Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

Posts

  • Jennifer M Mueller-Phillips
    Real Earnings Management: A Threat to Auditor Comfort?
    research summary posted January 12, 2017 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.06 Earnings Management – Detection and Response 
    Title:
    Real Earnings Management: A Threat to Auditor Comfort?
    Practical Implications:

    Given that REM often causes significant auditor discomfort, the authors’ paper provides broader REM and auditor comfort-related questions pertaining to the effects of management’s focus on short-term results, the extent to which REM is a problem that can or needs to be fixed, and the possibility that REM is a gateway to more serious forms of accounting manipulation. 

    Citation:

    Commerford, B. P., D. R. Hermanson, R. W. Houston, and M. F. Peters. 2016. Real Earnings Management: A Threat to Auditor Comfort? Auditing: A Journal of Practice and Theory 35 (4): 39 – 56. 

    Keywords:
    real earnings management, auditor, comfort, rationality, emotions, and body senses
    Purpose of the Study:

    The authors address two overarching questions that have not received very much attention to date. First, “To what extent does real earnings management (REM) affect auditor comfort?” Second, “What strategies do auditors rely on in trying to reach a state of comfort when the client engages in REM?” Auditing standards that relate to REM are vague and limited and, despite evidence showing that REM is becoming increasingly common, little research considers auditors’ perceptions of REM and how they respond to it. The authors wish to fill this void by writing this paper. 

    Design/Method/ Approach:

    The authors conduct in-depth interviews with experienced auditors to examine how auditors respond to an emerging issue in the post-SOX period, the increasing use of real earnings management to achieve financial reporting objectives. 

    Findings:
    • The authors find that auditors are aware of REM and often identify it through formalized audit protocols, including analytical procedures, discussions with management, ad/or their knowledge of the business.
    • The authors find that formal audit procedures play a role in identifying sources of discomfort but also find references to body senses and the use of emotive language related to feelings of discomfort.
    • The authors find that most of the interviewees have concerns about REM, largely because they believe it indicates management’s desire to meet short-term targets, implying poor management tone, which could signal other, less acceptable earnings management methods. 
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Management Integrity
  • Jennifer M Mueller-Phillips
    Fraud dynamics and controls in organizations.
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.02 Fraud Risk Models, 06.04 Management Integrity 
    Title:
    Fraud dynamics and controls in organizations.
    Practical Implications:

    The findings have important implications for auditors and other individuals responsible for assessing fraud risk and detecting and preventing fraud. First, for certain types of organizations aggregate fraud levels can vary tremendously over time. Furthermore, the effectiveness of mechanisms to prevent and detect fraud can be contingent on the type of organization and related individual susceptibilities to social influence. Therefore, it may be inappropriate for auditors to evaluate fraud prevention and detection mechanisms in a uniform manner. The results suggest that the same fraud prevention and detection mechanisms implemented in a similar manner in two different organizations cannot be expected to be equally effective without considering the average susceptibilities to social influence of the individuals therein.

    Citation:

    Davis, J. S., and H. L. Pesch. 2013. Fraud dynamics and controls in organizations. Accounting, Organizations & Society 38 (6/7): 469-483.

    Keywords:
    fraud, fraud dynamics, impact of fraud in organizations, fraud risk assessment, management integrity
    Purpose of the Study:

    Fraud has become a popular area of inquiry among accounting academics because of the magnitude of losses (estimated by the Association of Certified Fraud Examiners in 2010 to be US$2.9 trillion worldwide) and requirements imposed on auditors to explicitly address the problem. To date, very little work has attempted to explicitly link individual behaviors in the organization to organizational outcomes within the fraud context. Understanding the individualorganization link is important because a focus on either individual behavior or the organization in isolation turns a blind eye to the social process through which individuals’ behaviors are influenced by the organization as a whole and vice versa. In other words, a narrow focus on individual behaviors or on the organization ignores the organization’s sociology, which can have profound effects on fraud outcomes and the efficacy of fraud prevention mechanisms.

    The authors develop a model of fraud in organizations that allows an evaluation of the relative efficacy of mechanisms designed to prevent fraud while explicitly recognizing the social processes underlying the formation of organizational norms. To develop the model, the authors use a method that is relatively new in accounting research: agent-based modeling (ABM). Designed to study the emergence of macro-level phenomena from micro-level interactions, ABM is well suited to address questions involving organizational outcomes (e.g., a culture of fraud) resulting from the interactions between individuals within an organization and organizational variables. The use of ABM allows the authors to gain insights into fraud even when data in organizations are censored.

    Design/Method/ Approach:

    The authors develop an agent-based model to examine the emergent dynamic characteristics of fraud in organizations. In the model, individual heterogeneous agents, each of whom can have motive and opportunity to commit fraud and a pro-fraud attitude, interact with each other. This interaction provides a mechanism for cultural transmission through which attitudes regarding fraud can spread.

    Findings:
    • When average susceptibility is low, the number of fraudsters in the organization tends toward a specific level and remains relatively stable over time.
    • When average susceptibility is moderate to high the authors observe a very different pattern in which the number of fraudsters in the organization vacillates over time between extremes; either virtually no one in the organization is a fraudster or virtually everyone is.
    • The impact of mechanisms to prevent fraud is contingent on average susceptibility to social influence within the organization.
    • A reduction in perceived opportunity or the introduction of influential, honest managers (tone at the top) reduces the number of fraudsters, but neither change to their model is effective in eliminating outbreaks of fraud when susceptibility is moderate or high.
    • Allowing honest employees to be more influential than fraudsters has no qualitative effect when susceptibility is low; however, it transforms behavior when average susceptibility is moderate to high, reducing the number of fraudsters to near zero and eliminating fraud outbreaks.
    • Efforts to remove fraudsters can effectively reduce the number of fraudsters to near zero regardless of the level of susceptibility, but such efforts do not eliminate fraud outbreaks when susceptibility is moderate to high.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Fraud Risk Models, Management Integrity
  • Jennifer M Mueller-Phillips
    The Impact of Authority on Reporting Behavior,...
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity 
    Title:
    The Impact of Authority on Reporting Behavior, Rationalization and Affect.
    Practical Implications:

    These results increase the understanding of how an authority figure’s directions to misreport impact the rationalizations and resulting reporting decisions. Situational inducement can be a powerful force on behavior and affect. The authors show that the situational inducement of being told to misreport enables individuals to mitigate the emotional cost of misreporting. The authors document the apparent ease with which misreporting individuals rationalize misreporting behavior in the presence of authority. This result can also be prevented by a good culture and leadership.

    Citation:

    Mayhew, B. W., & Murphy, P. R. 2014. The Impact of Authority on Reporting Behavior, Rationalization and Affect. Contemporary Accounting Research 31 (2): 420-443.

    Keywords:
    accounting fraud, rationalization, fraudulent reporting, fraud triangle
    Purpose of the Study:

    The authors conduct an experiment to examine reporting choices, rationalizations, and emotional responses when an authority figure directs participants to misreport. Several accounting scandals reportedly involved an authority figure instructing subordinates to perpetrate fraudulent financial reporting. The authors utilize the fraud triangle in their research setting to connect the theory of moral disengagement to the rationalization leg of the triangle. The fraud triangle suggests that three elements are necessary for fraud to occur: opportunity, motivation, and attitude/rationalization.

    The experimental reporting setting provides opportunity by allowing participants to report any income within the range of possible income. It also provides motivation by paying participants the income they report rather than the income they earn. The authors manipulate the setting to allow for ease of rationalization, by using an authority figure who instructs participants to misreport. When told to misreport, participants can rationalize their misreporting behavior by displacing responsibility. In a mixed design, the authors vary when the authority figure instructs participants to misreport, either on the first or second of two reporting opportunities. This design allows us to open the “black box” of whether and how an easily accessible rationalization impacts behavior and resulting emotion (affect).

    Design/Method/ Approach:

    The authors conduct an experiment using 88 participants recruited from an intermediate accounting class at a North American university. The average age of participants is 21 years. Participants listen to a lecture and complete two different multiple-choice quizzes. Each quiz culminates in an earned income based on the participant’s answers. Upon completing each quiz, participants learn their earned income and are then asked to report an income. They are paid what they report. The evidence was collected prior to 2014.

    Findings:
    • When not told to misreport before the first quiz, 49 percent of participants misreported. When the same participants were told me misreport 76 percent misreported.
    • When a separate set of participants were told to misreport after the first quiz, 72 percent misreported. They were not told to misreport after the second quiz, and 74 percent misreported.
    • When participants are told to misreport by an authority, they are significantly more likely to do so.
    • Misreporters rationalize their decision by displacing responsibility when they are told to misreport.
    • Misreporters in the authority treatments displace responsibility by saying, “I was told to” at significantly higher rates. The use of displacing responsibility fully mediates the relation between misreport instructions and misreporting behavior.
    • There are higher levels of guilt and discomfort (negative affect) among misreporters than honest reporters.
    • Misreporters feel increased negative affect. However, negative affect is significantly lower for misreporters who are instructed to misreport than those who misreport on their own volition.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Management Integrity
  • Jennifer M Mueller-Phillips
    Cumulative Prospect Theory and Managerial Incentives for...
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 12.0 Accountants’ Reports and Reporting, 12.04 Investigations 
    Title:
    Cumulative Prospect Theory and Managerial Incentives for Fraudulent Financial Reporting.
    Practical Implications:

    The study extends the fraudulent financial reporting literature by formulating fraud incidence as a function of performance outcomes using peer performance as a reference point. By testing CPT's individual-level behavioral implications on firm-level archival data, the study re-conceptualizes the investigation of fraudulent financial reporting in terms of risk attitude and extends prior investigations of CPT from laboratory experiments to a real-world setting of fraudulent financial reporting.

    Citation:

    Fung, M. K. 2015. Cumulative Prospect Theory and Managerial Incentives for Fraudulent Financial Reporting. Contemporary Accounting Research, 32 (1): 55-75.

    Keywords:
    fraud, probability theory, reporting, restatements
    Purpose of the Study:

    Risk-taking is fundamental to the survival and development of a firm. Nevertheless, some managerial risk-taking behaviors, like fraudulent financial reporting with an intention to deceive or mislead investors, are potentially disastrous to firm value. Fraudulent reporting of financial results is a risky way to improve the firm’s financial appearance, and thus the incidence of fraudulent reporting is expected to be associated with the manager’s propensity to take risks. In the current study, reference gains and losses (i.e., performance outcomes) are respectively defined as positive and negative deviations of the firm’s actual accounting-based performance from a reference point. The reference point is defined as the mean performance of industry peers. The study extends the cumulative prospect theory, CPT, fourfold pattern of managerial incentives to fraudulent financial reporting, hypothesizing that a manager is more likely to engage in fraudulent financial reporting over low-probability reference gains or high-probability reference losses, and is less likely to do so over high-probability reference gains or low-probability reference losses. The intuition is that a manager is more likely to be risk-seeking when he is faced with a high (low) probability of underperforming (outperforming) the rivals, and is more likely to be risk-averse if he is faced with a high (low) probability of outperforming (underperforming) the rivals.

    Design/Method/ Approach:

    To compile the misstatement sample, a list of firms that have restated their financial statements during the period of 19972005 for accounting irregularities was taken from the U.S. Government Accountability Office (GAO), which were then matched with the COMPUSTAT database. The sample contains 12- misstating firms and 152 misstated firm-years. The outcomes are framed as gains and losses relative to a reference point, defined as the mean performance of industry peers.

    Findings:
    • The findings show that fraud incidence is positively related to the probability of a loss; more sensitive to the probability of a loss; and more sensitive to an extra unit of the probability at a high- or low- probability level (i.e., nonlinear probability weighting function.
    • The findings also show that fraud incidence is negatively related to the probability of a gain; less sensitive to the probability of a gain; and less sensitive to an extra until of the probability at a medium- probability level.
    • The study empirically substantiates the fourfold incentive pattern characterized by loss aversion and shows that fraud incentives are nonlinear in the probabilities of performance outcomes due to CPT’s nonlinear probability weighting function.
    • Imperfect information faced by managers about competitors’ performance is a possible concern arising from framing performance outcomes relative to peer performance.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Management Integrity, Restatements
  • Jennifer M Mueller-Phillips
    The Ties that Bind: The Decision to Co-Offend in Fraud.
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity 
    Title:
    The Ties that Bind: The Decision to Co-Offend in Fraud.
    Practical Implications:

    The phenomenon of co-offending is an important key to understanding fraudulent behavior. Understanding co-offending is best approached through a study of social ties. The reasons for co-offending vary according to the type of bond that exists between the co-offenders. Internal controls, such as job rotation policies, mandatory holidays with role replacement, forensic audits and surprise audits, that are specifically geared toward unraveling organizational cliques and subcultures help uncover fraudulent activities within a firm. This research suggests that the fraud triangle presents an overly parsimonious explanation of offending, and should incorporate materialistic, cultural, and affective considerations.

    Citation:

    Free, C., & Murphy, P. R. 2015. The Ties that Bind: The Decision to Co-Offend in Fraud. Contemporary Accounting Research 32 (1): 18-54.

    Keywords:
    fraud, forensic accounting, insider trading in securities, money laundering, co-offending
    Purpose of the Study:

    This article investigates the reasons why individuals co-offend in fraud. It is frequently observed that fraud has a greater economic impact on society than any other category of crime. “Co-offending” here refers to the perpetration of a fraud by more than one person and includes criminal cooperation at different times and places, a process in which individuals willingly pool their resources in the pursuit of shared but illegal goals. The focus of the article is on why some offenders opt to co-offend rather than offend alone in committing fraud. In the case of fraud, co-offending carries the risk that one party will cheat an accomplice, divulge his or her identity to authorities, or increase the latter’s likelihood of detection or arrest. In spite of these risks, in the many cases it is only by building a co-offending group that the opportunity can be accessed.

    Design/Method/ Approach:

    The authors researched instances where the fraud was perpetrated by a group of co-offenders. The data for this study is drawn from semi-structured interviews with 37 participants in the United States, 31 of whom were serving a sentence for fraud, and 6 of whom had completed their prison sentences. In each instance, the fraud was perpetrated by a group of two or more co-offenders. Each inmate had to volunteer to be interviewed. The evidence was collected prior to June 26, 2014.

    Findings:

    Two dimensions of fraudulent co-offending were identifiedthe primary beneficiary of the fraud and the nature of group attachmentto derive three distinct archetypes of bonds between co-offenders: (1) individual-serving functional bonds, (2) organization-serving functional bonds, and (3) affective bonds.

    • The findings suggest that the social nature of fraud is not merely an incidental feature of the crime but is instead a potential key to understanding its etiology and some of its distinctive features.
    • 60 percent of responders committed fraud as a co-offender.
    • The largest portion of participants (21 of 37) fell in the individual-serving functional bounds category. Usually, under this category, one person suggests that fraud and others follow.
    • Some individuals often feel a need to emulate others outside of greed or financial need.
    • In some instances organizational costs and benefits are more salient to offenders than self-interest.
    • Group norms of loyalty, trust and distrust, and even antagonism toward other parties can cement a group together while providing easy rationalizations for perpetrating fraud.
    • Some participants felt that societal and cultural factors effectively sanctioned fraud.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Management Integrity
  • Jennifer M Mueller-Phillips
    Does Internal Audit Function Quality Deter Management...
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Does Internal Audit Function Quality Deter Management Misconduct?
    Practical Implications:

    These findings suggest that regulators, audit committees, and other stakeholders should consider ways to improve IAF quality, specifically IAF competence, and IAFs improve corporate governance by assisting audit committees in monitoring management. This study provides empirical evidence consistent with the proposition that IAF quality and competence deter management misconduct. IAF quality and, particularly, IAF competence are important in deterring observable instances of management misconduct, both accounting- and nonaccounting-related. These findings are important because in the early 2000s, regulators responded to public outcry over observable management misconduct, yet IAF quality was largely left out of the regulatory debate and reforms that followed.

    Citation:

    Ege, M. S. 2015. Does Internal Audit Function Quality Deter Management Misconduct? Accounting Review 90 (2): 495-527.

    Keywords:
    corporate governance, internal audit function, internal audit quality, management misconduct
    Purpose of the Study:

    This study examines the relation between internal audit function (IAF) quality, as defined by standard-setters, and the likelihood of management misconduct, such as financial reporting fraud, bribery, and misleading disclosure practices. Standard-setters posit that IAFs serve as a key resource to audit committees for monitoring senior management and that high-quality IAFs deter management misconduct. However, U.S. regulators do not enforce IAF quality or require disclosures relating to IAF quality. The U.S. Securities and Exchange Commission (SEC) proposed requirements to increase IAF quality by adding the appointment, compensation, retention, and oversight of the internal auditor to audit committee responsibilities, but these proposed requirements were abandoned. Ten years later, after withdrawing its recent proposal to require high-quality IAFs, NASDAQ is considering how to revise the proposed rules. These proposals demonstrate the need for evidence regarding whether IAF quality results in improved monitoring of management.

    This study informs standard-setters, regulators, audit committees, and shareholders about whether IAF quality deters management misconduct incrementally to other monitors.

    Design/Method/ Approach:

    The author obtained the initial sample from the Institute of Internal Auditors’ proprietary Global Auditing and gathered additional information from COMPUSTAT. The final sample covers 1,398 firm-years representing 617 unique firms from 2000 through 2009. The management misconduct sample comes from four data sources: the Federal Securities Regulation Database, the Stanford Securities Class Action Clearinghouse, SEC’s website and the Department of Justice website.

    Findings:

    The author finds a negative relation between IAF quality and management misconduct, even after controlling for other determinants of misconduct, including board of director, audit committee, and external auditor quality. This effect is economically significant, as a firm with IAF quality one standard deviation above the mean is approximately 2.3 percentage points less likely to have management misconduct than a firm with average IAF quality. This is approximately 29.5 percent of the 7.7 percent unconditional probability of management misconduct. Further analysis reveals that IAF competence, but not objectivity, is negatively related to the likelihood of management misconduct, suggesting that IAF competence is important in deterring management misconduct.

    Misconduct firms have low IAF quality and IAF competence during misconduct years as compared to a matched sample of firms. Then, in post-misconduct years, misconduct firms increase IAF quality through IAF competence. This increase in competence is due to hiring more certified internal auditors and increasing training. However, misconduct firms do not appear to have lower IAF objectivity during or after misconduct years compared to a matched sample. These results are consistent with the proposition from standard-setters that IAFs serve as a key resource for audit committees in monitoring management.

    The findings suggest that high-quality IAFs are effective at deterring both types of management misconduct. Disclosures related to IAF quality would assist stakeholders in predicting accounting-related management misconduct.

    Category:
    Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Management Integrity
  • Jennifer M Mueller-Phillips
    Tone Management.
    research summary posted July 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 06.06 Earnings Management 
    Title:
    Tone Management.
    Practical Implications:

    The evidence indicates that tone manipulation succeeds in misleading investors, and that this effect is incremental to the effect of accruals management. An abnormally positive tone incites an overly optimistic immediate stock price response to the earnings announcement and a subsequent return reversal. The evidence indicates that abnormal positive tone contains negative information about future firm fundamentals, that firms tend to engage in tone management particularly when incentives to manipulate investor perceptions are high, and that investors are misinformed by tone management.

    Citation:

    Huang, X., Teoh, S. H., & Zhang, Y. 2014. Tone Management. Accounting Review 89 (3): 1083-1113.

    Keywords:
    behavior finance, earnings management, market efficiency, qualitative disclosure, tone management, management integrity
    Purpose of the Study:

    The tone of the qualitative text in earnings press releases can be too optimistic or pessimistic relative to concurrent disclosures of quantitative performance. The authors call the choice of the tone level in qualitative text that is incommensurate with the concurrent quantitative information tone management. The authors investigate whether managers engage in tone management for informative or strategic purposes, and whether and to what extent the capital market discounts for strategic motives, if any, when reacting to earnings announcements.

    Earnings press releases, being voluntary, are not subject to explicit rules about the disclosure, so management has wide latitude in the qualitative presentation of the quantitative information. The authors are interested in studying how the tone of the press release affects readers’ response to the communication, and whether and how tone can be used as a tool to affect investors’ perception about the firm. As the old adage goes, “It’s not what you say; it’s how you say it.”

    A key goal for this paper is to test whether tone management in earnings press releases informs or misinforms investors. The authors examine how abnormal positive tone relates to future firm performance, whether abnormal tone is more likely used in situations where managerial strategic incentives to manipulate investor perception are present, and whether and how investors react to tone management at the time of, and subsequent to, the earnings announcements.

    Design/Method/ Approach:

    The authors obtain a sample of 14,475 observations of firm-year abnormal positive tone from the text of annual earnings press releases from PR Newswire and Business Wire, historical financial data from Compustat, stock returns from CRSP, analysts’ earnings forecasts data from I/B/E/S, seasoned equity offering (SEO) and merger and acquisition (M&A) effective dates from SDC, and option grants data for CEOs from ExecuComp. The sample period was 19972007.

    Findings:

    The evidence indicates that abnormal positive tone is associated with a more positive immediate market response to the earnings announcement and a more negative market response in one and two quarters subsequent to the announcement. The return reversal in the post-announcement period is strong evidence of an over-reaction to abnormal positive tone at the earnings announcement. Among firms that use both accruals and tone management in a consistent direction, the authors find that tone management is more likely in older firms and firms facing higher balance sheet bloat, as proxied by lagged assets scaled net operating assets, and so are more constrained in further upward accruals management. Abnormal positive tone is usually higher when firms just meet or beat past earnings or analysts’ consensus forecasts, when earnings are upwardly biased to such an extent as to require a future restatement, and before a new equity issuance or a merger or acquisition activity. When firms award stock options to CEOs, with an associated managerial incentive to reduce the share price, they prefer to manipulate abnormal tone downward. Overall, the evidence suggests that managers use tone management to mislead investors and other financial statement users.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Management Integrity
  • Jennifer M Mueller-Phillips
    The Effects of Auditors’ Accessibility to “Tone at the Top...
    research summary posted February 24, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 09.0 Auditor Judgment, 09.02 Documentation Specificity 
    Title:
    The Effects of Auditors’ Accessibility to “Tone at the Top” Knowledge on Audit Judgments
    Practical Implications:

    The results of the study identify two points where decision aids are likely to be successful in improving audit quality—when developing a mental representation of the “tone at the top” and/or when establishing a preliminary assessment of control environment effectiveness. Although developing an understanding of the client’s “tone at the top” requires retrieval of positive evidence supportive of “tone at the top” effectiveness, the process of doing so may undermine auditors’ efforts at incorporating negative evidence into their mental representations. Structuring decision aids, working papers, and reviews to ensure that the relatively abundant positive “tone at the top” information does not suppress the negative information would alleviate a favorable bias in the auditors’ “tone at the top” mental representations. This is critical given that “tone at the top” mental representations permeate subsequent audit decision making.  

    For more information on this study, please contact Regan Schmidt.

    Citation:

    Schmidt, R.N. 2014. The effects of auditors’ accessibility to “tone at the top” knowledge on audit judgments. Behavioral Research in Accounting 26 (2): 73-96.

    Keywords:
    auditor, tone at the top, control environment, knowledge, mental representation, interference, decision aid
    Purpose of the Study:

    Auditors must evaluate the “tone at the top” due to its pervasive impact on the client’s financial reporting practices and the auditors’ reliance on internal controls. However, few studies have examined how audit evidence unique to the “tone at the top” impacts audit judgments. The prior research has noted that, even in organizations that experience fraud, evidence for assessing “tone at the top” effectiveness tends to comprise a higher proportion of positive evidence supporting “tone at the top” effectiveness and a lower proportion of negative evidence supporting “tone at the top” ineffectiveness. There is also a concern expressed in auditing standards regarding the lack of documentary evidence relevant to assessing “tone at the top” effectiveness. Lacking such documentation, auditors must rely on their memory processes when evaluating “tone at the top” effectiveness. This study investigates whether the approach auditors use when accessing their memory of audit evidence influences their evaluations of “tone at the top” effectiveness and subsequent audit judgments.

    Design/Method/ Approach:

    The experimental research evidence was collected in 2008. The study participants were auditors with approximately two years of audit experience on average. Participants read the background information of the client company and were provided with 50 unchanging “tone at the top” information items (i.e., evidence). The study then manipulated how participants recalled the evidence from memory. Participants subsequently provided a preliminary assessment of the effectiveness of the control environment, a plausibility assessment of management’s explanation for differences noted in preliminary analytical procedures, and fraud risk assessments. 

    Findings:
    • Holding the underlying evidence of the “tone at the top” constant, auditors who recall positive evidence supportive of “tone at the top” effectiveness prior to negative evidence develop more favorable “tone at the top” mental representations as compared to auditors who recall negative evidence prior to positive evidence. Accordingly, retrieving the abundant positive “tone at the top” evidence from memory may suppress accessibility to the negative “tone at the top” evidence.
    • The auditors’ “tone at the top” mental representation significantly impacts the auditors’ control environment assessment, as well as subsequent audit judgments including the auditors’ reliance on client management’s explanation in analytical procedures and fraud assessments. Mediation analyses document that the control environment assessment mediates the relationship between the auditors’ “tone at the top” mental representation and subsequent audit judgments.
    • This study clarifies the results of prior research that documented audit judgments were not sensitive to “tone at the top” information. By examining intervening cognitive processes, the results of this study provides an insight to suggest that, in prior studies, when auditors were making their audit judgments, the “tone at the top” evidence was not accessible (i.e., the negative “tone at the top” evidence was inhibited from the mental representation).
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Documentation Specificity, Management Integrity
  • Jennifer M Mueller-Phillips
    Management Credibility and Investment Risk: An Experimental...
    research summary posted December 1, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 09.0 Auditor Judgment, 09.13 Recognition vs. Disclosure 
    Title:
    Management Credibility and Investment Risk: An Experimental Investigation of Lease Accounting Alternatives
    Practical Implications:

    The research helps identify conditions under which financial statement users are more likely to detect accounting and disclosure choices that are seemingly intended to misrepresent firms’ financial positions.  The evidence indicates that participants in the experiment do not naturally adjust for financial statement impact. These participants perceive a deficiency in management credibility only when they understand both the financial statement impact of an incentive-consistent accounting choice and believe that management has not been forthcoming about that choice.  The research suggests that investors make credibility judgments based on the forthcomingness of corporate disclosure as well as on what they understand about managers’ choices from the broader information environment.

    For more information on this study, please contact Susan Krische.

    Citation:

    Krische, S. D., P. R. Sanders, and S. D. Smith.  2014.  Management credibility and investment risk: An experimental investigation of lease accounting alternatives.  Behavioral Research in Accounting 26 (1): 109-130.

    Keywords:
    lease transaction structuring; recognition and disclosure; reconciliation; management credibility.
    Purpose of the Study:

    What are the conditions necessary for an investor to question managers’ choices as attempts to misrepresent their firms’ financial positions? This paper examines how users’ understanding of the financial statement impact of accounting alternatives and the disclosure choices management has made jointly influences users’ assessments of management credibility and investment risk.

    The authors place the research in the context of bright-line lease accounting standards and reporting decisions because lease structuring to achieve operating lease treatment is among the most prevalent strategies for off-balance sheet financing, while academic research has produced mixed evidence on whether and how market participants detect and respond to managers’ efforts to obfuscate those obligations. The authors expect that users will perceive lower management credibility only when they understand that management has made an accounting decision for strategic financial reporting purposes and that management has not been forthcoming about that decision in its disclosures.

    Design/Method/ Approach:

    The research requires careful control of users’ understanding of the financial statement impact of management’s reporting choices. Participants in the experiment were therefore students in a junior-level management accounting course at a large public university, who were asked to evaluate a company’s financial information and provide several judgments including management credibility and investment risk. The financial information varies in three ways: (1) whether the lease obligations are recognized or disclosed; (2) whether a supplemental reconciliation to lease capitalization is presented; and (3) whether the source of the reconciliation is internal or external. Data from the experiment was collected in 2006.

    Findings:
    • When the firm merely discloses lease obligations vs. recognizing (capitalizing) them, participants:
      • assess lower investment risk, but
      • do not perceive lower management credibility. 
    • When an externally sourced supplemental reconciliation of lease accounting treatments is provided, participants:
      • assess higher investment risk, and
      • perceive lower management credibility.
    • The authors find that participants’ assessments of management credibility mediate the difference in investment risk judgments caused by the reconciliation source.
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Management Integrity, Recognition vs. Disclosure
  • Jennifer M Mueller-Phillips
    The Effects of Clients’ Controversial Activities on Audit P...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 06.06 Earnings Management 
    Title:
    The Effects of Clients’ Controversial Activities on Audit Pricing
    Practical Implications:

    We focus on the business risk associated with controversial corporate activities. By examining a wider range of controversial corporate activities, we are able to conduct a broader investigation into the association between auditor business risk and audit fees.  Our study finds that adverse social performance arising from controversial activities affects firms’ audit fees. Specifically, our results indicate that auditors charge fee premiums ranging from 5.4% to 13.2% for clients that are involved with controversial activities related to consumers, employees, the community, and the environment.  We also find that corporate controversial activities are associated with higher risks of financial misstatement and adverse financial performance.  These results provide triangulation on our inference that auditors’ raise their assessment of clients’ business risks when their clients are involved in controversial activities, and charge such clients higher audit fees.  

     

    For more information on this study, please contact Kevin Koh.

    Citation:

    Koh, K. and Y. H. Tong. 2013. The Effects of Clients’ Controversial Activities on Audit Pricing. Auditing: A Journal of Practice and Theory 32 (2): 67-96.

    Keywords:
    audit fees; audit pricing; corporate social responsibility (CSR); controversial corporate activities; business risk; financial misstatement
    Purpose of the Study:

    We examine the effects of clients’ involvement in controversial corporate activities on audit pricing. Clients’ involvement in controversial activities raises concerns about management integrity and ethics. Moreover, clients involved in such activities are perceived to have higher risk of adverse financial performance. As a result, there is greater potential for financial misstatement, which increases the auditor’s perceived business risk. We hypothesize that, given the higher perceived business risk, auditors charge higher fees to clients engaged in controversial activities. We also hypothesize that lower corporate social performance is associated with adverse financial performance as these clients can face public criticism, consumer boycotts, reputation loss, fines or other regulatory actions over their controversial activities. Adverse financial performance heightens managerial incentives to manage earnings, increasing the risk of financial misstatement.

    Design/Method/ Approach:

    Our sample spans the period 2000 to 2010, as audit fee data are publicly available only as of 2000.  We obtain audit fee data from the Audit Analytics database and identify audit clients involved in controversial activities related to consumers, employees, the community, and the environment using a unique dataset from Kinder, Lydenberg, and Domini (KLD).   The KLD dataset is the most commonly used database for assessing corporate social performance. KLD rates each firm’s social actions along seven broad dimensions: consumer, employee, diversity, community, human rights, environment, and corporate governance. We use a regression model to examine the relation between controversial activities and audit fees. In order to examine the validity of our assumptions and to triangulate our results, we investigate the association between controversial activities and the risks of financial misstatement and adverse financial performance with regression models.   

    Findings:

    We find evidence consistent with audit firms charging higher audit fees to firms involved in controversial activities. Specifically, our results indicate that auditors charge fee premiums ranging from 5.4% to 13.2% for clients that are involved with controversial activities related to consumers, employees, the community, and the environment.  In comparison, in our sample, the Big 4 and industry-specialist audit fee premiums amount to 29.7% and 10.8%, respectively.  The fee premiums related to the various controversial activities thus appear to be economically significant. 

    We also find that clients involved in controversial activities report higher level of abnormal accruals and are more likely to be issued a going concern opinion compared to clients not involved in such activities. These results strengthen our inference that auditors raise their assessment of auditor business risk for clients engaged in controversial activities and charge higher audit fees.   

    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fee Decisions, Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment, Earnings Management, Earnings Management, Management Integrity

Filter by Type

Filter by Tag