auditor Judgment
    Sub-category:
    Adequacy of Evidence
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  • The Auditing Section
    A Comparison of Auditor and Client Initial Negotiation...
    research summary posted May 4, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind, 10.0 Engagement Management, 10.04 Interactions with Client Management 
    Title:
    A Comparison of Auditor and Client Initial Negotiation Positions and Tactics
    Practical Implications:

    This study provides a more complete examination of auditor-client pre-negotiation decisions and negotiation tactics when confronted with an ambiguous accounting issue.  Because auditors and clients approach conflict resolution and make negotiation decisions in very different ways, the results should be of interest to auditors. 

    Citation:

    Bame-Aldred, C. W. and T. Kida. 2007. A Comparison of Auditor and Client Initial Negotiation Positions and Tactics. Accounting, Organizations, and Society 32 (6): 497-511.

    Keywords:
    Auditor-client negotiation, revenue recognition, financial reporting.
    Purpose of the Study:

    Auditors must work with clients when forming their financial reporting decisions and the two parties may encounter situations where their reporting goals are different.  This conflict can compel the auditor and client to enter into formal or informal negotiations.  Various studies have previously examined auditor-client negotiation behavior, but none have directly compared the negotiation decisions of auditors and clients when faced with the same negotiation context. As such, the overall purpose of the study is to further examine the negotiation behavior of auditors and clients when facing an ambiguous revenue recognition issue.  Negotiation behavior will ultimately have an impact on the firm’s financial reporting decisions. Below are the objectives that the authors address in their study: 

    • Examine the degree of flexibility inherent in auditor and client initial negotiation positions.
    • Examine whether auditors and clients accurately perceive the other party’s initial positions.
    • Examine the types of negotiation tactics auditors and clients are likely to use. 
    Design/Method/ Approach:

    The authors collected their evidence via research questionnaires mailed to auditors at national CPA firms and experienced financial managers at various companies during the Spring and Summer of 2002.  The auditor participants included partners, senior managers, and managers.  The financial managers included CFOs, controllers, accounting managers, and analysts from 38 different companies.  Participants read summary financial information, a description of the auditor-client relationship, and a scenario about the proper amount of revenue recognition in a specific conflict scenario.  Participants were asked questions about their initial negotiation positions, their range of acceptable amounts, their perceptions of the other party’s positions and limits, the importance of certain revenue recognition issues, and the likelihood of using specific types of negotiation tactics.

    Findings:
    • Auditors and clients differ in their desired recognition amounts, thus establishing the need for negotiation to resolve this conflict. 
    • Auditor solution sets (i.e., the revenue recognition amounts between their reporting goal and their limit) were about half as large as client solution sets, indicating considerably less flexibility by auditors during the negotiation process. 
    • Auditors’ and clients’ had overlapping solution sets, indicating that a negotiated settlement should still be quickly attainable for most auditor-client negotiations.
    • Clients’ perceptions were significantly more accurate than auditors’ perceptions about the other party’s goals and limits of recognition amounts.  Auditors appear to overestimate clients’ actual reporting goals and limits.
    • Auditors considered issues supporting higher revenue recognition (e.g., missing the analysts’ earnings estimates and management incentive bonus) as less important than clients.  Clients thought that consistency with existing revenue recognition methods and increased earnings variability were more important issues than did auditors.  However, auditors and clients considered issues supporting lower revenue recognition to be equally important.
    • Tactics:
      • The highest rated tactic by both auditors and clients was problem-solving (i.e., to provide substantial rationale for their solution to persuade the other party to change their mind). 
      • Both auditors and clients agreed they should try to get information about the other party’s preferences and that they would try to appear as if they would not back down from their initial position. 
      • The lowest rated tactic by both auditors and clients was to threaten to qualify the opinion (by auditors) or to threaten to terminate the relationship (by clients). 
      • Clients were more likely than auditors to use a tactic of bid high / concede later and a tactic of attempting to trade-off certain issues. 
      • Overall, auditors were less likely to use tactics that could be interpreted as appearing inconsistent with their professional responsibilities.
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Prior Dispositions/Biases/Auditor state of mind, Interactions with Client Management
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