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  • The Auditing Section
    A Field-Based Analysis of Audit Workpaper Review
    research summary posted April 13, 2012 by The Auditing Section, tagged 09.11 Auditor judgment in the workpaper review process, 11.0 Audit Quality and Quality Control, 11.03 Management/Staff Interaction, 11.06 Working Paper Review – Conduct, Biases and Predispositions 
    Title:
    A Field-Based Analysis of Audit Workpaper Review
    Practical Implications:

    The results of this study are important for audit firms to consider when determining documentation review processes and standards.  The results provide perspective on how auditors approach the review process, and they also provide opportunities for firms to potentially improve processes.  The determination that auditors prepare workpapers to meet reviewer preferences, and that this practice can affect both the content and presentation of the workpapers, is relevant for reviewers.  This knowledge may allow firms and reviewers to consider if any adjustments should be made to their existing review process.   Additionally, it provides evidence on the unique roles of managers and senior associates within the review process.

    Citation:

    Fargher, N. L., Mayorga, D. and K. T. Trotman. 2005. A Field-Based Analysis of Audit Workpaper Review. Auditing: A Journal of
    Practice & Theory
    24 (2): 85-110

    Keywords:
    Workpaper review, reviewer styles, stylization, review methods
    Purpose of the Study:

    The audit review process is considered to be a key quality control mechanism for the audit process.  The review process allows the team to assess whether a sufficient and appropriate amount of evidence has been obtained and to determine that proper conclusions have been made about the accuracy of the client’s financial statements.  Because of the importance of the review process, previous accounting research has considered audit managers’ behaviors during the audit review process.  The primary aspects of the research are the following: 

    • Extent of review:  primarily refers to the amount of time that the reviewer spends on the review, but also includes the focus of the review (e.g., identifying errors in the documentation or errors related to the ultimate conclusions reached by the auditor).
    • Level of stylization:  the preparer of the audit documentation will either tailor the audit procedures or the method of documentation to the reviewer’s preferences.
    • Review styles: the manner in which the review comments are communicated.  This is generally done in either face to face meetings or via written review comments. 

    The authors extend the previous research by considering a few additional aspects of the review process.  Since the initial research focused only on audit managers, the authors consider if there are differences in the review process between managers and senior associates.  Additionally, the authors utilize a sample of public sector auditors (i.e. those who audit government or not for profit organizations) to determine if there are different conclusions reached by studying another subset of auditors.  Finally, they consider what factors affect the style of the review, whether the reviewers are sensitive to the stylization attempts of the auditor preparing the documentation, how auditors learn about the reviewers’ preferred style, and also the factors that affect the reviewer’s choice of review style.

    Design/Method/ Approach:

    The research evidence was collected prior to October 2003 from a group of audit managers and seniors from an Australian public sector audit firm.  Data was collected through the use of surveys that were previously developed to study the audit review process, and the surveys were distributed by a representative of the organization.  The participants were instructed to select two engagements on which they recently completed working paper reviews.  They were free to select the first case without restrictions, and then they were asked to select a case that had either significantly more or significantly less review time than the first case.  At the completion of the surveys, the participants mailed the completed questionnaires back to the researchers.

    Findings:
    •  The authors verify that findings from prior studies are relevant for public sector auditors: reviewers spend more time reviewing workpapers when the client is large, and when there is greater time pressure.  They make a unique contribution by finding that review time is greater when the reviewer anticipates the next level of review will be pedantic (i.e., overly concerned with minute details). 
    • The authors find several differences based on rank:
      • Managers spend more time reviewing workpapers than senior associates.
      • Senior associates tend to spend more time focusing on detecting documentation errors while managers tend to spend more time focusing on conclusion errors.
      • Senior associates are more likely to modify their documentation style based on their perceptions of the next reviewer’s preferences.
      • Seniors devote more time in the review process to training staff than managers do.
    • Preparers consider reviewer preferences when creating workpaper documentation.  This can affect both the content and presentation of the workpapers.
    • The reviewer’s documentation style preferences are often learned from previous experience with the reviewer or from conversations with the reviewer during the planning stages of the audit.
    • Reviewers are more likely to communicate review comments in written communication than face to face conversations, and the primary focus of the review is documentation or conclusion related.  Individual reviewers typically use a consistent style across engagements. 
    • The review process serves several important functions: assessing documentation, opinion formation, and training of preparers/staff.  Lesser amounts of time were spent on training when preparer quality was deemed high, when time pressure was high, and for high-risk engagements.
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Auditor judgment in the workpaper review process, Management/Staff Interaction, Working Paper Review – Conduct - Biases & Predispositions
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  • Jennifer M Mueller-Phillips
    A Framework for Understanding and Researching Audit Quality
    research summary posted February 17, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control 
    Title:
    A Framework for Understanding and Researching Audit Quality
    Practical Implications:

    This study identifies the gap between audit research and audit practice. It recognizes key elements of audit quality and suggests additional research to be performed that could potentially bridge that gap. The research suggested in this study aims to help to comprehensively understand the drivers of audit quality by starting with an analysis of the macro-level inputs of audit quality, and then studying how they influence and shape the micro-level inputs. Further, several reasons are proposed to explain why the use of auditing research is not generally deemed important by audit practitioners, but that cooperation between practitioners, regulators, and scholars would improve overall audit quality.

    For more information on this study, please contact Jere R. Francis. 

    Citation:

    Francis, J.R. A Framework for Understanding and Researching Audit Quality. Auditing, A Journal of Practice and Theory. 30 (2): 125- 152.

    Keywords:
    audit quality, research
    Purpose of the Study:

    This article serves to provide a guide for future research in the study of audit quality. 

    Design/Method/ Approach:

    The author developed a framework for studying audit quality at various levels of analysis. The levels identified are: Audit Inputs, Audit Processes, Accounting Firms, Audit Industry and Audit Markets, Institutions, and Economic Consequences of Audit Outcomes. 

    Findings:
    • Audit Inputs- 1) The people who do the audits and 2) the audit tests that are performed. The quality of the audit is increased by the more competent people are and the higher the quality of evidence generated from the audit tests is. The author suggests that more research should exist to develop comprehensive models of audit testing.
    • Audit Process- The implementation of the audit inputs. These are the decisions and judgments made by auditors in order to meet the requirements of audit standards.
    • Accounting Firms- 1) Engagement teams, 2) Hiring, training, compensations, and development of audit guidance 3) Audit reports with the firm’s name. The author suggests that the audit quality metrics listed in IOSCO provide little information about audit quality, and rather an investigation of measures that have been shown to systematically affect audit quality, paired with a greater transparency of audit firms reporting of their operations, would be a more useful indicator of both overall accounting firm quality and engagement specific audit quality.
    • Audit Industry and Audit Markets- 1) Accounting firms constitute an industry and 2) Industry structure affects markets and economic behavior. The author suggests that more research is needed to understand the effect of industry structure with regards to audit quality as the Big 4 firms continue to dominate the market and create an oligopoly.
    • Institutions- Institutions, like the SEC, affect auditing and provide incentives for quality. Research that analyzes the role of auditing standards and research that identifies which is the main institutional driver of audit quality is necessary to properly determine the role of regulating institutions in audit quality.
    • Economic Consequence of Audit Outcome- An economic analysis demonstrates that an audit has value and can result in material economic consequences; additionally, market responses to an audit provide evidence of the effects of differential audit quality. The author suggests that more research should be done on the effects of audit quality on economic outcomes and the economic consequences of an audit. 
    Category:
    Audit Quality & Quality Control
  • Jennifer M Mueller-Phillips
    Abnormal Audit Fees and Audit Quality: The Importance of...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 11.0 Audit Quality and Quality Control, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management.
    Practical Implications:

    This paper provides new evidence on the fee-quality relationship using the propensity to use income-increasing discretionary accruals to meet or beat analysts' forecasts. The evidence in this paper suggests that abnormal audit fees are positively related to audit quality. This result is consistent with concerns raised by regulators that lower audit fees could reflect a lower level of effort provided by the auditor. This is important, given the trend of declining audit fees in recent years. By finding different results using a more focused sample of firms with the incentive and ability to manage earnings, this study highlights the importance of considering the context when performing tests of earnings management. This information is of interest to regulators, such as the SEC.

    Citation:

    Eshleman, J. D., & P. Guo. 2014. Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management. Auditing: A Journal of Practice & Theory 33 (1): 117-138.

    Keywords:
    audit fees, audit quality, discretionary accruals, meet-or-beat, earnings management
    Purpose of the Study:

    In this study, the authors attempt to shed light on the conflicting evidence by performing a study of the relationship between abnormal audit fees and audit quality using a new research design. Specifically, the authors examine whether clients paying abnormal audit fees are more or less likely to use discretionary accruals to meet or beat the consensus analyst forecast.

    A growing body of accounting literature examines the relationship between audit fees and audit quality. Researchers are interested in this relationship because, ex ante, it is not clear whether receiving higher fee revenue from a client will improve audit quality or harm it. On the one hand, it could be argued that an auditor who receives abnormally high audit fees from a client will lose their independence and allow the managers of the client firm to engage in questionable accounting practices. However, it is also possible that audit fees are a measure of audit effort, i.e., higher fees indicate that the auditor worked more hours, signaling greater effort. To the extent that audit fees are a measure of audit effort, low audit fees could harm audit quality.

    Design/Method/ Approach:

    Audit fee and auditor data are obtained from Audit Analytics, financial statement data are obtained from Compustat, and analyst forecast data are obtained from the I/B/E/S database. The authors perform tests on two samples of 4,476 firm-years and 1,670 firm-year observations spanning 2000 to 2011.

    Findings:

    The authors find that clients paying higher abnormal audit fees are significantly less likely to use discretionary accruals to meet or beat the consensus analyst forecast. If abnormal audit fees are held at their mean, a one-standard-deviation increase in abnormal audit fees decreases the client's likelihood of using discretionary accruals to meet or beat the consensus forecast by approximately 5 percent. This is consistent with higher audit fees being indicative of greater auditor effort and, ultimately, better audit quality. The authors obtain similar results whether they use the audit fee model of Choi et al. (2010), the one proposed by Blankley et al. (2012), or their own audit fee model.

    Category:
    Audit Quality & Quality Control, Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Earnings Management
  • The Auditing Section
    Academic Instruction as a Determinant of Judgment...
    research summary posted May 7, 2012 by The Auditing Section, tagged 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind, 11.0 Audit Quality and Quality Control, 11.05 Training and General Experience 
    Title:
    Academic Instruction as a Determinant of Judgment Performance
    Practical Implications:

    The results of this study are important for audit firms to consider providing decision aids and/or on job training. The results suggest that considerable practical experience is necessary to achieve good judgment performance. In addition, the evidence indicates that auditing firms may wish to concentrate their training earlier to more quickly create a basis for high-quality auditor judgments.

    Citation:

    Wright, William F. 2007.  Academic Instruction as a Determinant of Judgment Performance. Behavioral Research in Accounting 19: 247-259.

    Keywords:
    Audit judgment; instruction; experience;
    Purpose of the Study:

    Knowledge and personal involvement are important factors that affect auditor judgment quality. It is generally believed that sufficient knowledge can lead to good auditor judgment.  Two sources of relevant knowledge are academic instruction and practical experience. Yet the relative benefits of the two sources remain unclear. The primary purpose of the study is to test for the benefit of task-specific academic instruction and practice relative to task-specific CPA training and experience in making auditor judgments. 

    Design/Method/ Approach:

    The research evidence is collected during 1991. Three groups of people participated in the experiment: (1) graduate business students, (2) inexperienced financial institution audit seniors, and (3) experienced financial institution auditors (managers, senior managers, and junior partners). Participants were asked to complete a simulated case involving evaluating the collectability of commercial loans to a fictitious manufacturer of microcomputers.

    Findings:
    • The author finds that, compared to the inexperienced audit seniors, the graduate students who completed an elective course in credit analysis made more accurate and less biased judgments.
    • The author finds that, the graduate students who completed an elective course in credit analysis made judgment similar to that of the experience auditors.
    Category:
    Audit Team Composition, Auditor Judgment, Audit Quality & Quality Control
    Sub-category:
    Industry Expertise – Firm and Individual, Prior Dispositions/Biases/Auditor state of mind, Training & General Experience
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  • The Auditing Section
    Accounting Firm Culture and Governance: A Research Synthesis
    research summary posted May 7, 2012 by The Auditing Section, tagged 11.0 Audit Quality and Quality Control, 11.03 Management/Staff Interaction, 11.12 Impact of National Office on Auditor Decisions, 11.13 Partner incentive schemes 
    Title:
    Accounting Firm Culture and Governance: A Research Synthesis
    Practical Implications:

    The article provides a broad summary of prior audit firm culture and governance research with an additional focus on areas for future research.  This literature review is important for accounting firms considering or expanding quality-oriented tone at the top initiatives.  In addition, this review of accounting firm governance structures includes methods for accounting firms to mold, mentor, manage, train and reward employees to improve firm performance and audit quality. 

    Citation:

    Jenkins, J.G., D.R. Deis, J.C. Bedard, and M.B. Curtis. 2008. Accounting Firm Culture and Governance: A Research Synthesis Behavioral Research in Accounting 20 (1): 45-74.

    Keywords:
    organizational culture, governance, ethics, audit firm management, audit firm quality control, culture assessment
    Purpose of the Study:

    This paper summarizes the academic literature related to accounting firm culture and governance.  The authors motivate the study as a response to the PCAOB’s intent to revise the standards on accounting firm quality control.  The authors argue that recent audit failures demonstrate the potential consequences of the cultural tension in audit firms between revenue generation and quality service.  Regulators stress that the “tone at the top” can establish the role of the audit as for the public good rather than as a mere commodity by encouraging objectivity, independence, professional skepticism and accountability to the public.  This paper addresses the concern that greed can change accounting firm’s emphasis on delivering professional services to an emphasis on profitability.  The authors addressed the following topics: 

    • the role of audit firm culture and how it impacts audit quality.
    • various governance and control mechanisms within accounting firms, including consultation policies, ethics training, and independent monitoring boards.  

    This paper is based on a literature synthesis prepared by the auditing section of the American Accounting Association (AAA) for the Public Company Accounting Oversight Board (PCAOB).

    Design/Method/ Approach:

    The authors presented a research overview of several topics based on a review of recent accounting literature.  The results of the review were summarized in topical areas relating to culture and governance.  The authors also presented a research agenda for each topical area in which they suggested a variety of research issues to stimulate future research.  Topical areas include: The Roles of Culture, Conflicts between Organizational and Individual Goals, The Roles of Subcultures within Organizations, Social Influence, Mentoring, Communicating Culture to the Outside, Measuring Culture, Control Mechanisms within Firms, Policies Related to Consultation, Ethics Training, Independent Monitoring Boards.

    Findings:
    • Firm employees undergo a socialization process in which they are molded to the organizational culture (the firm’s set of beliefs and values).  Regulators encourage firms to use this acculturation process to stress the importance of high quality audits and taking difficult stands on issues involving earnings management, fraud or illegal acts, or contentious accounting issues.  The authors offer suggestions for future research to improve understanding in this area.
    • Subcultures may develop in firms based on functional areas (tax, audit, and consulting), individual offices in large firms (particularly foreign firm offices or firms acquired in a merger), or the influence of non-accounting professionals.  Cultural complexities may arise from power imbalances or from national political, public policy and legislative differences.
    • Social influence pressures and power from accounting firm superiors manifest in areas such as engagement time budgets and performance reviews.  Using their power, superiors positively or negatively affect the work efforts of subordinate auditors.  Firm culture can moderate or exacerbate the influence of social influence pressure and power and affect audit quality, client relationships, and employee retention.
    • The goal of accounting firm governance is to achieve goal congruence among the individuals and the organization and to foster consistency and firm-wide policies through authority structures, rules, procedures, and incentive systems.  Research suggests that partner compensation schemes should be based on more than revenue generation alone.  Partners should be focused on limiting firm risks through using a larger pool of revenue for partner compensation schemes, focusing on technical expertise among audit teams, and recognizing the importance of audit quality in the face of budgetary pressures. 
    • Ethics training may direct and alter employee behavior.  However, firms appear to rely primarily on colleges to educate their members.  Since the effects of ethics training may deteriorate over time, firms should consider supplementing this exposure with periodic reinforcement.    

    The authors suggest that their literature review reveals that accounting firm governance is a largely unexplored research topic and that accounting firms have unique ownership structures and operating characteristics in comparison to other large organizations.   

    Category:
    Audit Quality & Quality Control
    Sub-category:
    Management/Staff Interaction, Impact of National Office on Auditor Decisions, Partner incentive schemes
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  • Jennifer M Mueller-Phillips
    Aggregate Quasi Rents and Auditor Independence: Evidence...
    research summary posted July 30, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 11.0 Audit Quality and Quality Control, 11.05 Training and General Experience 
    Title:
    Aggregate Quasi Rents and Auditor Independence: Evidence from Audit Firm Mergers in China.
    Practical Implications:

    The findings of this study have policy implications for regulators in China and other emerging economies with regard to administering the auditing profession and improving the corporate governance of public companies by fostering auditor independence. One policy implication of this finding is that simply increasing audit firm size fails to enhance auditor independence. The experience of mature markets suggests that, in addition to public regulatory enforcement, other mechanisms, such as private litigation against auditors and improved disclosures on audit services, are helpful in ensuring a well-functioning audit market.

    Citation:

    Chan, K. H., and Wu, D. 2011. Aggregate Quasi Rents and Auditor Independence: Evidence from Audit Firm Mergers in China. Contemporary Accounting Research 28 (1): 175-213.

    Keywords:
    consolidation & merger of corporations, auditor independence, aggregate quasi rents, audit quality
    Purpose of the Study:

    Prior research suggests that large audit firms have more aggregate quasi rents, which are defined as audit fees in excess of audit costs, to serve as collateral against opportunistic behavior on the part of auditors. Audit firm size affects not only auditor independence, but also auditor competence, which makes clear inferences on the relationship between audit firm size and independence difficult. The economic and regulatory changes in China’s audit market induced a large number of audit firm mergers in a short period of time, thus enabling the authors to investigate the impact of mergers on audit quality in a similar environment for an important economy. In the multi-license mergers, mergers occur between two (or more) accounting firms that are licensed to audit listed companies; in the single-license mergers, an accounting firm with such a license merges with non-licensed firms.

    Using data on audit firm mergers in China, the authors investigate the empirical relationship between audit firms’ aggregate quasi rents at stake and auditor independence in a setting that allows us to mitigate potential problems. However, they do have an immediate and significant impact on audit firm size and auditors’ aggregate quasi rents. Therefore, the changes in audit quality that occur immediately after mergers take place can be attributed mainly to changes in auditors’ independence rather than competence. The authors investigate the differences in independence between the pre-merger and immediate post-merger periods of the auditors in the same audit firms.

    Design/Method/ Approach:

    The authors collect data for audit firm mergers that took place between 1999 and 2006 from the CICPA and several leading financial newspapers. Client firm financial statement and stock market data are from the China Stock Market & Accounting Research database (CSMAR). The sample consists of 59 cases, including 21 multi-license mergers (MULTI hereafter) and 38 single-license mergers (SINGLE hereafter).

    Findings:

    The evidence indicates that an increase in audit firm size does not necessarily lead to an improvement in auditor independence. What matters is the size of the public clientele, where the quasi rents are more likely to serve as collateral against auditor malfeasance.

    • The level of independence, and thus audit quality, is determined by the auditor’s trade-offs between the costs and benefits of opportunistic behavior.
    • Audit firms involved in MULTI mergers are more likely to issue MAOs (modified auditor opinions) to their clients after the mergers.
    • This increased propensity to issue MAOs is significantly related to the change in audit firm size after the mergers.
    • There is no evidence to suggest any significant change in the issuance of MAOs among audit firms involved in SINGLE mergers.
    • The different effects of mergers on audit quality support the theory that auditor independence is a positive function of the aggregate quasi rents a stake.
    • The increase in MAOs is positively correlated with the change in the size of listed clientele that results from multi-license mergers.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Sustainability ServicesTraining & General Experience
  • Jennifer M Mueller-Phillips
    An Accountability Framework for Financial Statement Auditors...
    research summary posted March 30, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.01 Supervision and Review – Effectiveness, 11.06 Working Paper Review – Conduct, Biases and Predispositions 
    Title:
    An Accountability Framework for Financial Statement Auditors and Related Research Questions
    Practical Implications:

    In conjunction with the changes discussed in the paper, as listed below, the authors hoped that their initial research would encourage other scholars to look into auditor accountability and formulate proposals of their own through examining intended and possible unintended consequences of the research questions identified.

    Citation:

    Peecher, M. E., I. Solomon, and K. T. Trotman. 2013. An accountability framework for financial statement auditors and related research questions. Accounting, Organizations and Society 38 (8).

    Purpose of the Study:

    In the past, public company auditing in many countries around the world was self-regulated but due to some major corporate collapses, worldwide changes were implemented. These changes led to entirely new regulatory bodies such as the Public Company Accounting Oversight Board and the Financial Reporting Council in the United Kingdom. Since these changes occurred, some believe audit quality has suffered. This paper attempts to address two overarching questions throughout it. (1) What kind of accountability framework could regulators use to motivate auditors to improve audit quality? (2) What accountability framework could regulators use to evaluate how well auditors have completed their duties? Based on these questions and the analyses of various research topics in psychology, neuroscience, economics and accounting, this paper hopes:

    • To establish that forward-looking estimates are the basis for most financial statement information and that some of these estimates are highly uncertain.
    • To propose an accountability framework with two dimensions:
      • Rewards versus penalties
      • Processes versus outcomes
    • To show that auditors’ current regulatory accountabilities are generally in the form of penalties rather than rewards and depend heavily on audit outcomes rather than attributes of auditors’ judgment processes.
    • To provide evidence that questions the suitability of the current system for improving the quality of auditors’ judgments and the quality of evaluations of those judgment made by inspectors.
    • To identify four potential changes for improvement in the quality of audits.
    Design/Method/ Approach:

    The authors use data and research from a variety of backgrounds including psychology, neuroscience, accounting, and economics and create new exhibits based on that information.  This information is gathered from a variety of journals across a large segment of time. The authors also utilized research questions in the article and attempted to answer each one as they presented it. 

    Findings:

    Based on preliminary research, the authors found:

    • It would be beneficial to identify new ways to reward financial statement auditors.
    • In certain instances steps should be taken to reframe auditors’ current incentives in reward terms.
    • Audit quality would likely increase if auditors were more accountable for the judgment-process quality.

    Based on research regarding the first proposed change, to introduce an auditor judgment rule, the authors found:

    • Practitioner risk taking, compounded with practitioner research and development on ways to improve existing practices, are reduced without a judgment rule.
    • Fear of liability makes it difficult to attract and retain the most talented individuals
    • Market mechanisms would penalize nonperformance even if a judgment rule was introduced.

    Based on research regarding the second proposed change, to add a concurrent element to regulators’ inspections, the authors found:

    • Using retrospective verbal or written accounts of participants’ judgment processes often entail stylization, bias, and omissions due to lapses in memory.
    • Audit working papers are stylized to reduce ambiguity, create a desired portrayal of the judgment process, and give a persuasive account of the auditor’s conclusions.
    • Training and quality-control benefits come from including concurrent reviews of subordinate auditors’ work, as opposed to relying on exclusively retrospective work.

    Based on research regarding the third proposed change, to encourage auditors to be skeptical of their own judgment processes, the authors found:

    • When asked to take the position of a “reasonable investor,” managers were far more conservative than they were with their regular decisions.

    Based on research regarding the fourth proposed change, to reward auditors who take stands on financial reporting quality, the authors found:

    • Providing significant and direct rewards for auditors who uncover fraud has the potential to motivate helpful innovation by auditors to actively search for fraud.
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Supervision & Review – Effectiveness, Working Paper Review – Conduct - Biases & Predispositions
  • Jennifer M Mueller-Phillips
    An Analysis of SEC and PCAOB Enforcement Actions against...
    research summary posted March 9, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.02 Engagement Quality Review – Processes and Effectiveness 
    Title:
    An Analysis of SEC and PCAOB Enforcement Actions against Engagement Quality Reviewers
    Practical Implications:

    The findings of this study:

    • “Provides important implications for practitioners and regulators, and areas for future research for those interested in engagement quality review.” (Summary Page)
    • "Shows that EQRs have been sanctioned due to violations of GAAP and GAAS; and that the violations of GAAS involved a lack of due professional care and failure to gather sufficient competent evidence. The analysis of the lack of due professional care showed that EQRs lacked professional skepticism, over-relied on management representations, and abused materiality. Too often, the EQRs were aware of audit quality problems and did little or nothing to correct them.” (pp 16-17).

    For more information on this study, please contact William F. Messier, Jr.

    Citation:

    William F. Messier Jr., Thomas M. Kozloski, and Natalia Kochetova-Kozloski (2010) An Analysis of SEC and PCAOB Enforcement Actions against Engagement Quality Reviewers. AUDITING: A Journal of Practice & Theory: November 2010, Vol. 29, No. 2, pp. 233-252.

    Keywords:
    Engagement quality review, SEC Enforcement Actions, and PCAOB Disciplinary Proceedings, Due professional care, Professional skepticism
    Purpose of the Study:

    “Engagement quality review is an integral part of the audit process. It is designed to be a quality control mechanism for assessing the quality of an audit engagement. Since the 1990s, the SEC has increased sanctions against partners serving as engagement quality reviewers. Recently, the PCAOB issued an auditing standard on engagement quality review as required by Section 103 of the Sarbanes-Oxley Act of 2002. This practice note reports on an analysis of SEC and PCAOB enforcement actions against engagement quality reviewers (EQRs). (Summary Page)”  

    Design/Method/ Approach:

    The authors have identified 28 cases since 1993 that involve some type of sanction against an EQR. They have performed three sets of coding for the 28 cases. The data for the 28 cases used in this study were gathered as follows: (1) AAERs identified by Epps and Messier (2007), (2) three graduate student groups at one US university completed a class project where they reviewed the SEC and PCAOB web sites for selected EQR cases, (3) a research assistant checked each student groups’ cases and also performed additional keyword searches of the SEC web site, and (4) two of the researchers performed keyword searches on the SEC web site and identified DPs from the PCAOB’s enforcement web site.

    Findings:

    The results of this study show the following (of the 28 cases):

    • Only eight cases involved the Big 4/5 public accounting firms.
    • All of the 28 cases involved sanctions due to violations of GAAS and 75 percent contained GAAP violations.
    • Twenty-three cases identified GAAS violations related to a lack of due professional care. Further analysis of those cases showed that the EQR demonstrated a lack of professional skepticism in 22 cases, over-relied on management representations in 20 cases, and ignored materiality concerns in 5 cases.
    • About half of the 28 cases resulted in the EQR being denied the privilege of practicing before the SEC or PCAOB for 3 or more years.
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Engagement Quality Review – Processes & Effectiveness
  • Jennifer M Mueller-Phillips
    An Examination of Partner Perceptions of Partner Rotation:...1
    research summary posted October 10, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.08 Impact of SEC Rules Changes/SarbOx, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience 
    Title:
    An Examination of Partner Perceptions of Partner Rotation: Direct and Indirect Consequences to Audit Quality
    Practical Implications:

    The findings of this study shed light on the perceived benefits and detriments of the five versus seven year partner rotation requirements.  The results highlight the potential unintended consequences of implementing the accelerated rotation including a reduction in partner quality of life and auditor independence and audit quality. 


    For more information on this study, please contact Brian Daugherty. 
     

    Citation:

    Daugherty, B., D. Dickins, R. Hatfield, and J. Higgs.  2012.  An Examination of Partner Perceptions of Partner Rotation:  Direct and Indirect Consequences to Audit Quality. Auditing: A Journal of Practice & Theory 31 (1): 97-114. 

    Keywords:
    Sarbanes-Oxley; audit partner rotation; auditor independence; audit quality; quality of life.
    Purpose of the Study:

    This study examines practicing audit partner perceptions regarding the mandatory partner rotation and cooling off periods.  Specifically, the authors investigate how recently enacted and stringent rules might negatively impact auditor quality of life leading to deterioration in audit quality.  As a result of the Sarbanes-Oxley Act of 2002 (SOX), the US moved from a seven-year rotation with a two-year cooling-off period to a five-year rotation and five-year cooling-off period.  This change in standard provides the authors the opportunity to investigate the perceptions of partner that have worked under both standards.

    Design/Method/ Approach:

    The authors conducted in-depth semi-structured interviews with seven practicing audit partners.  Most of these partners were managing partners from various geographic locations.  Based on those interviews, the authors developed a model of the effects of mandatory rotation and created a field survey that was completed by 370 audit partners.  Collection of survey results occurred prior to May 2011. 

    Findings:

    The audit partners in the study believed that rotation generally improved independence which has a positive impact on audit quality.  However, partners also expressed that accelerated rotation reduced client-specific knowledge and had a negative impact on audit quality.  Partners suggested that the accelerated rotation and extended cooling-off period imposed by SOX has increased the need to relocate if the partner wishes to remain in the same industry.  As a result partners often choose to gain new industry experience and stay in the same location, rather than to relocate.  This decision maintains the partner quality of life, but possibly at the expense of industry depth and to the detriment of overall audit quality.  Partners also discussed a two to three-year new-client familiarization process, resulting in an increase in the amount of time that engagements suffer from “start-up efficacy”.  In sum, although the partners view rotation in general as a means to improve independence, they believe the accelerated rotation imposed by SOX may actually result in a reduction in independence and possibly audit quality.

    Category:
    Audit Quality & Quality Control, Independence & Ethics, Standard Setting
    Sub-category:
    Impact of SEC Rules Changes/SarBox, Impact of SOX, Industry Experience
  • Jennifer M Mueller-Phillips
    An Examination of the Credence Attributes of an Audit
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind, 11.0 Audit Quality and Quality Control 
    Title:
    An Examination of the Credence Attributes of an Audit
    Practical Implications:

    At its core, the theory proposed by the authors assumes that auditors are economic agents who provide a valuable service and can be expected to behave rationally to maximize their profits. Strategic behaviors such as under-auditing, over-auditing, or overbilling would be unobservable by an auditee in many instances. The possibility of such behaviors has important implications for the level of assurance over financial reports and can potentially affect the efficient allocation of capital resources. One of the goals of this study was to analyze how the credence aspect of audits could influence important policy decisions. Regulation may play a powerful role in mitigating the credence nature of auditing, e.g., PCAOB inspections. However, regulation can be a double-edged sword if it increases the incentive or opportunity for auditors to behave strategically. Therefore, auditors can take the theories and models presented in this study to evaluate their firms for potential profit maximizing biases that may negatively impact audit quality and efficiency. Policy makers could also use these theories and models to evaluate how new auditing policies might influence auditors’ incentives and behaviors.

    For more information on this study, please contact W. Robert Knechel.
     

    Citation:

    Causholli, M., and W. R. Knechel. 2012. An Examination of the Credence Attributes of an Audit. Accounting Horizons 26(4): 631-656.

    Keywords:
    Credence attributes; audit quality; audit efficiency.
    Purpose of the Study:

    The purpose of this study was to expand the understanding of the economics of auditing and audit markets by using the theory of credence goods as the basis for explaining auditors’ incentives. The idea of a credence good or service is that (1) the seller of the good or service is an expert who both recommends and provides a level of service to the buyer; (2) buyers of credence goods or services cannot assess how a service is a delivered and must rely on a seller’s recommendation; and (3) buyers cannot assess how well the service was performed. The authors suggest that the external audit is a credence good which provides auditors with incentives to under-audit, over-audit or overcharge their clients.

    Design/Method/ Approach:

    The authors take a purely theoretical approach to study the perspective of an audit as a credence good. The authors rely on prior research of credence goods and on the principles of Game Theory to help explain auditors’ incentives to under-audit, over-audit or overcharge clients and predict auditors’ behaviors under certain scenarios. The authors use theoretical decision trees to describe an auditor’s possible strategies for bidding for an audit, and for executing the audit. The authors also describe examples of prior auditing research that present results that support the author’s credence theory.

    Findings:

        The authors propose that if an audit is a credence good, the auditee cannot determine any of the levels of audit effort that define the auditor’s decisions. This creates information asymmetry between the auditor and auditee both before and after the audit because the auditee cannot be sure of the true level of assurance that is necessary before the audit, and the auditee cannot be sure of the true level of assurance that is gained as a consequence of the audit. The information asymmetry goes in favor of the auditor, who can act strategically to under-audit and earn greater profits because the auditee has imperfect information about the auditor’s work and the level of assurance gained by the auditor’s efforts.

     The authors also propose that there are disciplining mechanisms in the market for audit services that are in place to mitigate an auditor’s incentive to behave strategically such as an auditee’s direct knowledge, audit firm reputation and size, professional regulation, legal liability, and competition between audit firms. However, while these mechanisms may be in place, an auditor facing low penalties or risk of detection may be more likely to consider strategic actions. In environments with weak courts or regulation, auditors have more incentives to act strategically and expect to reap superior profits as a result. Similarly, changes in regulations or other structural changes in the audit market can induce changes in the incentives for auditors to behave strategically. Overall, disciplining mechanisms facilitate the operation of audit markets even though they may not completely resolve the information (credence) problem.
     

    Category:
    Audit Quality & Quality Control, Auditor Judgment, Standard Setting
    Sub-category:
    Changes in Audit Standards, Prior Dispositions/Biases/Auditor state of mind

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