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  • Jennifer M Mueller-Phillips
    Joint Impact of Materiality Guidance and Justification...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments 
    Title:
    Joint Impact of Materiality Guidance and Justification Requirement on Auditors’ Planning Materiality
    Practical Implications:

    The features that the authors examine, guidance structure and need of justification, vary among the Big 4 public accounting firms, and the authors show that variations in these features result in systematic differences in auditors’ planning materiality judgments. They specifically show that in circumstances where auditors’ reliance on structured guidance is inappropriate, a justification requirement can mitigate this dysfunctional effect. 

    Citation:

    Audsabumrungrat, J., S. Pornupatham, and H. Tan. 2016. Joint Impact of Materiality Guidance and Justification Requirement on Auditors’ Planning Materiality. Behavioral Research in Accounting 28 (2): 17 – 27. 

    Keywords:
    planning materiality, structured guidance, and justification.
    Purpose of the Study:

    The authors of this study investigate whether the requirement to document a justification can overcome auditors’ overreliance on decision aids in a context where their use can lead to dysfunctional outcomes. They examine this issue in a planning materiality setting because planning materiality influences the effectiveness of the overall audit process. The decision aid they examine in this study relates to structured guidance to be used in materiality assessments. Public accounting firms have developed structured guidance to assist their staff in making planning materiality judgments and to increase judgment consistency within the firms, but variations exist in the use of such guidance. They also examine justification, which is the need to provide a rationale or reason to support one’s decisions. 

    Design/Method/ Approach:

    The authors test their prediction experimentally with audit managers from three Big 4 public accounting firms in Thailand. They employ a planning materiality assessment setting where merely following the steps documented in the structured guidance without making adjustments for client-specific factors can lead to less conservative materiality assessments. 

    Findings:
    • The authors find that audit managers make less conservative and less appropriate planning materiality assessments in the presence of structured materiality guidance, but this detrimental effect is mitigated by the need to justify their judgments.
    • Participants’ materiality assessments across all conditions are higher than that made by the expert panel, suggesting that participants are not making overly low assessments that have efficiency implications. 
    Category:
    Auditor Judgment
    Sub-category:
    Audit Scope & Materiality Judgements
  • The Auditing Section
    Judgment and Decision Making Research in Auditing: A Task,...1
    research summary posted April 13, 2012 by The Auditing Section, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 09.10 Prior Dispositions/Biases/Auditor state of mind 
    Title:
    Judgment and Decision Making Research in Auditing: A Task, Person, and Interpersonal Interaction Perspective
    Practical Implications:

    The last 25 years has been an exciting and very productive period for judgment and decision making research in auditing.  The author of the discussion believes this review study will help stimulate important audit judgment and decision making research.  This line of
    research is important because it has potential to make important contributis to the audit practice.

    Citation:

    Nelson, M.W. and H. Tan. 2005. Judgment and Decision Making Research in Auditing: A Task, Person, and Interpersonal Perspective. Auditing: A Journal of Practice & Theory 24 (Supplement): 41-71.

    Trotman, K. T. 2005. Discussion of Judgment and Decision Making Research in Auditing: A Task, Person, and Interpersonal Perspective. Auditing: A Journal of Practice & Theory 24 (Supplement): 73-87.

    Keywords:
    Auditing, Judgment and decision making, Literature review
    Purpose of the Study:

    The purpose of the study is to review and discuss research in auditing specifically related to auditor judgment and decision making.  This line of research uses a psychological lens to understand, evaluate, and improve auditors’ judgments and decisions.  The authors
    classify the research into three broad areas: (1) the audit task, (2) the auditor and his/her attributes, and (3) the interaction between auditor and other stakeholders in task performance.  The authors synthesize the prior research and identify gaps and opportunities for future research. 

    The objective of the discussion paper is to build on the study by providing additional insights into areas of productive future research for judgment and decision making in auditing. 

    Design/Method/ Approach:

    The authors review judgment and decision making research in auditing conducted over the past 25 years.  Much of the research uses the laboratory experimental approach, but they also include some survey and field study approaches.  The review primarily considers papers published in major accounting journals such as The Accounting Review; Journal of Accounting Research; Contemporary Accounting Research; Accounting, Organization and Society; and Auditing: A Journal of Practice & Theory, as well as some selected working papers. 

    Findings:

    The Audit Task:  

    • The authors of the study find that much of the research related to audit tasks is grounded by the practice and professional standards.  The audit tasks most recently studied include (1) risk assessments, including the audit-risk model and related audit planning decisions, (2) analytical procedures and evidence evaluation, (3) auditors’ correction decisions regarding whether to require clients to book proposed adjustments, and (4) going concern judgments.  The authors stress the need for more research examining how auditing tasks are adapting to the current post-SOX reporting and regulatory environments. 
    • The author of the discussion feels there has been a lack of attention to audit task effects in prior research.  Prior research has not allowed us to make many general statements about the state of knowledge for each of the audit tasks.  The author
      stresses the importance of researchers to place more emphasis on audit tasks and to consider how specific audit tasks are different from the generic judgment and decision making (i.e., psychology-based) tasks.  

    Auditor Attributes: 

    • The authors of the study explain how auditors’ individual characteristics such as knowledge, ability, and personality, as well as their cognitive limitations, leave them susceptible to biases in audit judgments.  The authors focus their review of the related literature on four topics: (1) auditor knowledge and expertise, (2) other individual characteristics including aspects of personality, (3) cognitive limitations, and (4) decision aids designed to improve auditor judgments.  The authors stress the need for more research to examine how auditors’ affect or emotions also influence audit performance. 
    • The author of the discussion encourages future research to examine “why” biases in judgment occur in order to identify remedies for reducing the biases.

    Interpersonal Interactions: 

    • The authors of the study stress that because auditors do not work in isolation it is imperative to understand how people, tasks, and the environment that auditors interact with influence auditors’ performance.  The authors specifically examine interpersonal interactions between (1) auditors and other auditors, (2) auditors and their clients, and (3) auditors and other participants in the financial reporting process (e.g., jurors, judges, investors, analysts, etc.).  The authors call for more
      research related to interactions between auditors and audit committees as well as to strategic interactions between auditors and important stakeholders.  
    • The author of the discussion provides several insightful areas for future research, such as interactions between auditors and other auditors, auditors and clients, and auditors and users of audit reports. 
    Category:
    Auditor Judgment
    Sub-category:
    Audit Scope & Materiality Judgements, Prior Dispositions/Biases/Auditor state of mind, Materiality & Scope Decisions
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  • Jennifer M Mueller-Phillips
    Materiality Guidance of the Major Public Accounting Firms
    research summary posted July 19, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments 
    Title:
    Materiality Guidance of the Major Public Accounting Firms
    Practical Implications:

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

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

    Citation:

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

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

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

    Design/Method/ Approach:

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

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

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

    Findings:
    Overall, the findings indicated relative consistency of the materiality guidance among the eight firms. Specifically:
    • Quantitative benchmarks (e.g., income before taxes, total assets or revenues, and total equity) used to determine overall materiality and the related percentages applied to those benchmarks are reasonably consistent across the eight firms.
    • Seven firms use a percentage of overall materiality for determining tolerable misstatement that fits in a 50 to 75 percent range; one firm uses a range of 70 to 90percent.
    • Seven of the firms establish a clearly trivial misstatement to be 3 to 5 percent of overall materiality; one firm uses a range of 5 to 8 percent.
    • All of the firms provide detailed guidance on the evaluation of detected misstatements including consideration of qualitative factors.
    • Applying materiality on group audits closely parallels the guidance provided in the standards.
    • There are differences in how the firms consider the possibility of undetected misstatements when evaluating uncorrected detected misstatements.
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Audit Scope & Materiality Judgements
  • Jennifer M Mueller-Phillips
    Misstatements in Financial Statements: The Relationship...
    research summary posted March 1, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments 
    Title:
    Misstatements in Financial Statements: The Relationship between Inherent and Control Risk Factors and Audit Adjustments
    Practical Implications:

    The findings provide support for the relationships between inherent and control risk factors and misstatements as proposed by the audit risk model. Our results are informative to audit standard setters and audit firms in designing and structuring their audit approaches, especially the audit manual or the corresponding requirements embedded in firm-specific IT-tools. The findings suggest that an auditor should consider entity-level controls, because the strength of these controls appears to be particularly associated with misstatements. Considering an explicit requirement for auditors to identify, assess, and evaluate entity-level controls would make sense. Additionally, the findings suggest developing additional guidance on the effectiveness of an internal audit department and on whether using the opinions reached in a client’s internal audit. Finally, the findings demonstrate the usefulness of audits. 

    Citation:

    Ruhnke, K. and M. Schmidt. 2014. Misstatements in financial statements: The relationship between inherent and control risk factors and audit adjustments. Auditing: A Journal of Practice and Theory 33 (4): 247–269

    Keywords:
    Audit adjustments, audit risk model, business risk audit approach, International Standards on Auditing (ISA), materiality
    Purpose of the Study:

    The authors analyze whether audit adjustments detected in the course of an audit vary systematically with inherent and control risk factors. Because the audit risk model also proposes these relationships, our analysis has a bearing on the empirical validity of the risk model. Audit adjustments also provide evidence of the usefulness of audits in general.

    Design/Method/ Approach:

    The analysis is based on proprietary data from a large sample of audit adjustments detected in 255 financial statement audits in 2007 conducted by a Big 4 audit firm in Germany. The authors use a series of multivariate regression analyses to study the association between inherent and control risk factors and the number and magnitude of audit adjustments. Client specific planning materiality is incorporated into the design by scaling the absolute magnitude of adjustments by materiality (magnitude of the adjustments relative to client specific materiality). The analyses control for other factors, such as tenure, GAAP, and audit input.

    Findings:

    The mean size of the audit adjustments is 8.5 times larger, and the income-affecting adjustments are 5.0 times larger, than the client specific planning materiality threshold as set by the audit firm. This finding constitutes strong evidence of the corrective function of audits and the usefulness of audits in general.

    Our findings show that audit adjustments vary systematically with inherent and control risk factors, as proposed by the audit risk model. Specifically, we find that the following risk factors (corresponding to variables in the model) have a significant effect on audit adjustments:

    • Inherent risk factors: The number and relative magnitude of audit adjustments, particularly income-affecting adjustments, is lower if the quality of a client’s management (integrity and competence) is higher or the client’s financial position is stronger.
    • Control risk factors: The relative magnitude of audit adjustments is lower if entity-level controls are stronger or if the entity has an effective internal audit function. The number of adjustments is lower if the internal control system is overall stronger.

    Our results are consistent with evidence from the audit quality literature suggesting an auditor’s ability to detect misstatements is lower in the initial years of an engagements but then increases for a certain period of time. 

    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Audit Scope & Materiality Judgements
  • Jennifer M Mueller-Phillips
    The Effect of Past Client Relationship and Strength of the...
    research summary posted September 26, 2013 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.04 Interactions with Client Management 
    Title:
    The Effect of Past Client Relationship and Strength of the Audit Committee on Auditor Negotiations
    Practical Implications:

    The authors note a number of implications for practitioners resulting from this study.  First, auditors need to be aware of the strength of the audit committee and the prior relationship with the client to determine potential dysfunctional results, particularly if dealing with a compromising client.  This could lead to making too large of a concession.  This study also shows the importance of having a strong audit committee and how that strength leads to having an auditor that is in a stronger position to negotiate.  However, it also shows the difficulty that can occur as a result of working on a client with a weaker audit committee.  Further, this study underscores the need to continue searching for other factors that may increase negotiation position in the event of a weak audit committee environment. 
     
    For more information on this study, please contact Helen L. Brown-Liburd.
     

    Citation:

    Brown-Liburd, H. L., and A. M. Wright. 2011. The Effect of Past Client Relationship and Strength of the Audit Committee on Auditor Negotiations. Auditing: A Journal of Practice & Theory 30 (4):51-69.

    Keywords:
    auditor negotiation; pre-negotiation planning; negotiation strategy; negotiation relationship; audit committee
    Purpose of the Study:

      The purpose of this study is to examine auditors in a pre-negotiation planning situation (i.e., situation where the auditor and client need to come to an agreement about how to treat an accounting issue).  This study is important because prior literature indicates that various contextual factors can be important.  The authors look at two of those factors, audit committee strength and prior negotiation relationships.  Audit committee strength has been shown to help in situations where management and the auditor disagree.  Further, audit committee strength is expected to increase the leverage an auditor has in these circumstances.  In addition, whether a client has been open to other opinions and arguments (i.e., compromising) or has been more insistent that their approach is the preferred position (i.e., contending) can impact auditor expectations about how this negotiation will progress.  This study extends existing literature by looking the effects of both factors when they interact with each other. 

    Design/Method/ Approach:

        The authors conducted an experiment including auditors (managers and partners) prior to November 2009.  The experiment manipulates audit committee strength (weak or strong) and prior client negotiation relationship (contending or compromising).  Participants are asked to read a case about a contentious but subjective issue and are asked to develop their preferred write-down, initial offer, range of acceptable write-downs, and to guess what the CFO’s position will be.  The experiment also simulated a negotiation with a computerized CFO to also determine level of concessions and final offers.

    Findings:
    • The authors find that auditors are most insistent about their preferred position when the strength of the audit committee is strong and when the past relationship with the CFO is also contending. 
    • While there is no difference between groups of the preferred inventory write-down, there are significant differences in the final offer and level of concession.
       
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Interactions with Client Management
  • Jennifer M Mueller-Phillips
    The Effects of Prior Auditor Involvement and Client Pressure...
    research summary posted September 26, 2013 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.04 Interactions with Client Management 
    Title:
    The Effects of Prior Auditor Involvement and Client Pressure on Proposed Audit Adjustments
    Practical Implications:

    Regulators and investors are concerned that conflicts of interest between auditor and client may result in material adjustments that are waived when they should be proposed.  As a result, certain regulations have been implemented to prevent that conflict (i.e., SOX).  This research indicates that auditors may still favor client preferences when possible. Therefore, the reforms of SOX may not have been sufficient.
    The authors also note that this study mirrors what might result in an audit partner or audit firm rotation in that proposed adjustments are higher when the auditor had no involvement in waiving the prior period adjustments.  The authors state that audit firm rotation is expected to be costly and have a number of other negative consequences.  However, they also note their results show benefits to not having that prior involvement and thus some of the benefits of audit firm rotation (e.g., less conflict of interest/client pressure) could be attained by audit partner rotation. 
     
    For more information on this study, please contact Richard C. Hatfield.
     

    Citation:

    Hatfield, R. C., S. B. Jackson, and S. D. Vandervelde. 2011. The Effects of Prior Auditor Involvement and Client Pressure on Proposed Audit Adjustments. Behavioral Research in Accounting 23 (2):117-130

    Keywords:
    audit adjustments; prior auditor involvement; client pressure
    Purpose of the Study:

    Prior research indicates that prior client-related decisions can influence an individual’s current year decisions.  The purpose of this study is to look at how prior decisions related to waived audit adjustments impact current year proposed audit adjustments.  This is important since individuals might not fully correct prior year adjustments in the current year since it could result in an admission of prior judgment errors. Further, this study tests whether client pressure further exasperates the situation by evaluating auditors in situations where client pressure is higher or lower.  Prior research finds that auditors unknowingly tend to make judgments closer to their client’s wishes in higher pressure situations. SOX was designed to decrease this likelihood.  This study evaluates a post-SOX sample to examine whether auditors are more likely to resist these pressures. 

    Design/Method/ Approach:

    The author conducted an experiment including auditors of the senior associate, manager, and partner ranks prior to November 2011.  The experiment manipulated both client pressure (high and low) and involvement on this client’s prior year audit adjustment (waived prior year adjustment or not involved in the waiving of the prior year adjustment).  Auditors were then asked to propose an audit adjustment for allowance for bad debts. 

    Findings:
    • The authors find that auditors who were not involved in the waiving of a prior period immaterial adjustment propose adjustments that are significantly larger than auditors who had waived the prior period adjustment. 
    • The authors also find that auditors propose smaller adjustments when client pressures are higher (i.e., larger audit client and CFO that is opposed to making the full adjustment). 
    • However, the authors find no evidence to suggest that prior involvement causes even smaller in proposed adjustments when client pressure is higher. 
       
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Interactions with Client Management
  • Jennifer M Mueller-Phillips
    The Effects of Uncertainty and Disclosure on Auditors'...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments 
    Title:
    The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions.
    Practical Implications:

    The findings suggest that auditors view disclosure as lessening their responsibility for the possible misstatement of recognized amounts, and that they are less likely to require adjustment to the body of the financial statements when preparers supplement recognized fair values with footnote disclosure. Auditors respond to uncertainty differently in the fair value setting than in earlier research on nonfair value materiality decisions. The author contributes to the understanding of how professional standards are implemented as auditors decide whether to adjust fair value measurements.

    Citation:

    Griffin, J. B. 2014. The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions. Journal Of Accounting Research 52 (5): 1165-1193.

    Keywords:
    audit adjustments, disclosure, fair value, materiality, uncertainty, subjectivity, imprecision
    Purpose of the Study:

    Standard setters increasingly prefer that assets and liabilities be measured at fair value, though implementing fair value measurement sparks considerable debate. Measuring fair values in the absence of reliable market prices is difficult because the estimation process often depends on relatively subjective information inputs and generates imprecise ranges of possible outcomes. Investor advocates warn that preparers could use this uncertainty to bias fair value estimates. Auditors must assess the reasonableness of their clients’ measurements and, when they deem misstatements material, require their clients to adjust fair value estimates before reporting them in the financial statements. Regulators’ efforts to address the uncertainty associated with fair value estimates may have the unintended consequence of changing how auditors view their fiduciary duty to the investing public, especially in the case of requiring their clients to adjust fair value estimates.

    The author experimentally examines how two types of uncertainty addressed by regulators, subjectivity and imprecision, and one reporting choice encouraged by regulators, supplemental footnote disclosure, influence auditors’ decisions to require fair value adjustments. Subjectivity affects the reliability of the inputs used to prepare accounting information. In measuring fair values under SFAS No. 157, Level 1 items involve little subjectivity because highly reliable inputs (e.g., active market prices) are available, while Level 2 and Level 3 items involve progressively greater levels of subjectivity because they depend on less reliable inputs (e.g., information from comparable situations or the reporting entity’s own assumptions). Imprecision reflects the degree of variability in possible future outcomes.

    Design/Method/ Approach:

    The author conducts a 2 x 2 x 2 between-participants experiment to examine how subjectivity, imprecision, and supplemental footnote disclosure affect auditors’ adjustment decisions in a fair value measurement setting. Participants from Big Four firms were chosen randomly; 106 practicing auditors with an average of 8.9 years of experience participated in the experiment. The experiment takes participants approximately 15 minutes to complete. The evidence was gathered prior to January 2012.

    Findings:

    Subjectivity and imprecision interact to increase the likelihood that auditors will require their clients to adjust recognized fair value estimates. Increasing the imprecision of possible fair value outcomes amplifies the likelihood that auditors will require adjustment of estimates that rely on more subjective information inputs. Auditors are most likely to require clients to adjust fair value estimates when subjectivity and imprecision are both high. Auditors are most likely to require adjustments when uncertainty is highest and their clients’ discretion is greatest.

    The supplemental footnote disclosure negates this interaction. Although subjectivity and imprecision interact to increase the likelihood that auditors will require an adjustment when supplemental disclosure is absent, the dollar amount of the adjustment depends on imprecision alone. Consistent with standards, auditors use the lower boundrather than the midpointof the range of possible misstatement outcomes to calculate the size of their required adjustments.

    Category:
    Auditor Judgment
    Sub-category:
    Audit Scope & Materiality Judgements
  • Jennifer M Mueller-Phillips
    The Joint Influence of the Extent and Nature of Audit...
    research summary posted September 19, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 11.0 Audit Quality and Quality Control, 11.09 Evaluation of Evidence 
    Title:
    The Joint Influence of the Extent and Nature of Audit Evidence, Materiality Thresholds, and Misstatement Type on Achieved Audit Risk
    Practical Implications:

    This study challenges the audit practice to think about what makes sufficient, relevant, and reliable audit evidence. It provides evidence that decreased audit risk does not always occur when materiality is lowered, an increased quantity of audit evidence is obtained, and traditional audit tests are performed. The nature and persuasiveness of the audit evidence should be evaluated in order to obtain the desired level of audit risk. 


    For more information on this study, please contact David V. Budescu.
     

    Citation:

    Budescu, D.V., Peecher, M.E and I. Solomon. 2012. The Joint Influence of the Extent and Nature of Audit Evidence, Materiality Thresholds, and Misstatement Type on Achieved Audit Risk. Auditing: A Journal of Practice and Theory 31 (2): 19-41.

    Keywords:
    Audit risk, audit evidence, fraud, error, materiality, misstatement
    Purpose of the Study:

    The role of the auditors is to provide assurance on a company’s financial statements by obtaining sufficient evidence to support the audit procedures performed.  Although there are professional and regulatory standards to guide an auditor, it is ultimately the auditor’s judgment to determine if the amount of evidence that is obtained is of the right quality and quantity to support the opinion.  Through a simulation model, the authors seek to provide evidence that an achieved audit risk is influenced jointly by the nature and extent of audit evidence, materiality, and the types of financial misstatement that may occur.  Using the audit risk model, the authors address how auditors use of the audit risk model lead to lower levels of achieved audit risk and whether fraud is the only type of misstatement where use of the audit risk model is suspect. Below are the factors that the authors assess to evaluate their influence on achieved audit risk in their study: 

    • Quantitative materiality (six levels ranging from .5-5% based on typical materiality measurement)
    • Extent of the evidence (the amount of times the auditor will evaluate a set of audit procedures.  For example, an auditor may perform analytics, inquiries, walkthroughs, and sample items to test a specific account are viewed as one “venture” at the audit evidence for the account). 
    • Nature of the evidence (third-party external evidence, internal evidence from management’s financial reporting process, or internal evidence from management’s business process)
    • Type of misstatement type (Unintentional error due to management’s random error, unintentional error due to bias in management’s judgments, or intentional error due to fraud)
       
    Design/Method/ Approach:

    The authors perform a simulation to model how achieved audit risk depends on the extent and nature of audit evidence, materiality levels, and the type of misstatements that may distort the financial statements. Specifically, they use the revenue account for purposes of their simulation.  They also manipulate four factors (the independent variables):  quantitative materiality, evidence extent, evidence nature, and misstatement type. The dependent variable is the achieved audit risk, which is measured as the probability that the auditors’ expectation for revenue departs from the true value by at least material amount. 

    Findings:
    • Increasing the extent of testing decreases the audit risk only under certain conditions (i.e. when the bias in audit evidence is less than quantitative materiality).  In certain circumstances, increasing the extent of testing may increase the audit risk (i.e. when the bias in audit evidence exceeds quantitative materiality).
    • Reducing materiality levels to perform a more precise audit may or may not enhance the effectiveness of the audit procedures.  Depending on the nature of the audit procedures and the evidence that is gathered, it may decrease or increase the audit risk.
    • Quality of the internal controls of an organization may assist an auditor to better judge the extent in which evidence from management is may be distorted or contain an intentional or unintentional misstatement.
    • In the circumstances of fraud, an auditor should supplement more traditional audit tests with tests that provide evidence that is unlikely to be biased by management (i.e. external evidence).
       
    Category:
    Audit Quality & Quality Control, Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Audit Scope & Materiality Judgements, Evaluation of Evidence

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