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  • Jennifer M Mueller-Phillips
    A Risk Model to Opine on Internal Control.
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.02 Fraud Risk Models, 06.05 Assessing Risk of Material Misstatement, 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses 
    Title:
    A Risk Model to Opine on Internal Control.
    Practical Implications:

    The auditor needs a different model for audits of internal control. The auditor needs to apply two different models in an integrated audit, the original model for the opinion on the financial statements and a different model for the opinion on internal controls.

    The author believes standard setters should sponsor research on an appropriate risk model for audits of internal control. Even before the research is completed, the standards could be enhanced in the following ways:
    • indicate that the original audit risk model is intended for use only in financial statement audits, not internal control audits;
    • write standards that consistently use risk terminology and are clear as to which risk they are discussing; and
    • provide guidance on the use of models in integrated audits.

    Citation:

    Akresh, A. D. 2010. A Risk Model to Opine on Internal Control. Accounting Horizons 24 (1): 65-78.

    Keywords:
    audit risk model, inherent risk, integrated audit, internal control, opinion, risk of material misstatement, risk of material weakness
    Purpose of the Study:

    The audit risk model has provided a conceptual framework for audits of financial statements for more than 40 years. Despite practical difficulties in implementation and criticisms of its theoretical foundation, the model has been fairly effective in helping auditors analyze risks and use that analysis to determine the nature, timing, and extent of audit procedures in audits of financial statements. In recent years, some auditors have tried to apply the audit risk model to audits of internal control, usually performed as parts of integrated audits. An integrated audit is an engagement where the auditor provides an opinion on the financial statements and an opinion on the effectiveness of internal control over financial reporting. It is integrated in the sense that the auditor tries to use some of the same procedures to meet both objectives.

    While the audit risk model was designed for audits of financial statements, it was not designed for audits of internal control. Audits of internal control are audits of processes rather than audits of outputs (financial statements). In addition, opinions on internal control do not rely on analytical procedures or on substantive tests of details. Because of this conceptual difference, the author asserts that audit risk model, as originally formulated, does not work as a coherent conceptual framework for audits of internal control. The need for a different risk model for internal control audits is not currently recognized in the auditing standards or in the auditing literature.

    Design/Method/ Approach:

    This article is a commentary.

    Findings:

    For an integrated audit, the auditor would use the two models sequentially. The auditor would use the internal control risk model as a framework to determine the extent of control tests. Then the auditor would use the financial statement audit risk model as a framework to determine the extent of substantive testing.

    Future research could determine a more specific model based on how auditors perform these audits. Some research questions include, for example:

    • What models and approaches are currently used in practice? How does current practice compare with the model proposed and other models?
    • Are models useful in providing a conceptual framework for integrated audits?
    • What are the current practices for the auditor’s evaluation of inherent risk? How do those practices compare with risk models?  
    • How do auditors assess design and implementation of internal controls in light of inherent risk without considering operating effectiveness?
    • What are the current practices for the auditor’s evaluation of design, implementation, and operating effectiveness of the control environment? Are those practices adequate to effectively use in a risk model?
    Category:
    Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Material Weaknesses, Assessing Risk of Material Misstatement, Fraud Risk Models, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Assessing Risk with Analytical Procedures: Do...
    research summary posted October 29, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 08.0 Auditing Procedures – Nature, Timing and Extent 
    Title:
    Assessing Risk with Analytical Procedures: Do Systems-Thinking Tools Help Auditors Focus on Diagnostic Patterns?
    Practical Implications:

    The diagrams used in this study contained identical information about changes in accounts; however, auditors who used a diagram that illustrated information in a way that explicitly outlined associations among accounts came to different conclusions about risk than those who used a simple business process diagram. Changing the way information is presented to auditors during the planning phase of an audit could help auditors develop more reliable risk assessments and could significantly improve the audit practice. 

    For more information on this study, please contact Ed O’Donnell.
     

    Citation:

    O’Donnell, E., and J. Perkins. 2011. Assessing Risk with Analytical Procedures: Do Systems-Thinking Tools Help Auditors Focus on Diagnostic Patterns? Auditing: A Journal of Practice and Theory 30 (4): 273-283.

    Keywords:
    analytical procedures; causal-loop diagrams: pattern recognition; risk assessment.
    Purpose of the Study:

    Auditors assigned to an assurance engagement must perform analytical procedures to identify any situations that could increase the risk of material misstatement in accounts. However, even when auditors perform adequate and appropriate procedures to assess risk, auditors often fail to recognize conditions that increase the risk of misstatement. This can occur when evidence manifests through inconsistent fluctuation of related accounts instead of manifesting through inconsistent fluctuations for a single account. This study addresses this auditor weakness by evaluating whether the way information is presented in the diagrams used to perform analytical procedures affects an auditor’s assessment of risk during the planning phase of an audit engagement. The authors suggest that an alternative way of presenting information could potentially allow auditors to more appropriately recognize and respond to patterns of changes in accounts. The two different types of information presentation compared in this study are:

    • Causal-loop diagram- a system-thinking tool that explicitly illustrates associations among process components.
    • Business-process diagram- a diagram that provides equivalent information than that presented in a causal loop diagram but presents it in a different format without explicit illustrations.
       
    Design/Method/ Approach:

    The authors collected the evidence for this study prior to November 2011. The lab experiment was conducted using auditors with audit experience ranging from 20 to 84 months, with an average of 41.7 months. The auditors were randomly assigned to a task that entailed either identifying fluctuations or explaining fluctuations by performing analytical procedure on given financial information with seeded inconsistent fluctuations in related accounts. Half of the participants in each task used the business process diagram while the other half used the causal loop diagram to reach a conclusion.

    Findings:
    • Compared to participants in the experiment who used the business process diagram, those who used the causal-loop diagram found the evidence about patterns in inconsistent fluctuations among related accounts more important and relevant to risk.
    • Compared to participants in the experiment who used the business process diagram, those who used the causal- loop diagram concluded that there was a higher level of misstatement risk given the inconsistent fluctuations in related accounts.
    • The findings suggest that changing the way information is organized and presented to auditors can increase their pattern focus when they perform analytical procedures during the planning phase and could potentially improve their assessment of misstatement risk.
    • Results from this study should be evaluated with respect to the limitations inherent in the laboratory experiment. It is possible that the auditors using the different diagrams could have come to the same conclusion about risk had they had as much evidence as is typically gathered from analytical procedures in real engagements. Future research should address this issue to come to a definitive conclusion about the usefulness of systems-thinking audit tools with respect to assessing misstatement risk.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement
  • Jennifer M Mueller-Phillips
    Audit risk Assessments Using Belief versus Probability
    research summary posted October 29, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism 
    Title:
    Audit risk Assessments Using Belief versus Probability
    Practical Implications:

    The primary contribution of the paper is the presentation of four alternative concepts or definitions of audit risk. The feasibility and impact on auditor judgments of auditors applying these approaches to audit risk assessments are tested in an experimental setting where a second aspect of auditing – how assertions are framed – is also examined. Both the risk assessment approach and assertion framing had a significant impact on risk assessment both before and after audit evidence was evaluated. Importantly, auditors who were given a negatively stated audit assertion tended to be more skeptical than those who were given a positively framed assertion. This result has possible audit effectiveness and efficiency implications. 

    Citation:

    Fukukawa, H., and T. Mock. 2011. Audit risk assessments using belief versus probability. Auditing: A Journal of Practice and Theory 30 (1): 75-99.

    Keywords:
    auditors’ risk assessments; belief functions; probability; assertion framing effects
    Purpose of the Study:

    To present and experimentally compare alternative approaches to defining audit risk based on probability theory and the theory of belief functions and the effects of these approaches and of assertion framing on audit judgment. The risk measures studied were:

    1. Belief that an assertion is false
    2. Plausibility that an assertion is false, which is the sum of the belief that an assertion is false and the explicitly measured ambiguity and thus is the most conservative measure
    3. Probability that an assertion is false
    4. Cobb-Shenoy transformed belief that an assertion is false

    The first two approaches are belief-based, while the third is a probability-based approach. The logical connection between probability and belief assessments is used to define and operationalize the forth measure.

    Additionally, this study experimentally tests the effects of positive and negative  assertion framing on risk assessment and whether or not these effects are contingent on the approach to risk assessment and the evidence presented.

    Design/Method/ Approach:

    An experiment was conducted using practicing auditors drawn from Big 4 firms in Japan. Each participant was randomly assigned to one of four conditions where the factors manipulated were assertion framing and approach to risk assessment. The participants were presented with tasks for which they made a series of audit risk assessment judgments related to assertions presented about trade accounts receivable.

    Findings:

    The authors found the risk assessment approach effects to be significant with the belief-based risk assessments being smallest, the plausibility assessments being largest, and the probability assessments and the Cobb-Shenoy transformed belief assessments being in-between. Most of the paired comparisons between these measures were statistically significant. These results imply that any audit methodology that focuses on any one of these risk assessment measures is likely to result in substantially different risk assessments and potentially significant effects on audit efficiency and effectiveness.

    The authors also found evidence of significant audit assertion framing effects. Firstly, auditors who were given a negatively stated audit assertion tended to be more skeptical than those who were given a positively framed assertion. Also, the results showed that auditors are prone to confirm a given assertion regardless of whether it is stated positively or negatively. The pervasive framing effects are more significant after audit evidence is presented, more significant when stronger audit evidence is presented, and are influenced by the risk assessment approach. The existence of such assertion framing effects clearly may directly affect audit effectiveness and efficiency.

    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Auditors’ Professional Skepticism
  • 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
  • The Auditing Section
    Auditor Risk Assessment; Insights from the Academic...
    research summary posted April 12, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.05 Assessing Risk of Material Misstatement, 06.08 SAS No. 99 Brainstorming – effectiveness 
    Title:
    Auditor Risk Assessment; Insights from the Academic Literature
    Practical Implications:

    This article provides a very informative summary of current research related to the risk assessment process that supports the audit.  By outlining both general audit risk insights as well as fraud risk insights, the authors provide a clear and informative summary that should be of use to any audit firm attempting to better understand the current theoretical and practical research related to this emerging area.  Finally, by utilizing the PCAOB questions, the discussion also provides insights directly relevant to the current regulatory process.

    Citation:

    Allen, R.D., D.R. Hermanson, T.M. Kozloski, and R.J. Ramsay. 2006.  Auditor Risk Assessment: Insights from the Academic Literature.  Accounting Horizons 20(2): 157-177.

    Keywords:
    Risk assessment; PCAOB risk assessment project; industry specialization, fraud risk assessment; audit risk model.
    Purpose of the Study:

    This paper summarizes insights from academic literature related to risk assessment in financial statement audits project.  Using the February 16, 2005 PCAOB Standing Advisory Group (SAG) briefing paper on risk assessments as the organizing framework, the authors provide a literature review of topics related to: business risk, inherent risk, control risk, fraud risk, linking risk assessment to subsequent testing, and the audit risk model. 

    Design/Method/ Approach:

    The authors organize the auditor risk assessment literature review around the PCAOB briefing paper’s ten questions.  While cknowledging that fraud risk is integral to the overall audit risk, the uthors separate audit risk and fraud risk in their responses to further acknowledge he special problems in identifying, assessing, and responding to fraud isk.  Therefore, for each question, the authors discuss general audit risk assessment issues first, followed by those ssues specific to fraud risk assessments.

    Findings:
    • While using a business process focus in assessing client risks appears to be an advantage in the audit, additional guidance for using this approach may be helpful to address the diverse approaches utilized by the firms.  Decision aids and analytical procedures may increase effectiveness.
    • Industry expertise and specialization are critical to effective risk assessment.
    • Considering fraud risks separately from misstatements due to error, brainstorming and strategic thinking about management’s efforts to commit and conceal fraud all enhance fraud risk assessment effectiveness.
    • Systems dynamics, a methodology for studying and managing complex feedback systems, may provide auditors a framework to assess potential risk.  Authors suggest further examination of this and models in other fields for use in the audit process would be beneficial.
    • Auditor fraud risk assessments may not be well calibrated to the presence of risk factors.  Evidence on the effectiveness of fraud risk decision aids is mixed.
    • Inherent risk assessments (a) often are not meaningfully applied to each assertion; (b) may be decreasing over time, possibly to promote audit efficiency; and, (c) sometimes are combined with control risk into one risk factor.
    • While auditors may respond to global factors (e.g., management integrity, corporate governance) during micro-level risk assessments, proper weighting of global factors is challenging in a fraud context.
    • Testing of and reliance on internal controls have increased markedly in recent years.
    • Limited research suggests subsequent audit testing is weakly positively related to assessed risks, thus supporting efforts to improve linkages.
    • While the audit risk model appears to be sound as a conceptual tool, there are some significant limitations as a mathematical equation. In particular, it does not consider the blurring of inherent risk and control risk, the risk of incorrect rejection, the quality of evidence, or inconsistencies that may exist with actual auditor judgments.

     

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Assessing Risk of Material Misstatement, SAS No. 99 Brainstorming – effectiveness
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  • Jennifer M Mueller-Phillips
    Auditors’ Risk Assessments: The Effects of Elicitation A...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Auditors’ Risk Assessments: The Effects of Elicitation Approach and Assertion Framing
    Practical Implications:

    These results imply that risk assessment approach can have a significant effect on the assessed risk of material misstatement and, thus, on audit program decisions that influence audit effectiveness and efficiency. The existence of assertion framing effects may directly affect the level of professional skepticism and audit effectiveness and efficiency. Both studies indicate that when belief-based assessments are transformed into probabilities, the difference from the direct probability assessments of risk is not significant; thus, obtaining belief-based assessments might make obtaining probability assessments redundant and also has the advantage of providing explicit assessments of ambiguity. 

    Citation:

    Mock, T. J. and H. Fukukawa. 2016. Auditors’ Risk Assessments: The Effects of Elicitation Approach and Assertion Framing. Behavioral Research in Accounting 28 (2): 75 – 84. 

    Keywords:
    auditors’ risk assessment, belief functions, probability, assertion framing, and skepticism.
    Purpose of the Study:

    The primary purpose of this experimental study is to replicate a previous study conducted by the authors, who examine the effects of “risk assessment elicitation approach” and “assertion framing” on auditors’ risk assessments. They find that auditors’ risk assessments differ in some important ways and that auditors’ risk assessments are influenced by assertion framing. However, the generalizability of these findings may be limited due to the use of Japanese practitioners as subjects. This study investigates U.S. practitioners in an attempt to corroborate the previous findings.

                The study focuses on two important factors that are found to affect auditors’ risk assessment judgments in the prior study: the risk assessment elicitation approach and the framing of financial statement assertions being audited. 

    Design/Method/ Approach:

    This study is an experimental replication of Fukukawa and Mock 2011. The risk assessment elicitation approach is manipulated by using scales based on either probability theory or the theory of belief functions. 

    Findings:
    • The authors find that both experimental results show significant “risk assessment approach” effects in the expected directions.
    • The authors find considerable evidence of significant “assertion framing” effects.
    • The authors find that the two risk elicitation approaches result in significantly different risk assessments.
    • The authors find that auditors’ assessed risks are higher; they seem to be more risk-sensitive and exhibit a higher level of professional skepticism when an assertion is stated in a negative way than in a positive way.
    • The authors find that while probability-based risk assessments are higher than belief-based assessments and lower than plausibility assessments, the differences between the two approaches are not significant when the belief-based assessments are transformed into probabilities using a newly proposed method. 
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement
  • Jennifer M Mueller-Phillips
    Client business models, process business risks and the risk...
    research summary posted November 14, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 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:
    Client business models, process business risks and the risk of material misstatement of revenue
    Practical Implications:

    The importance of understanding the operation of a client’s business and its competitive environment to achieve an effective audit is well-known. More specifically, the PCAOB requires that an auditor understand the company’s objectives and strategies and those related business risks that might reasonably be expected to result in risks of material misstatement. Valid understanding also is necessary to both interpret results from analytical procedures and to engage in effective professional skepticism for management’s assertions. The author’s results reveal a previously unreported level of understanding of process-oriented business risks and their association with the RMM of revenue for essentially new staff auditors. 

    Citation:

    Wright, W. F. 2016. Client business, models, process business risks and the risk of material misstatement of revenue. Accounting, Organizations and Society 48: 43-55. 

    Keywords:
    business risk auditing, risk-based auditing, risk assessment, analytical procedures, strategic management, and business models.
    Purpose of the Study:

    There are undeniable benefits for financial auditors to understand a client’s business strategy, strategic objectives and critical business processes, as well as understanding the business risks of a client’s business model during the reporting period. In fact, an inadequate understanding of business risks can result in an audit failure. While business risk auditing continues to be a central framework for auditing, whether auditors can achieve the necessary in-depth understanding of the business risks generated by different strategies and business models remains unclear.  Current research tests for understanding of the theory of business risk auditing, but this author tests the premise that informed graduate students acting as surrogates for staff auditors will understand and implement in their judgments the process risk implications of different business strategies and business models. This should prove important because the existing literature indicates inconsistent results on auditor’s ability to conduct an effective strategic analysis. 

    Design/Method/ Approach:

    The author conducted a 2x2 randomized between subjects design. The participants were all accounting Masters students who were a few weeks from their graduation. These participants were presented with an array of facts, until ultimately deciding which business strategy applied and assessing the performance and the associated business risk of each of the five processes of the case. 

    Findings:
    • The author finds that, with a few exceptions, surrogates for entry-level auditors made the subtle yet important distinctions among process-level business risks given the requirements of two different business strategies.
    • The author finds that the participants were able to report risk assessments for the critical Production process such that the indirect effect of process-specific business risk mediated the direct relationship between judgments of process performance and the RMM of revenue.
    • The author finds that the participants were able to make the distinction between the two different business strategies and could correctly indicate that there is no significant difference in the RMM of revenue for the two strategies when product generation performance was relatively high and business risk was relatively low. 
    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)
  • Jennifer M Mueller-Phillips
    Client business models, process business risks and the risk...
    research summary posted March 22, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Client business models, process business risks and the risk of material misstatement of revenue.
    Practical Implications:

    The study provides evidence on the extent to which auditors can implement the theory of business risk auditing, including the linkages between business strategies, business models, assessment of process-level business risks and the RMM of revenue. The study provides new insights on the ability of auditors to use non-financial information effectively to assess process-level business risks and relate them to RMM of revenue. The study also provides evidence that staff auditors can distinguish between many of the subtle and important business risk implications of the two different types of business strategies  product differentiation and operational excellence.

    Citation:

    Wright, W. F. 2016. Client business models, process business risks and the risk of material misstatement of revenue. Accounting, Organizations and Society 48: 43-55.

    Keywords:
    Business risk auditing, risk-based auditing, risk assessment, analytic procedures, strategic management, business models
    Purpose of the Study:

    This study examines the theory of business risk auditing. Regulators, researchers, and practitioners indicate the importance of understanding the operation of a client’s business and its competitive environment to achieve an effective audit. A valid understanding of a company’s objectives and strategies and those related to the business risks is necessary to interpret results from analytical procedures and engage in effective professional skepticism for management’s assertions. The author focuses process-level (instead of entity-level) business risk assessment and tests for relationships between risk assessments given differing business strategies (product differentiation versus operational excellence) and the fundamental operating processes of a manufacturing firm. Process-specific business risks are important because they can cause misstatements and can cause entity-level business risks.

    Design/Method/ Approach:

    Experimental data was collected from accounting Masters students, a few weeks prior to their graduation. Evidence was collected prior to August 15, 2014. The participants read an introduction on auditor’s risk assessment context then a case describing a client’s strategic orientation, prevailing conditions and competition in the industry, details on the operation of each of the client’s five primary business processes, and the client’s current unaudited financial results with audited results from prior years. Participants provided judgments on which business strategy applied, assessed the performed and associated business risk of each of the five processes, and reported three risk of material misstatement (RMM) assessments.

    Findings:

    Overall, participants indicate business risk and RMM judgments that reflect significant understanding of the subtleties of business risk assessment. Specifically:

    • Participants provided process-specific business risk judgments consistent with RMM judgments for the critical processes of the product differentiation strategy.  
    • The process-specific judgments of business risk link the judgments related to the production process performance and the RMM of revenue.
    • When the three product generation processes were performing less well, participants correctly assessed the highest RMM of revenue.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement
  • Jennifer M Mueller-Phillips
    Construal instructions and professional skepticism in...
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism, 09.0 Auditor Judgment, 09.02 Documentation Specificity, 11.0 Audit Quality and Quality Control, 11.09 Evaluation of Evidence 
    Title:
    Construal instructions and professional skepticism in evaluating complex estimates.
    Practical Implications:

    The findings of this study have important implications for practice. Given the concern from the PCAOB regarding auditors’ lack of professional skepticism, this paper finds a mechanism to increase and improve the level of professional skepticism. In addition, the technique the author finds (providing high-level construal instructions) to auditors is “simple to use, inexpensive, and can easily be tailored for a firm’s specific needs or language

    Citation:

    Rasso, J.T. 2015. Construal instructions and professional skepticism in evaluating complex estimates. Accounting, Organizations and Society 46: 44-55.

    Keywords:
    professional skepticism, material misstatement, auditor judgment
    Purpose of the Study:

    The purpose of this study is to examine whether instructing auditors to create summaries of their audit findings during evidence evaluation in a broad/abstract manner (creating high-level construals) increases professional skepticism. Theoretical research suggests that using these high-level construals (or interpretations) helps individuals to process and understand numerous pieces information. The author suggests that this method could help auditors to ‘see the big picture’, which could help identify patterns in the evidence or possible material misstatements. Then, auditors may be more willing to gather and evaluate additional evidence to test for these potential problems.

    Design/Method/ Approach:

    Data for this paper was collected prior to April 2015 by using a computerized experiment. Auditors were used as participants in the study, and they averaged 5.4 years of audit experience (ranging from staff auditor to partner). In addition, ninety percent of the auditors had audited fair value estimates in the past.

    Findings:

    Auditors that were given documentation instructions to create high-level construals were more likely to exert professional skepticism compared to auditors given low-level construals (identifying specifically how an estimate could be fairly stated or misstated) or auditors given no instructions. Specifically, they spent more time collecting and evaluating audit evidence, collected more evidence, and rated the risk of the fair value estimate higher. These findings suggest that auditors using the high-level construal instructions process the information from their findings better and recognize a need to gather more evidence when given an incomplete amount of evidence. In addition, when evidence suggests that the fair value is overstated, auditors given the high-level construal instructions are more likely to realize the high risk.

    Category:
    Audit Quality & Quality Control, Auditing Procedures - Nature - Timing and Extent, Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Auditors’ Professional Skepticism, Documentation Specificity, Evaluation of Evidence
  • Jennifer M Mueller-Phillips
    Detecting and Predicting Accounting Irregularities: A...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.02 Fraud Risk Models, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Detecting and Predicting Accounting Irregularities: A Comparison of Commercial and Academic Risk Measures
    Practical Implications:

    The results of this study should be useful to research practitioners, regulators, investors, auditors (internal and external), managers, boards of directors, and analysts.  Academic researchers who study fraud or aggressive financial reporting should also be interested in understanding which risk measures have the highest statistical power and construct validity.  One clear advantage of the academic risk measures is that, unlike commercially developed risk measures that are proprietary by nature, researchers know all of the inputs to the academic measures.  On the other hand, studies that need an overall estimate of ex ante financial reporting risk or studies with small or limited sample sizes are likely to benefit the most from using comprehensive, commercially developed risk measures like AGR due to its improved statistical power.

     

    For more information on this study, please contact David A. Wood.

    Citation:

    Price III, R. A., N. Y. Sharp, and D. A. Wood. 2011. Detecting and predicting accounting irregularities:  A comparison of commercial and academic risk measures. Accounting Horizons 25 (4): 755-780

    Keywords:
    Accounting irregularities, detecting fraud, predicting fraud, risk measures, commercial risk ratings
    Purpose of the Study:

    A substantial body of academic research is devoted to developing and testing risk proxies that detect accounting irregularities but the academic literature has paid little attention to commercially developed risk measures.  The authors compare the commercially developed Accounting and Governance Risk (AGR) and Accounting Risk (AR) measures with academic risk measures to determine which best detects financial misstatements that result in: (1) Securities and Exchange Commission enforcement actions; (2) egregious accounting restatements; and (3) shareholder lawsuits related to accounting improprieties.  By making this comparison, the authors provide evidence concerning which metrics among the academic and commercial measures have the greatest ability to detect accounting irregularities and, second, to provide insight on the attribute of superior risk metrics. The authors of this paper also include relatively new academic risk measures that were unavailable for examination in prior studies that compared academic risk measures. 

    Design/Method/ Approach:

    The research sample data is based on the set of firms in Compustat from 1995 to 2008.  Data was obtained from several additional sources, including the Center for Research on Security Prices, Audit Analytics, and Audit Integrity.  The AGR measure is produced commercially by Audit Integrity to estimate the likelihood that reported financial information includes elements that are misleading or fraudulent.  Multivariate logistic regressions were run to test the detective and predictive ability of the measures.

    Findings:
    • The authors find the commercially developed risk measure AGR is useful as a proxy for the risk of accounting irregularities.
    • In comparisons between AGR and academic risk measures, the authors find that AGR performs as well as or better than academic risk measures in all comparisons.
    • The authors find that among the academic risk measures, accrual estimation errors and unexplained audit fees appear to perform the best.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Fraud Risk Models

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