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  • Jennifer M Mueller-Phillips
    Does Incentive-Based Compensation for Chief Internal...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 04.02 Impact of Fees on Decisions by Auditors & Management, 08.11 Reliance on Internal Auditors 
    Title:
    Does Incentive-Based Compensation for Chief Internal Auditors Impact Objectivity? An External Audit Risk Perspective
    Practical Implications:

    The results of this study suggest that companies who offer incentive-based compensation to chief internal auditors, especially through equity, are more likely to be perceived as having a higher audit risk by external auditors. Consequently, external auditors may charge a higher fee for their services. This study gives a basis for the benefit/cost analysis of providing incentive-based compensation for chief internal auditors. While it is possible internal auditors will respond positively to an IBC and bring extra value to the organization, there is a risk that an external auditor could raise audit fees cancelling out this added benefit.   

    Citation:

    Chen, Lucy Huajing, H. H. Chung, G. F. Peters., and J. P. Wynn. (Jeannie).2017. Does Incentive-Based Compensation for Chief Internal Auditors Impact Objectivity? An External Audit Risk Perspective. Auditing, A Journal of Practice and Theory 36 (21): 21-44

    Keywords:
    Incentive-based compensation; internal auditor objectivity; audit fees
    Purpose of the Study:

    The internal audit function (IAF) is increasingly seen as a key component of corporate governance. The extent to which external auditors can rely on information from the IAF depends largely on the internal auditor’s objectivity. The researchers question whether receiving incentive-based compensation (IBC) linked to company performance threatens internal audit employees’ objectivity. Subsequently, this threat would lead to a higher assessment of client audit risk and therefore higher audit fees. The authors also consider whether external auditors view stock- and option-based compensation differently from cash incentives. Finally, the authors examine whether the objectivity threat from IBC depends on the company’s financial reporting risks, alignment of IAF compensation with CEO compensation, and presence of any internal audit outsourcing arrangements.

    Design/Method/ Approach:

    The authors surveyed chief internal auditors of NYSE-listed firms in 2007. The participants were asked to rank the performance measures in order of their emphasis and to indicate the form of IBC payment. By asking survey respondents to provide their company names, the authors could match the financial, audit fee, governance, and incentive data from various databases (Compustat, Audit Analytics, proxy statements, etc.). The final sample included 183 companies. Authors used multivariate regression to analyze their research questions.

    Findings:

    The overall finding is that when a company offers incentive-based compensation to a chief internal auditor, external audit fees increase. This finding suggests that external auditors do consider IBC for chief internal auditors as a threat against objectivity.

     

    Additionally, the authors find that:

    • External auditors are more likely to charge higher fees for stock- and option-based compensation compared to cash bonuses. They attribute this result to employees placing more of an emphasis on personal wealth rather than firm value.
    • There is a stronger positive effect of chief internal auditors receiving IBC and external auditor fees increasing when inherent risk is higher in the audit. Specifically, the authors focused on inherent risk related to inventory levels.
    • In situations where the CEO’s equity incentives are aligned with IAF’s equity incentives there is an even greater rise in external auditor fees.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Executive Equity Risk-Taking Incentives and Audit Pricing.
    research summary posted January 19, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 14.0 Corporate Matters, 14.10 CEO Compensation 
    Title:
    Executive Equity Risk-Taking Incentives and Audit Pricing.
    Practical Implications:

    The study results are important to regulators and audit practitioners as they show an association between executive compensation and auditor compensation. The study results show that high executive risk-taking incentives, as measured by vega, contributes to higher audit fees. These results provide important insights into how incentives designed to compensate and motivate executives can alter the audit fee structure.

    Citation:

    Chen, Y., F. A. Gul, M. Veeraraghavan, and L. Zolotoy. 2015. Executive Equity Risk-Taking Incentives and Audit Pricing. The Accounting Review 90 (6): 22052234.

    Keywords:
    executive compensation, audit fees, vega, misreporting, SOX
    Purpose of the Study:

    This study assesses whether there is an association between executive stock compensation and audit fees. The authors specifically investigate whether the sensitivity of CEO compensation to stock return volatility (vega) and stock prices (delta) are associated with audit fees. Prior literature shows that higher vega leads managers to engage in more financial misreporting. This increase in financial misreporting could in turn influence audit risk assessment and audit fees.  

    The main motivation for this study comes from the PCAOB’s recent related-party standard proposal. The proposed standard requires auditors to perform procedures to evaluate compensation practices when gaining an understanding of relationships between the company and its executive officers. In addition, current audit fee models do not consider executive compensation incentives in the pricing of audit services. Finally, there are extensive literatures on executive compensation and auditor compensation but no evaluation at the intersection of executive compensation practices and their effect on audit fees. This study attempts to address these gaps in the literature.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. They obtain audit fee data from the Audit Analytics database and executive compensation from ExecuComp. The sample period is from 2000-2010. Company financial data is from Compustat Fundamentals Annual File.  

    Findings:
    • The authors show that for clients with a high executive vega, audit firms charge higher audit fees. This follows the logic that clients with higher vega have a higher likelihood to misreport and that auditors consider that likelihood when pricing audit services. The authors also found that the increase in fees is not related to the effort needed to audit expenses related to stock-based compensation.
    • The introduction of the Sarbanes-Oxley Act weakens the association between vega and audit fees.
    • CEO characteristics affect the relationship between vega and audit fees. Specifically, the positive association between vega and audit fees is stronger when the CEO is older and when the CEO is the board chair.
    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, CEO Compensation, Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Client Engagement Risks and the Auditor Search Period.
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment 
    Title:
    Client Engagement Risks and the Auditor Search Period.
    Practical Implications:

    This paper contributes to the auditing literature in three ways. First, it sheds light on whether or not perceived engagement risks affect the ASP, a previously unaddressed question. Second, it provides greater insight into the client acceptance decision. This decision has become increasingly important because of auditor litigation, insurance costs, reputational damage, and regulatory review of the auditing profession in the post-SOX era. Third, it contributes to the understanding of whether the provision of nonaudit services alters auditor decision making by documenting that the potential to provide nonaudit services does not necessarily alter the attractiveness of a prospective client or shorten the search period.
     

    Citation:

    Khalil, S. K., J. R. Cohen, and K. B. Schwartz. 2011. Client Engagement Risks and the Auditor Search Period. Accounting Horizons 25 (4): 685-702.

    Keywords:
    audit risk, auditor search period, client acceptance
    Purpose of the Study:

    The past decade has witnessed an increased interest in the auditor’s client acceptance decision and in the way audit firms evaluate potential clients. The interest arises, in part, from litigation against auditors, competitive market forces, and recent advances in information technology that have affected and redefined the attestation process. Audit firms assess the risks associated with a prospective client (also known as engagement risks or client acceptance risks), the profitability and billing rate, and the risk/return relationship before submitting a formal engagement proposal and entering into fee negotiations.

    The authors investigate whether risk lengthens the acceptance phase for audit firms and results in a longer auditor search period for their clients. The authors posit that the auditor search period (ASP) following auditor resignations is significantly longer for riskier clients because of the additional time needed to collect and analyze information and to obtain required approvals within the audit firm. They focus on auditor resignations since the ASP, which is essentially unobservable, can be more accurately approximated for auditor resignations than auditor dismissals. Firms whose auditors resign may know about the resignation decision at or just before the resignation date. As such, the audit search process formally starts at or a short time before the auditor resignation date reported on a registrant’s Form 8-K filing. In contrast, firms planning to dismiss their auditor are aware of the dismissal decision long before the dismissal date. Hence, the auditor search period may start long before the dismissal date reported on the Form 8-K filings.

    Design/Method/ Approach:

    The authors test the hypotheses using a sample of auditor resignations obtained from the Audit Analytics database. The final sample includes 216 auditor resignations in firms (1) listed on major U.S. stock exchanges (NYSE, AMEX, NASDAQ), (2) with a ticker available, and (3) reporting at least one auditor resignation over the period 20032008.

    Findings:

    Findings support the client business risk hypothesis by documenting a longer ASP for firms that are in financial distress. Results also support the audit risk hypothesis, given that the ASP is longer for firms that report internal control weaknesses issues. Findings further support the auditor business risk hypothesis by showing a shorter ASP for firms hiring an industry specialist audit firm.

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Auditor Resignation and Risk Factors.
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 02.06 Resignation Decisions, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
    Title:
    Auditor Resignation and Risk Factors.
    Practical Implications:

    This study sheds light on why auditors choose to resign from auditing particular clients. The authors find that public information about audit risk, business risk, and litigation risk as well as private information about audit risk and business risk all play a role in the auditor’s resignation decision. This is useful for audit firms and regulators to consider. 

    Citation:

    Ghosh, A. and C.Y. Tang. 2015. Auditor Resignation and Risk Factors. Accounting Horizons 29 (3): 529-549.

    Keywords:
    auditor resignations, litigation risk, audit risk, business risk
    Purpose of the Study:

    While prior research has suggested litigation risk as the main reason for auditor resignations, the competing explanations of audit risk and business risk have not been tested concurrently to discover their incremental importance. Furthermore, prior research has not been able to isolate the auditor’s private information from public information about these risks. The authors attempt to close this gap in the literature by studying whether and how much the auditor’s private information about future audit risk, business risk, and litigation risk impacts the auditor’s resignation decision.

    Design/Method/ Approach:

    The authors use data from publicly-traded companies that switched auditors during the 1999-2010 time period. First, they compare auditor resignations to auditor dismissals based on pre-switch audit risk, business risk, and litigation risk. Then they test whether auditor resignations predict post-switch audit risk (e.g. internal control problems), business risk (e.g. delisting from stock exchange), and litigation risk (e.g. class-action lawsuits).

    Findings:
    • Compared to clients from which auditors have been dismissed, clients from which auditors resigned tend to have greater litigation risk, audit risk, and business risk before the change in auditors, but greater audit risk and business risk after the change.
    • The litigation risk, business risk, and audit risk existing before an auditor chooses to resign from an engagement all impact the auditor’s resignation decision, with litigation risk having the largest impact and audit risk the smallest.
    • Clients whose auditors have resigned are more likely to experience class-action lawsuits, internal control problems, and delisting from a stock exchange.
    • Auditor resignations reveal no private information about future litigation risk.
    • Auditor resignations reveal private information about future audit risk and future business risk, especially when one of the Big 4 audit firms resigned.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment, Litigation Risk, Resignation Decisions
  • Jennifer M Mueller-Phillips
    CEO Equity Incentives and Audit Fees.
    research summary posted September 15, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
    Title:
    CEO Equity Incentives and Audit Fees.
    Practical Implications:

    According to the authors, stock options and restricted stocks are important components in CEO compensation. This study shows that auditors do perceive greater audit risk due to CEO equity compensation adjust pricing decisions accordingly. Auditors appear more concerned about CEO’s incentives to increase a company’s risky behavior so as to the CEO’s equity based compensation as opposed to increasing stock price specifically. As a CEO’s vega (i.e. change in value of a manager’s equity portfolio due to a change in stock return volatility) increases, a manager becomes less risk averse and more willing to engage in risky behavior such as earnings management. This study offers additional insights into the cost/benefits of equity based compensation.

    Citation:

    Kim, Y., H. Li, and S. Li. 2015. CEO Equity Incentives and Audit Fees. Contemporary Accounting Review 32 (2): 608-638.

    Keywords:
    Stock Option Compensation, Audit Fees, Earnings Management
    Purpose of the Study:

    This study examines the relationship between CEO equity incentives and audit risk assessment and pricing. More specifically, it examines whether/how auditors perceive CEO equity as a risk factor and incorporate into their audit pricing decisions. The authors also seek to start reconciling prior mixed evidence regarding equity incentives and earnings management and determine whether earnings management risk is due to equity compensation’s (i.e. manager’s wealth) relationship with stock return volatility (i.e. risk) or stock price. This study refines insights into the determinants of audit risk/pricing decisions and links two literatures, executive compensation and auditor compensation.

    Design/Method/ Approach:

    Sample: S&P 1500 companies over 20002009
    Source: Audit Analytics (Audit Fees), COMPUSTAT’s ExecuComp (CEO compensation)
    ModelOLS with Log Audit Fees regressed on Log CEO Vega, Log CEO Delta, Audit Fee determinants from previous studies, and year/industry fixed effects

    Findings:

    Findings show that a CEO’s portfolio vega (i.e. change in value of a manager’s equity portfolio due to a change in stock return volatility) is the important determinant of audit risk/pricing and subsumes the effects found in the previous research of a CEO’s portfolio delta (i.e. change in value of a manager’s equity portfolio due to a change in stock price) on audit risk/pricing.

    Additional analyses/results include:  

    • Repeat main analysis for CFO equity incentives. No association found.
    • Examining “direct” effect of equity incentives on audit fees (i.e. general complexity of auditing stock-based compensation) by exploring post SFAS 123R period requirements to fair value nonexecutive employees’ stock options. No association found.
    • Alternative measures of CEO equity incentives including total options held by CEO, percent of CEO equity compensation of total CEO compensation, and broader measures of CEO equity compensation. Similar results to main results.

    Results are robust to several endogeneity tests including:

    • First time options grants and changes in audit fees model
    • Inclusion of firm fixed effects
    • Instrumental variables approach
    • Dynamic panel GMM estimation (Arellano-Bond system GMM estimator)
    • Additional controls for riskiness of firm investment and financial policies
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Earnings Management, Earnings Management
  • Jennifer M Mueller-Phillips
    Pricing of Risky Initial Audit Engagements.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.04 Predecessor Auditor Factors 
    Title:
    Pricing of Risky Initial Audit Engagements.
    Practical Implications:

    This research contributes to the initial engagement literature by providing evidence that successor auditors charge higher fees to their clients that previously reported disagreements and other reportable events. The authors also contribute to the literature by examining fees over a six-year period surrounding the auditor change. More importantly, they find that only Big 4 auditors appear to charge higher fees following disclosures of disagreements and other reportable events. Finally, the authors add to the existing literature on audit fees for risky clients, especially the internal control weakness literature, by providing evidence that disagreements and other reportable events are priced incremental to internal control issues.

    Citation:

    Elliott, J. A., A. Ghosh, and E. Peltier. 2013. Pricing of Risky Initial Audit Engagements. Auditing: A Journal of Practice & Theory 32 (4): 25-43.

    Keywords:
    audit fees, auditor changes, Big 4 auditors, engagement risk
    Purpose of the Study:

    In this study, the authors reexamine the association between audit fees and risky initial engagements by developing an ex ante client-risk metric that is based on auditor change 8-K filings. They group adverse disclosures embedded in auditor change filings into four categories: clients with 

    1. Internal control weaknesses,
    2. Going concern issues or those filing for bankruptcy,
    3. Disagreements with the predecessor auditor, and
    4. Other reportable events.

    Because prior studies examine internal control weaknesses and going concern opinions, the authors focus on auditor-client disagreements and other reportable events, including restatements, management integrity issues, scope limitations, illegal acts, and reaudits. A fundamental distinction between this study and prior studies on risk and fees is that the authors measure client risk based on public information available to auditors before they accept an engagement.

    The authors investigate the association between an ex ante measure of risk (using information in auditor change 8-K filings) and audit fees for initial engagements. The authors also examine whether the size of the successor/predecessor auditor affects fees. Finally, they examine inter-temporal fee changes, i.e., how fees change subsequent to a switch and how fees change prior to the switch, for both risky and other clients.

    Design/Method/ Approach:

    The auditor change and fee data are obtained from Audit Analytics. Data for the financial variables are from Compustat Annual files.  The final sample consists of 2,396 auditor switches over the years 2001 to 2011. The categorization based on auditor change 8-K filings indicates that 317 auditor switches have a disagreement or other reportable event disclosed in the filings, while the remaining 2,079 observations do not report any such issue.

    Findings:
    • The authors find that firms disclosing reportable events or auditor-client disagreements pay a fee premium of about 23 percent compared to less risky initial engagements.
    • They find that only clients switching to Big 4 auditors pay higher fees when disclosing disagreements or other reportable events in the 8-K.
    • The results indicate that Big 4 auditors charge a fee premium for risky clients, but not non-Big 4 auditors.
    • Over the three years prior to the auditor switch, audit fees for risky Big 4 clients increase by about 36 percent. Following the auditor switch, the fee premium persists for at least three years.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Predecessor Auditor Factors
  • Jennifer M Mueller-Phillips
    Conditional Conservatism and Audit Fees.
    research summary posted July 24, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment 
    Title:
    Conditional Conservatism and Audit Fees.
    Practical Implications:

    The results should be of interest to regulators, standard setters, auditors, and firms. Regulators and standard setters may benefit from the results as they consider promulgating accounting rules and standards, particularly those involving fair value measures. Auditors and the firms’ managers may also benefit from the results by knowing the possible effect of accounting conservatism on audit fees and the moderating effect of the quality of corporate governance as they select auditors and accounting policies.

    Citation:

    Lee, H. S., Li, X., & Sami, H. 2015. Conditional Conservatism and Audit Fees. Accounting Horizons 29 (1): 83-113.

    Keywords:
    audit fees, conditional conservatism, corporate governance, litigation risk
    Purpose of the Study:

    Accounting conservatism is an important characteristic of the accounting information system. As a fast-growing literature, academic accounting research has developed measures of conservatism to capture this characteristic and has investigated the role of accounting conservatism in debt contracts and corporate governance quality. However, very little is known about the impact of conservatism on audit risk. In this paper, the authors first investigate whether the level of a company’s accounting conservatism affects audit risk, which they proxy with audit fees. More importantly, the authors investigate how corporate governance quality influences the relationship between conditional conservatism and audit fees. Higher corporate governance quality could lead to lower litigation risk, and hence lower audit risk. When the audit risk is low because of better corporate governance, higher conservatism is less likely to further reduce audit fees.

    Design/Method/ Approach:

    The sample includes 16,455 firm year observations in the annual Compustat Xpressfeed files with fiscal year-ends included in the years 20032009 with valid total assets, sales, and fiscal year-end stock price data. The authors obtain corporate governance data from Risk Metrics, which reduces the sample size to 4,814.They use three different models to estimate firm-year conditional conservatism: (1) the Basu standard regression, (2) the accruals-cash-flows-based model, and (3) the current and lagged earnings-changes model.

    Findings:

    The authors document that firms benefit from conservative reporting because higher conservatism decreases audit fees. The results indicate that higher levels of conditional conservatism are associated with lower audit fees. They find that the audit fee reduction associated with more conservative reporting is attenuated when corporate governance is stronger. The findings are consistent with the explanation that both better corporate governance and conservatism can reduce uncertainty. Therefore, firms with low corporate governance quality have more to gain from conservative reporting.

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment
  • Jennifer M Mueller-Phillips
    CEO Turnover and Audit Pricing.
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment 
    Title:
    CEO Turnover and Audit Pricing.
    Practical Implications:

    Voluntary turnover of a CEO does no effect the audit fees of a company. Forced CEO turnover causes the business risk of both the client and the auditor to increase. Thus, audit fees increase. The study has practical implications for companies, by estimating the extra audit costs associated with forced CEO turnover.

    Citation:

    Huang, H., Parker, R. J., Yan, Y., & Lin, Y. 2014. CEO Turnover and Audit Pricing. Accounting Horizons 28 (2): 297-312.

    Keywords:
    audit fees, audit risk, CEO turnover
    Purpose of the Study:

    Accounting researchers have expended considerable resources over the last thirty years investigating factors that influence the audit fees charged by accounting firms. Researchers have found that accounting firms consider the risks of an audit in determining the audit price and that higher risk results in higher prices.

    This study examines the relationship between CEO turnover in client companies and the fees charged by their audit firms. According to the proposed theoretical framework, forced turnover is associated with higher risk for the auditing firm and, consequently, higher audit prices. The authors propose that forced CEO turnover (such as dismissals) pose higher business and audit risks for the audit firm than voluntary turnover (such as retirements); further, greater risk leads to higher audit prices. Forced CEO turnover often is a signal that the board of directors believes that corporate leadership and strategy need to change. This change, in turn, results in uncertainties regarding the competency of a new CEO and the effectiveness of a new strategy. The business risk of both the client and the auditor increases.

    Design/Method/ Approach:

    The authors develop two related regression models to examine audit fees. From the Audit Analytics database, the authors obtain a final sample of 13,692 firm-year observations with audit fees from 2004 to 2011. Of these, there were 1,030 cases with a CEO turnover (7.5 percent of total observations), including 166 observations with forced CEO turnover and 864 observations with voluntary turnover. Voluntary retirement is classified as a CEO who is 60 or older.

    Findings:

    Results for both models indicate that firms with forced CEO turnover have significantly higher audit fees than firms with either voluntary turnover or no turnover. Further, the authors find no difference in audit fees between companies with voluntary turnover and companies without turnover.

    Firms with forced CEO turnover have higher audit fees than both firms with voluntary turnover (mean difference of $763,000, p , 0.001) and firms with no turnover (mean difference of $858,000, p , 0.001); these results suggest forced CEO turnover has a meaningful economic difference. The authors find similar results in a model that examines change in audit fees from the prior year. Firms with forced CEO turnover have a larger increase in audit fees than both firms with voluntary turnover ($956,000 difference, p , 0.001) and firms with no turnover ($1,135,000 difference, p , 0.001).

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Strategic analysis and auditor risk judgments
    research summary posted March 11, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Strategic analysis and auditor risk judgments
    Practical Implications:

    The results of this study have important implications:

    • First, the results demonstrate that auditor judgments of the risk of material misstatement at the entity (financial statement) level are linked to the performance and documentation of strategic analysis of strategy positioning and the strategy implementation process
    • Second, this study provides preliminary evidence on the association between performing an analysis of the entity’s strategy implementation process and auditors’ judgments of the strength of the control environment
    • Third, the fact that auditors who performed strategic analysis did not identify a greater number of significant business and financial statement risks than auditors who did not perform strategic analysis warrants further research

    For more information on this study, please contact Natalia Kochetova-Kozloski.

    Citation:

    Kochetova-Kozloski, N., and W. F. Messier Jr. 2011. Strategic analysis and auditor risk judgments. Auditing: A Journal of Practice & Theory 30(4): 149-171.

    Keywords:
    risk assessment; strategic analysis; strategic positioning; strategy implementation.
    Purpose of the Study:

    Conducting a business risk-based audit requires the auditor to develop an understanding of the client and its environment, make risk assessments based on that knowledge, and design appropriate audit procedures to respond to those risks. A significant component of understanding the client and its environment involves conducting a strategic analysis of the client.

    The study investigates whether and how senior auditors’ strategic analysis of a client affects their identification of significant business and financial statement risks, and their risk assessments by addressing these two issues:

    • Whether strategic analysis undertaken by auditors to develop an understanding of the client’s business affects their risk identification
    • How two aspects of strategic analysis (analysis of strategic positioning and the strategy implementation process) influence auditors’ risk assessments
    Design/Method/ Approach:

    The study employed a 3 x 1 between-subjects factorial design with no strategic analysis (‘‘No SA’’) as a control condition, and analysis of strategic positioning (‘‘SA: strategic positioning’’) and analysis of strategy implementation process (‘‘SA: strategic process’’) as treatment conditions.  Experimental materials were delivered to the participants by e-mail or at a national training session. Sixty-seven (67) audit seniors from three Big 4 firms completed the experiment. The experimental materials included a cover letter, Additional Task Instructions, Risk Assessment and Audit Planning and Debriefing Questionnaire.

    Findings:

    The authors find:

    • Auditors who performed guided strategic analysis did not identify more significant business and financial statement risks than auditors who did not perform strategic analysis,
    • Senior auditors who performed strategic analysis of strategic positioning or the strategy implementation process assessed risk of material misstatement at the entity level more consistently with an expert panel than auditors who did not perform such an analysis,
    • Senior auditors’ analysis of the client’s strategy implementation process was associated with assessments of the strength of the control environment that were more consistent with the expert panel than assessments done by auditors who did not perform any strategic analysis or who performed only an analysis of strategic positioning.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Auditor business process analysis and linkages among auditor...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Auditor business process analysis and linkages among auditor risk judgments
    Practical Implications:

    The results of this study have implications for public accounting firms that have adopted business-risk audit methodologies and for regulators that have incorporated ideas and concepts from business-risk audit methodologies into promulgated standards

    • Public accounting firms adopting business-risk methodologies have broadened, deepened, and reemphasized the long-standing requirement in auditing standards to understand the client business so as to use this understanding as a source of information about possible material misstatements to the financial statements.
    • Firms and regulators should be encouraged by the support found in this study for the relationship and connections between, for instance, the significant business risks identified and the magnitude of the assessments of the risk of material misstatement at the entity level; the performance of business process analysis and the conservatism of entity- and process-level assessments of the risk of material misstatement; and the significant business risks identified and the risk of material misstatement at the process level.

    For more information on this study, please contact Natalia Kochetova-Kozloski.

    Citation:

    Kochetova-Kozloski, N., T. M. Kozloski, and W. F. Messier Jr. 2013. Auditor business process analysis and linkages among auditor risk judgments. Auditing: A Journal of Practice & Theory 32(3): 123-139.

    Keywords:
    business process analysis; risk assessment; risk of material misstatement; business risk identification
    Purpose of the Study:

    This research note examines two important and related issues:

    • Whether performance of a business process analysis assists auditors’ identification and assessment of significant business risks and the risk of material misstatement at a core process level.
    • Whether auditors link their entity-level risk assessments to their core business process risk assessments

    Based on review of the current literature, there has been relatively little research that has specifically examined how these two issues affect auditors’ risk-related judgments. Therefore, the current study examines the linkage between business risk identification, taking into account severity of each risk at the entity and process level, and the assessment of the risk of material misstatement at both the entity and process level in a more direct and externally generalizable fashion than was done previously—i.e., by focusing on efficacy of the process described by the auditing standards worldwide. 

    Design/Method/ Approach:

    The study employed a between-subject experimental design to test the hypotheses. The experiment was administered at training sessions of the Big 4 accounting firms held in the United States and Norway. The authors obtained usable responses from one hundred thirty-four (134) audit seniors after they completed a detailed case where performing or not performing a business process analysis was manipulated as a between-subject factor. The case used in this study was a hypothetical grocery retailer - National Foods, located in the Southeastern United States.

    Findings:

    The authors find:

    • A significant positive association between the identification of significant process-level business risks and the identification of significant business risks at the entity level for auditors who performed a business process analysis of the core business process.
    • Performing a business process analysis led to higher assessments of the risk of material misstatement at the core process level.
    • Auditors linked their assessments of misstatement risk at the process level with similar assessments made at the entity level, taking into account significant process-level risks.

    The authors stipulate that taken together, these results suggest that auditors link their entity-level identified business risks and assessments of the risk of material misstatement to risks and related assessments at the process level.

    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Client Risk Assessment

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