Auditors should recognize that an implicit tradeoff exists between the availability of subsequent event evidence and timelier reporting. However, the net effect is not well understood because prior research has only focused on quantifying the benefits of timely reporting, not the costs associated with obtaining less subsequent event evidence. The low evidence discovery rate reported by participants suggests that the current audit methodology might suffer from inefficiencies. Further research should establish relative frequency information to help auditors generate hypotheses and guide audit planning.
Janvrin, D. J. and C. G. Jeffrey. 2007. An Investigation of Auditor Perceptions about Subsequent Events and Factors That Influence This Audit Task. Accounting Horizons 21 (3): 295-312
Generally accepted auditing standards require auditors to consider subsequent events by examining transactions that occur after the balance sheet date. In light of the Securities and Exchange Commission’s (SEC) decision to shorten the time between the balance sheet and report dates, this study seeks to better understand how auditors search for and discover subsequent event evidence in this new reporting environment. Prior literature on this subject is sparse. The Canadian Institute of Chartered Accountants (CICA) and the American Institute of Certified Public Accountants (AICPA) are concerned that audit quality will suffer because auditors now have less time to discover evidence of subsequent events. For example, earnings management behavior is difficult to detect without persuasive evidence. Specific study goals are as follows:
A field-based experiential questionnaire was issued to U.S. auditors from each of the Big-4 firms and one national firm over a one-year period prior to November 2004. Participants had an average of 9.6 years of experience. Participants were asked to rate how often they search for and discover subsequent event evidence both in general, and using the ten procedures found in auditing standards.
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.
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.
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:
(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 nonmisstatement causes.
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.
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.
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.
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:
(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.
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.
Based on the interviews and problems identified, the authors conjecture that potentially suboptimal auditing methods are being used to evaluate complex estimates which are an important and growing part of the financial statements. This may be negatively impacting audit quality. More specifically, auditors over-rely on management estimates because they lack the knowledge and incentives to behave otherwise. This possibility has direct consequences for auditor professional skepticism because increasing professional skepticism may be less effective unless auditors are also given the requisite knowledge to properly use it. These problems are reinforced by auditing standards and regulators which generally outline/criticize the current auditing methods without suggesting new or better ones.
Griffith, E., J. Hammersley, and K. Kadous. 2015. Audits of Complex Estimates as Verification of Management Numbers: How Institutional Pressures Shape Practice. Contemporary Accounting Research 32 (3): 833-863.
Complex estimates are increasingly important to financial statements and of growing concern to both regulators and investors. While auditors have well-established procedures for auditing more objective account balances (i.e., valued at historical cost), little is known about the process auditors use to evaluate more subjective, complex estimates. This article conducts interviews with experienced audit personnel to determine how auditors evaluate such estimates, determines the problems with such approaches, and uses “institutional theory” to theorize the reason such problems exist and persist. The authors consider the influence of both audit firms themselves and regulators (i.e., information from PCAOB inspection reports) on auditors’ complex estimate audit procedures.
The authors conducted semi-structured phone interviews with experienced audit personnel. Participants are from 6 large accounting firms with at least manager level experience. Interviews were conducted between October and November 2010. The authors analyzed the audit process steps discussed by participants for complex estimates and coded these steps according to the PCAOB auditing standards related to accounting estimates (AU 342 and 328). For steps that could not be appropriately classified into ones discussed by the auditing standards, the authors developed additional classifications.
While auditing standards allow for different approaches to evaluating complex estimates (e.g., testing management process, preparing independent estimate, etc.), the authors find that auditors usually just test management’s process (i.e., verifying inputs such as historical cost, understanding who and how estimate is generated, testing controls surrounding process, and testing sensitivity of assumptions used).
Based on institutional theory, the authors theorize two key reasons that auditors mainly use management process verification when auditing complex estimates instead of other (potentially more creative and skeptical) approaches. The reasons are:
This study has implications for public accounting firms engaging in GHG engagements. Team training that establishes an understanding of the knowledge and role of the team members from differing disciplines might help to alleviate over-reliance on peer-provided evidence. In the context of multidisciplinary assurance teams, establishing and adhering to audit firm quality control mechanisms relating to evidence collection, evaluation, and review are of particular importance. Accounting firms may also need to pay particular attention in fostering an assurance environment that encourages objective evidence processing.
Kim, S., W. J. Green, and K. M. Johnstone. 2016. Biased Evidence Processing by Multidisciplinary Greenhouse Gas Assurance Teams. Auditing: A Journal of Practice and Theory 35 (3): 119-139.
Due to the increased attention being paid to the environment as well as how humans are impacting the environment, there exists growing demand for a range of corporate social responsibility information. In order to be most efficient, assurors conduct greenhouse gas (GHG) assurance engagements using multidisciplinary teams containing varying technical expertise, with some possessing financial audit-related expertise and others possessing science or combined science/financial-related expertise. The purpose of this study is to investigate how auditors respond to the discipline-specific expertise of other team members in undertaking GHG assurance.
The authors test this by conducting an experiment in which traditional auditor participants respond to a simulated multidisciplinary team and examine whether the auditors bias their weighting of evidence based on if the senior assuror has a science background as opposed to a financial background.
Incorporating Big Data into an audit poses several challenges. This article establishes how Big Data analytics satisfy requirements of audit evidence, namely that it is sufficient, reliable, and relevant. The authors bring up practical challenges (such as transferring information, privacy protection, and integration with traditional audit evidence) and provide suggestions for addressing them in incorporating Big Data into audit evidence. They also suggest that Big Data can complement tradition audit evidence at every level of audit evidence: financial statement, individual account, and audit objective.
Yoon, K., L. Hoogduin, and L. Zhang. 2015. Big data as complementary audit evidence. Accounting Horizons 29 (2): 431-438.
This paper frames Big Data in the context of audit evidence, specifically looking at the requirements for something to be considered audit evidence, to provide an argument for the usefulness of Big Data to auditors. The authors address the sufficiency, reliability, and relevance of Big Data analytics; they then outline potential challenges to using Big Data for adequate audit evidence.
The authors summarize existing literature on audit evidence as it applies to Big Data. They perform no original analyses, but rather discuss the characteristics of Big Data analytics as they relate to regulations and research findings.
The authors address:
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.
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.
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.
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.
The results have implications about situations in which others evaluate the auditor’s work after the fact, such as the audit review process or the examination of audit evidence by regulators, jurors, or judges. In such situations, decision makers need to evaluate the strength of previously gathered audit evidence, and to judge the extent to which the evidence supports a previously reached conclusion. Regarding the assessed sufficiency of audit evidence, the results suggest that evaluators of the auditor’s work could require larger sample sizes under sequential sampling than under fixed sampling, to support the same level of confidence in the auditor’s opinion. Although sequential sampling might in fact increase audit efficiency, the findings suggest that this benefit could be negated by subsequent unfavorable assessment of audit evidence from a sequential sampling plan.
For more information on this study, please contact Marietta Peytcheva.
Gillett, P. R., and M. Peytcheva. 2011. Differential evaluation of audit evidence from fixed versus sequential sampling. Behavioral Research in Accounting 23 (1): 65-85.
The authors examine whether the assessed value of audit evidence depends on whether it was collected using fixed or sequential sampling. Opposing views are held by the two main schools of statistical theory: Bayesian statisticians maintain the value of audit evidence is the same, regardless of the sampling plan, whereas frequentist statisticians argue the sampling plan should affect evidence evaluation. This study tests empirically how using fixed versus sequential sampling plans influences the subsequent evaluation of audit evidence.
In two experiments, audit students and practicing auditors assess the strength of audit evidence obtained using different sampling plans. The experimental task involves testing of internal controls as part of the audit of the revenue cycle. The research evidence is collected in 2005—2008.
Audit evidence obtained from a fixed sampling plan is invariably assessed as stronger, by both audit students and practicing auditors. This finding is consistent with frequentist statistical theory, but not with Bayesian theory. Participants in the first experiment who considered the fixed sampling plan (the plan more widely used in audit practice) were prone to consider additional factors (such as whether or not they had gathered the evidence themselves) in their assessment of the strength of observed audit evidence. Participants exposed to the sequential plan, however, did not respond to these additional factors but assigned generally lower strength to evidence obtained from a sequential plan. Qualitative data on the reasoning behind auditors’ observed preferences suggest that auditors perceive fixed sampling plans as unbiased. Sequential plans, in contrast, are perceived to leave room for bias. The main concern auditors report regarding the sequential sampling plan is that this plan presents samplers with an opportunity to influence the test results by increasing or altering sample size until the desired results are observed.
The increasing use of uncertain fair value measurements and other estimates in financial statements place an increasingly difficult burden on auditors, who are required to provide a high level of positive assurance that financial statements—including those containing items subject to enormous inherent estimation uncertainty such as those described above—are fairly stated in all material respects. The authors state that auditors are doing their best within the requirements imposed by standard setters and regulators, but also suggest that it is time for those who set and regulate standards to consider ways to more clearly convey where extreme estimation uncertainty exists within financial statements, and to reconsider auditors’ ability to provide positive, high level audit assurance on these inherently uncertain estimates.
For more information on this study, please contact Steven M. Glover.
Christensen, B. E., S. M. Glover, and D. A. Wood. 2012. Extreme Estimation Uncertainty in Fair Value Estimates: Implications for Audit Assurance. AUDITING: A Journal of Practice & Theory 31 (1):127-146.
The prevalence of fair value and other estimates in financial statements, as well as their inherent estimation uncertainty, has increased dramatically in recent years. Auditors are placed in a difficult position, as no amount of auditing can remove the underlying estimation uncertainty in reported values that are determined by management-derived estimation models that are hypersensitive to small changes in inputs. Despite the increase in uncertainty, the content of the audit report and the information conveyed on the face of the financial statements have changed relatively little. The study discusses how recent events have seemingly resulted in higher expectations and tighter constraints, thus placing a potentially unrealistic burden on auditors, essentially requiring them to provide a product that may be beyond their reach. Finally, the study questions whether auditing and financial reporting standards provide for effective conveyance of the uncertainty contained in financial statements.
The study uses estimates reported by Wells Fargo and General Motors to illustrate how changes in estimation model inputs impact fair value point estimates. The authors compare estimation uncertainty in the point estimates, as reported by management, to audit materiality for the financial statements taken as a whole. The level of estimation uncertainty highlights potential challenges that auditors face in providing assurance on account balance estimates with uncertainty ranges that often are many times larger than materiality for the financial statements taken as a whole.
Analysis of disclosures from Wells Fargo and GM show that:
The Wells Fargo and GM cases highlighted in the study demonstrate the extreme estimation uncertainty in some significant accounting estimates. Hypersensitivity to small changes in unobservable inputs, the large number of such inputs, the large number of estimates in the financial statements of complex entities that involve such inputs, and the level of management discretion involved in accounting estimates all add to the burden placed on auditors in providing assurance surrounding these estimates.
The study provides evidence that the format of the audit evidence (using the business model evidence versus using the chronological evidence) impacts the level of fraud risk assessment. This indicates that using the business model provides an advantage in evaluating and assessing the potential risk of fraud. The advantages of using both forms of evidence may enable auditors to determine the nature, timing and extent of procedures to corroborate management’s explanations for fluctuations beyond the context of fraud. Therefore, the findings of this study have broader implications, as it can be applied to other audit procedures to ensure that auditors are obtaining sufficient evidence throughout the audit as well as for an assessment of fraud risk.
For more information on this study, please contact William F. Wright.
Wright, W.F., and L. Berger. 2011. Fraudulent Management Explanations and the Impact of Alternative Presentations of Client Business Evidence. Auditing: A Journal of Practice and Theory 30 (2): 153-171.
When planning an audit, auditors perform analytical procedures and inquiries of management regarding any significant fluctuations in the key financial information. Auditors will assess these significant changes based on these procedures and use the information to assist in planning the nature, timing and extent of audit procedures. In the context of fraud, the explanations for fluctuations will be based on evidence that either emphasizes the client’s business model or knowledge of the auditor’s chronological presentation of audit evidence. The chronological presentation of evidence is based on given knowledge of the client’s business, prior year results compared current year information, and other items such as key ratios. The business model explanation provides linkages between the client’s business strategy and objectives to support the fluctuations. The use of the chronological information evaluates the comparison of the year over year financial condition and results as well as trend analysis.
Since auditors use these as audit evidence, the study uses this evidence for generating expectations and for making risk assessments regarding fraud. The authors hypothesize the following when management provides a fraudulent explanation:
The authors perform an experiment with 73 participants, 42 of which were auditors who had recently graduated from a Canadian university less than a year before. The remaining participants were graduate students. The authors used a randomized 2x2 between-subjects design. The factors that were evaluated included whether management’s explanation was or was not fraudulent as it related to the unexpected fluctuation in sales and the two client business evidence presentation methods: business model or chronological.