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  • The Auditing Section
    Differences in Industry Specialist Knowledge and Business...
    research summary posted May 7, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Differences in Industry Specialist Knowledge and Business Risk Identification and Evaluation
    Practical Implications:

    The findings in this study are not intended to undermine the benefits of specialization in generic industries. Rather, they serve to highlight the importance and impact that specializing across differing industries has on auditor knowledge and experience.  From a
    practical perspective, the results of this study provide audit firms insights into the possible effects experience from industries of varying complexity has on auditors’ abilities to evaluate audit risks.  The results highlight the challenges in simply grouping industry specialists homogeneously, as the benefits accruing to specialists may vary depending on the nature and complexity of the industry.

    Citation:

    Moroney, R., and R. Simnett. 2009.  Differences in Industry Specialist Knowledge and Business Risk Identification and Evaluation.  Behavioral Research in Accounting 21(2): 73-89.

    Keywords:
    Behavioral decision theory; industry specialization; business risks
    Purpose of the Study:

    Prior literature has reported that auditors who are considered industry specialists outperform non-specialists on tasks within their area of expertise.  Noting that not all industries are the same, the authors build on this prior literature to examine the relative performance gains between auditors specializing in a complex (pension fund) industry vs. generic (manufacturing) industry.  Below are the primary objectives that the authors address in their study: 

    • The authors argue that the nature of a complex industry causes a specialist to possess a more developed sub-specialty knowledge base compared to his/her counterpart specializing in a generic industry.  In response, it is believed that the complex industry specialist will outperform the generic industry specialist in identifying appropriate business risks, within their respective industries.
    • The authors additionally examine information-gathering attributes. Specifically, they argue that complex industry specialists will 1) list more appropriate information sources, 2) list more appropriate evidence gathering processes, and 3) will list more appropriate accounts and related assertions when compared to generic industry specialist auditors.
    Design/Method/ Approach:

    An experiment, which uses Big 4 auditors ranging in experience from 2 to 27 years, is conducted. The average experience levels of the auditors are 5.2 and 4.6 years, respectively, for the complex and generic industry specialists. This data was collected in Australia, prior to 2009. Two expert panels of Big 4 industry specialists (one from each industry) were involved in the development of the experimental materials.  

    Findings:
    • Complex industry specialists (i.e., pension fund auditors) were able to list relatively more business risks when working in their industry than generic industry specialists (i.e., manufacturing auditors) were able to in their respective industry.
    • Complex industry specialists, working in their industry, were able to list a greater number of appropriate information sources and appropriate evidence gathering processes, compared to their generic industry peers. However, they were not able to list a greater number of accounts or related assertions.
    Category:
    Client Acceptance and Continuance, Audit Team Composition, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Business Risk Assessment (e.g. industry - IPO - complexity), Industry Expertise – Firm and Individual, Assessing Risk of Material Misstatement
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  • The Auditing Section
    Discussion of: “The Importance of Account Relations when R...
    research summary posted May 7, 2012 by The Auditing Section, 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, 08.01 Substantive Analytical Review – Effectiveness 
    Title:
    Discussion of: “The Importance of Account Relations when Responding to Interim Audit Testing Results”
    Practical Implications:

    Bedard’s (2006) discussion of Vandervelde (2006) reinforces the fact that auditors do incorporate the relationships among accounts in their responses to increases in misstatement risk.  He also suggests that it is important to consider how this pattern maps to auditors’ risk assessments at the financial statement assertion level.  His discussion emphasizes that in response to fee pressure, auditors may shift planned audit hours between accounts (i.e., from low risk areas to high risk areas), rather than increasing overall planned audit hours.  Finally, despite Bedard’s (2006) caveat that this result could be due to auditor self-presentation concerns or a change in the mix of audit procedures that does not result in increased hours, it is important to note that auditors do not appear to reduce planned audit hours in response to fee pressure – and that this could reflect auditors’ cognizance of the heightened importance that investors and the market currently placed on the role of auditing.

    Citation:

    Bedard, J. 2006. Discussion of: “The Importance of Account Relations when Responding to Interim Audit Testing Results”. Contemporary Accounting Research. 23(3): 823 – 831.

    Keywords:
    Account relations, audit planning, interim evidence, profit pressure, auditing procedures - nature, timing, and extent
    Purpose of the Study:

    This study is a conference discussion of Vandervelde (2006).  The purpose of the discussion is to critically analyze the motivation, hypotheses, experimental design, results, and implications of Vandervelde (2006).  Please see the summary of Vandervelde (2006) for further details.  

    The discussant first reviews research on risk-based auditing. The discussant believes that Vandervelde (2006) is studying an important aspect of the audit by examining how auditors incorporate relationships between accounts in their audit testing. Regarding Vandervelde’s (2006) predictions, the discussant believes that Vandervelde’s (2006) hypotheses could more accurately reflect the mathematical model’s predictions. The following points illustrate the primary differences between the expectations in Vandervelde (2006) and Bedard (2006).

    • In response to Vandervelde’s (2006) prediction that the increase in planned audit hours as the severity of the problem increases is greater for related vs. unrelated accounts, the discussant observes auditors may compensate for increased hours in higher risk areas of the audit with decreased hours in lower risk areas of the audit, which explains why prior studies find that auditors do not always respond to risk.  
    • Contrary to Vandervelde (2006), the discussant suggests that the increase in planned audit hours for low-relatedness accounts is not mitigated by fee pressure; rather there is a decline in planned audit hours, which is heightened by fee pressure.
    Design/Method/ Approach:

    The discussant reviews and provides suggestions for Vandervelde’s (2006) motivation, hypotheses, experimental design, and results.  The discussant also integrates Vandervelde (2006) in the context of prior research and suggests avenues for future research.

    Findings:
    • The discussant observes that Vandervelde’s (2006) findings suggest that auditors do consider the relationship between accounts, as planned audit hours increase for accounts related to the account where the problem was discovered and do not materially change for nonrelated accounts. 
    • The discussant states that Vandervelde’s (2006) finding that profit pressure does not influence auditors’ response to increases in risk is consistent with the market scrutiny on audit quality spurring audit firms to decrease emphasis on profit pressure.  However the discussant also observes that this finding could have been an artifact of the experimental design of the study, as auditors may have been reluctant to show that they are affected by profit pressure.  Further, this result suggests that auditors may change the mix of audit procedures for an account to address increases in risk, rather than changing the planned hours for that account.   
    • The discussant suggests that it could be informative to examine how auditors react to risks at the assertion level, rather than the account level. He suggests that accounts can be classified as “derived” vs. “generating transactions”, which can assist in mapping to assertions.  In Vandervelde’s (2006) context, the purchases account would be classified as “generating transactions”, while accounts payable and inventory are classified as “derived” (from purchases on account/disbursements and purchases/sales, respectively).  Thus, loss of documents would suggest issues with the completeness assertion for purchases, accounts payable and inventory.  The loss of documents should prompt an auditor to adjust audit procedures related to completeness, but not other assertions.
    Category:
    Risk & Risk Management - Including Fraud Risk, Auditing Procedures - Nature - Timing and Extent
    Sub-category:
    Assessing Risk of Material Misstatement, Substantive Analytical Review – Effectiveness
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  • Jennifer M Mueller-Phillips
    Do Critical Audit Matter Paragraphs in the Audit Report...
    research summary posted February 16, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.01 Changes in Reporting Formats, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Do Critical Audit Matter Paragraphs in the Audit Report Change Nonprofessional Investors’ Decision to Invest?
    Practical Implications:

    This paper provides the first evidence on the effect of proposed CAM paragraphs on investor decision making, thus informing the PCAOB’s proposed standard. The results indicate that including CAM paragraphs in audit reports provides useful information for well-informed, nonprofessional investors. However, regulators should also be aware that providing the resolution to the CAM seems to mute investors’ concern about the issue raised in the CAM.

    For more information on this study, please contact Professor Brant Christensen.

    Citation:

    Christensen, B. E., S. M. Glover, and C. J. Wolfe. 2014. Do Critical Audit Matter Paragraphs in the Audit Report Change Nonprofessional Investors' Decision to Invest? Auditing: A Journal of Practice & Theory 33 (4): 71-93.

    Keywords:
    Audit report, critical audit matter, nonprofessional investors, estimation uncertainty, audit assurance
    Purpose of the Study:

    Both U.S. and international standard setters have recently proposed changes to the standard audit report, including a requirement to include a critical audit matter (CAM) paragraph. These paragraphs are intended to discuss those items encountered during the audit that required significant auditor judgment or that posed difficulty to the auditor in obtaining sufficient audit evidence. However, it is unclear whether or how investors will use this additional information when making investment decisions. This paper examines how nonprofessional investors react to an audit report’s CAM paragraph that is centered on the audit of fair value estimates. Specifically, the authors examine how investors’ investment decisions are affected by 1) the inclusion of a CAM paragraph in the audit report (i.e., an information effect) and 2) the location of the CAM paragraph information in the audit report versus the footnotes (i.e., a source credibility effect). In additional analysis, the authors also examine the effect of recognizing estimation uncertainty on the face of the financial statements as well as conveying the resolution of the critical audit matter in the audit report. The findings of the paper should be of interest to regulators and standard setters as they consider the feasibility of CAM paragraphs and whether and how to convey the resolution of critical audit matters.

    Design/Method/ Approach:

    In 2013, the study used Qualtrics.com to host the experiment. The authors used alumni from a large, public university’s business school as nonprofessional investors, analyzing responses from those individuals with experience investing in individual stocks and reviewing financial statement information.

    Findings:
    • The authors find that investors who receive a CAM paragraph are more likely to change their investment decision than are investors who receive a standard audit report (an information effect) or investors who receive the same CAM paragraph information in management’s footnotes (a source credibility effect).
    • Further, the authors find that investors who receive a CAM paragraph are more likely to stop considering the company as an investment than are investors provided with the resolution of the critical audit matter in the audit report.
    • The authors also find that disclosure of estimation uncertainty through a CAM paragraph has an effect on investor decision making that is indistinguishable from the effect of formally recognizing estimation uncertainty in the income statement.
    • Finally, using path analysis, the authors find that the effect of the CAM paragraph on investor decision making emanates from ease of information assessment, thus making investors more aware of the uncertainty.
    Category:
    Risk & Risk Management - Including Fraud Risk, Standard Setting
    Sub-category:
    Assessing Risk of Material Misstatement, Changes in Reporting Formats, Changes in Reporting Formats
  • Jennifer M Mueller-Phillips
    Documentation Requirements and Quantified versus Qualitative...
    research summary posted September 19, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 09.0 Auditor Judgment, 09.02 Documentation Specificity, 09.12 Impact of potential post-audit review - e.g., PCAOB, internal firm inspections 
    Title:
    Documentation Requirements and Quantified versus Qualitative Audit Risk Assessments
    Practical Implications:

    This study should be of interest to both regulators and audit firms.  In the future, standard setters should consider how natural human behavior may result in unintended consequences.  By considering psychology, standard setters may be able to write the standards in a way to minimize those potential consequences or at least be aware of the risks. 
        This study should also be of interest to audit firms because current auditing standards are neutral with respect to whether audit documentation of risk assessments are performed quantitatively or qualitatively.  This implies that either option is adequate and treats the potential costs as minor.  As risk assessments that are more lenient in nature tend to lead to fewer audit procedures and less substantive evidence, the costs may be more than inconsequential. 

    For more information on this study, please contact M. David Piercey.
     

    Citation:

    Piercey, M. D. 2011. Documentation Requirements and Quantified versus Qualitative Audit Risk Assessments. Auditing: A Journal of Practice & Theory 30 (4):223-248.

    Keywords:
    quantitative versus qualitative audit risk assessments; elastic re-definition; documentation requirements
    Purpose of the Study:

    The purpose of this study is to examine whether there are any potential unintended consequences that result from Auditing Standard No. 3 (AS3) – Audit Documentation, which requires auditors to document most judgments.  The intent of AS3 is to improve documentation so that it is easier to inspect the firms’ working papers and understand what was done and why.  The expectation is that due to the increased potential scrutiny from reviewers (e.g., PCAOB review or litigation) the added documentation will cause auditors to improve their judgments and increase their levels of objectivity and professional skepticism.   
    This study looks at auditor risk assessments, which, according to the standard, can be documented quantitatively (i.e., using numerical assessments) or qualitatively (i.e., using worded assessments).  The author is concerned that if an auditor has a preference to arrive at a conclusion that is client-preferred and more lenient, the added documentation requirements will cause auditors to be even more lenient than if they were not required to meet these new documentation requirements.  This would be contrary to what one would expect given the potential risk of the firm opening itself up to liability in the event of review or litigation.
     

    Design/Method/ Approach:

    The author conducted an experiment including auditors of all ranks from 2 large accounting firms and senior accounting students prior to May 2011.  The experiment manipulated two factors (documentation requirements and response mode).  Participants were asked perform a risk assessment of material misstatement in one of three ways (one of which is quantitative and two are qualitative).  Then participants were told whether or not their assessment was going to be documented (or not) in the working papers and thus be subject to potential PCAOB review.  

    Findings:
    • The author finds that when auditors are required to document risk assessments and assess risk in qualitative terms, they are more apt to be even more lenient when they have pressures to provide a client-preferred assessment.  The qualitative terms seem to allow auditors to rationalize the more lenient judgments.
    • When using quantitative assessments, the author does not find similar results.  There is no difference in these judgments regardless of whether auditors are required to document their judgments in working papers or not.
    • These findings are not unique to auditors.  Humans, in general, assess risk differently when they are doing so with words instead of numbers. 
       
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Documentation Specificity, Impact of potential post-audit review (e.g. PCAOB - internal firm inspections)
  • Jennifer M Mueller-Phillips
    Does Auditor Explanatory Language in Unqualified Audit...
    research summary posted March 30, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk?
    Practical Implications:

    The results suggest that explanatory language modifications, although less apparent than opinion qualifications, are informative of misstatement risk.  Under the present-day audit reporting requirements, auditors do communicate some risk-related information to financial statement users.  This finding had implications for standard-setters who are currently considering revising the audit reporting model to make future audit reports more informative.  The authors also highlight that auditors use unqualified audit reports to indicate heighted risk, building upon findings from prior research showing that auditors use going concern explanatory language to communicate risk.

    Citation:

    Czerney, K., J. Schmidt, and A. Thompson. 2014. Does auditor explanatory language in unqualified audit reports indicate increased financial misstatement risk? The Accounting Review, 89 (6): 2115–2149.

    Keywords:
    explanatory language; audit opinions; financial misstatements
    Purpose of the Study:

    Investor advocates believe the present-day auditor’s report is boilerplate and uninformative.  However, over 60% of audit opinions in the authors’ sample make use of explanatory language within an unqualified audit opinion to emphasize matters to financial statement users.  According to professional standards, explanatory language should not affect the auditor’s unqualified opinion on the financial statements and theoretically should not be indicative of increased financial statement risk.  But because the Securities and Exchange Commission (SEC) precludes publicly traded companies from releasing financial statements with any audit opinion except unqualified, adding explanatory language is the auditor’s only practical mechanism to communicate risk, and often is the only distinguishing feature among audit reports.  The purpose of this study is to:

    • Determine if financial statements accompanied by unqualified audit reports with explanatory language are more likely to be subsequently restated than those without explanatory language,
    • Investigate whether the likelihood of subsequent restatement differs based on the type of explanatory language, and
    • Examine whether the financial statement accounts referenced in auditor explanatory language are the financial statement accounts subsequently restated.
    Design/Method/ Approach:

    Using data from publicly-traded companies in the United States over the time period from 2000-2009, the authors investigate the association between opinions with explanatory language and the likelihood that the corresponding financial statements are subsequently restated.  The authors then classify audit opinions by the type of explanatory language based on Auditing Standard AU Section 508 into four categories: (1) Inconsistency with previously issued financial statements, (2) ‘‘Emphasis of matters’’ in financial reports, (3) Audit-related information, and (4) Other language to determine if the likelihood of subsequent restatement differs based on the type of explanatory language.  Finally, the authors conduct an additional analysis to examine whether the financial statement accounts referenced in the explanatory language are those most likely to be subsequently restated.

    Findings:

    The authors report the following findings:

    • Financial statements that have audit opinions with explanatory language are more likely to be subsequently restated than those with audit reports without explanatory language, but this association is limited to certain types of explanatory language.
    • Specifically, they find that a subsequent restatement is more likely if the auditor emphasizes inconsistency with previously issued financial statements by referencing changes in accounting principles and previous restatements in the audit report.
    • However, financial statements whose audit reports include other types of inconsistencies, such as references to fresh-start accounting or use of a non-GAAP accounting basis, are less likely to be subsequently restated.
    • The likelihood of subsequent restatement is higher for financial statements with audit reports that include ‘‘emphasis of matter’’ language referencing mergers, related-party transactions, and management’s use of estimates, but only if the restatement relates to the same account referenced in the explanatory language.
    • A subsequent restatement is more likely if the auditor divides responsibility for the opinion, but not for any other type of audit-related explanatory language.
    • The authors do not find an association between subsequent restatements and explanatory language that references supplemental information, going concern, and/or financial distress.
    • The financial statement accounts discussed in the explanatory language correspond to the financial statement accounts subsequently restated.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Restatements
  • Jennifer M Mueller-Phillips
    Fear and Risk in the Audit Process
    research summary posted November 24, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind, 11.0 Audit Quality and Quality Control, 11.03 Management/Staff Interaction 
    Title:
    Fear and Risk in the Audit Process
    Practical Implications:

    Our analysis of fear helps better understand the relationship between comfort, confidence and fear in the audit process from the perspective of risk. On one hand, it suggests that confidence (self-confidence, confidence in work instrument and confidence in colleagues) without fear is a risky cocktail for auditors, who will not be sufficiently vigilant in carrying out their mission. On the other hand, it shows that fear without confidence is also a dangerous combination, which may induce auditors to maintain at a distance (and thus ignore) the inherent risks of their responsibilities. Ultimately, a sense of fear curbed by confidence and a sense of confidence tempered by fear is what enables public accountants to develop their ‘practical intelligence’, and thus to become comfortable without overlooking the risks of their job. Accordingly, the main implication which falls out of our study is the necessity for audit firms and audit regulators to create the conditions for the development among auditors of the right mix of fear and confidence.

    For more information on this study, please contact Henri Guénin-Paracini.

    Citation:

    Guénin-Paracini, H., Malsch B. and A. Paillé-Marché. 2014. Fear and risk in the audit process. Accounting, Organizations and Society 39 (4): 264-288

    Keywords:
    Auditors, audit process, fear, risk, practical intelligence, defensive strategies
    Purpose of the Study:

    While a number of studies have highlighted the role played by the feeling of comfort in audit work, comfort, in real audit settings, only arises at the very end of the audit task. The rest of the time, auditors seek to feel comfortable, but are inhabited primarily by fear. This became apparent to us in the course of an ethnographic study aimed at better understanding the work performed by auditors in the field. Of course, fear is not experienced by auditors all day long; it varies in intensity from individual to individual and depending on the circumstances; however, in general, public accountants have to deal with this emotion. If one considers that fear is the emotional experience of risk, this should hardly come as a surprise. In the post-Enron climate and after the enactment of the Sarbanes-Oxley Act, the risks associated with auditing have increased dramatically. Yet, associated with the perception of risk, the experience of fear and the role that fear plays in risk management processes have largely been overlooked in the literature. Our paper aims to ‘emotionalize’ and challenge the dominant cognitive orientation adopted by academics and regulators in their understanding of audit risks and auditors’ skepticism. It seeks better understand the role played by fear in audit practice, focusing specifically on the following questions: 1) What exactly is it that auditors worry about? 2) How do auditors manage fear in the field? 3) How does fear shape, and how is it shaped by, auditors’ work activity?

    Design/Method/ Approach:

    The research evidence was collected as part of a field study.

    • Seven audit teams including nine partners, five managers, 11 seniors and 19 assistants, were monitored in real time in June and July 2002 and between November 2003 and July 2004 (455 hours of observation).
    • Numerous documents were examined.
    • Interviews were conducted with four partners, three managers, eight seniors and 16 assistants.

    The psychodynamics of work theory of Dejours was used to interpret the data.

    Findings:
    • Confronted with technical knowledge and methodological standards’ limitations, auditors are nevertheless asked to certify the unknowable (i.e. to turn uncertainties into quasi certitudes), while being often reminded by the media that a failure on their part can have serious consequences. This ‘impossible mission’ creates fear within them. They are afraid of not detecting significant anomalies (a risk always present in auditing), and feel anxious about the judgments that they and others may pose over their possible mistakes.
    • Auditors manage their fear in two different ways. On one hand, they cultivate it through informal and formal techniques to stimulate vigilance, encourage self-surpassment, mitigate the ‘anesthetizing’ effect of habit, and maintain reputation. On the other hand, they strive to alleviate their fear before the end of each audit engagement, in order to convey their conclusions with a certain degree of comfort.
    • In the field, auditors finally become comfortable (i.e. quell their fear) either by mobilizing their ‘practical intelligence’ (which helps them handle that which, in their mission, cannot be obtained through the strict execution of standardized procedures) or by adopting defensive strategies (such as distancing themselves from work-related problems, mechanically applying audit methodologies, or relaxing their conception of a job well done). 

     

    Category:
    Audit Quality & Quality Control, Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Management/Staff Interaction, Prior Dispositions/Biases/Auditor state of mind
  • Jennifer M Mueller-Phillips
    How Do Audit Workpaper Reviewers Cope with the Conflicting...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 11.0 Audit Quality and Quality Control, 11.01 Supervision and Review – Effectiveness, 11.06 Working Paper Review – Conduct, Biases and Predispositions 
    Title:
    How Do Audit Workpaper Reviewers Cope with the Conflicting Pressures of Detecting Misstatements and Balancing Client Workloads?
    Practical Implications:

    These findings have implications for both practice and future research. For example, the PCAOB has raised questions about (1) the thoroughness with which engagement managers and partners review audit documentation, and (2) the extent to which their attention to engagements reflects audit-related risks. Further, the IFAC has acknowledged that reviewers in today’s audit environment have alternative ways in which to conduct their reviews, and prior research suggests that the choice of review format has implications for audit. The results presented here advance the understanding of the factors that influence this choice. The findings provide insight to firms, regulators, and inspectors regarding the impact of workload pressure and misstatement risk on how audit managers and partners conduct their reviews. These issues are increasingly relevant given recent changes to the regulatory environment.

    Citation:

    Agoglia, C. P., J. F. Brazel, R. C. Hatfield, and S. B. Jackson. 2010. How Do Audit Workpaper Reviewers Cope with the Conflicting Pressures of Detecting Misstatements and Balancing Client Workloads? Auditing: A Journal of Practice & Theory 29 (2): 27-43.

    Keywords:
    audit quality, electronic communication, face-to-face interaction, misstatement risk, review process, workload pressure
    Purpose of the Study:

    This study examines how risk of misstatement and workload pressure affect audit workpaper reviewers’ choice of review format. Recently, auditors have witnessed a number of changes in their regulatory environment that have increased their workloads. The advent of electronic communication and electronic workpapers has provided auditors with the means to alleviate certain pressures on firm resources. Electronically reviewing workpapers and transmitting review notes can ease scheduling issues and reduce reviewer travel time as it permits reviewers to review multiple jobs concurrently and from a remote location. However, prior research suggests that face-to-face communication during review has the potential to improve audit quality. Concerns over the effectiveness of reviews are highlighted by recent PCAOB inspections which raise questions about how engagement risk impacts the thoroughness of the review process. Further, the International Federation of Accountants (IFAC) acknowledges current alternatives available to reviewers and advises that explicit consideration be given to the review format choice during the audit planning process. While prior research has concentrated on the impact and extent of review, the study contributes to the literature by focusing on the choice between alternative review formats.

    Design/Method/ Approach:

    The authors surveyed twenty-three practicing auditor managers and partners to learn their beliefs about in-person and electronic communication during review. Seventy-eight percent of survey participants were from international firms, while 22 percent were from large regional firms. For the authors experiment participants were 60 practicing auditors from international, national, and large regional firms. They were primarily managers (43 percent) and partners (50 percent) with an average of 14.5 years of experience. Evidence was gathered prior to July 2009.

    Findings:

    Results of the survey suggest that reviewers view in-person interaction during review as more effective and electronic interaction as more convenient. In addition, reviewers report that they use electronic and in-person communication for roughly an equal proportion of their reviews. Results of the experiment indicate that risk of misstatement and workload pressure interact to affect participants’ review mode choices. Misstatement risk moderates the effect of workload pressure such that, when risk is high, the effect of workload pressure is effectively eliminated. These findings suggest that reviewers perceive reviews involving face-to-face interaction to be more appropriate when effectiveness of procedures is essential to ensure an acceptable level of audit quality and, when risk conditions allow, consider electronic review to be a practicable way to cope with workload pressures associated with a hectic client schedule.

    Given the survey and experimental results, the authors conclude that reviewers will choose to sacrifice convenience when higher risk calls for employing a more effective review format. They document a relationship between risk and review format. Therefore, the authors are able to shed light on how auditors are concurrently reacting to the pressures of client risk and balancing a portfolio of clients while maintaining audit quality.

    Category:
    Audit Quality & Quality Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Engagement Quality Review – Processes & Effectiveness, Working Paper Review – Conduct - Biases & Predispositions
  • The Auditing Section
    Integrating business risk into auditor judgment about the...
    research summary posted May 4, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Integrating business risk into auditor judgment about the risk of material misstatement: The influence of a strategic-systems-audit approach
    Practical Implications:

    The authors’ results indicate that audit methods like SSA help auditors see the connection between business risks and the risk of material misstatement and consider business risk in their assessments about the risks of material misstatement better.  The authors also indicate their results generally support the idea that when a mismatch arises between audit training and audit task structures, processing limitations are likely to occur (i.e. auditors will be less likely to effectively integrate business risk assessments with their assessment of RMM if they are trained in SSA but are not provided information in SSA format).

    Citation:

    Schultz Jr., J. J., J. L. Bierstaker, and E. O’Donnell. 2010.  Integrating business risk into auditor judgment about the risk of material misstatement: The influence of a strategic-systems-audit approach.  Accounting, Organizations, and Society 35 (2):  238-251. 

    Keywords:
    Risk and Risk Management, including fraud risk; business risk
    Purpose of the Study:

    The purpose of this study is to test whether the firms’ use of a strategic-systems approach (SSA) or a transaction-focused approach (TFA) influences the likelihood that auditors will integrate business risk judgments into their judgments about the risk of material misstatement (RMM) as required during the planning phase of the audit.  SSA focuses on business processes and evaluating key performance indicator benchmarks before analyzing accounting metrics to find conditions that increase the likelihood of misstatement, whereas TFA focuses on transaction cycle relationships. The argument is that SSA may improve audit effectiveness over use of TFA by considering business processes that drive financial performance and integrating nonfinancial benchmarks.

    Design/Method/ Approach:

    The authors used a laboratory experiment on experienced, staff-level auditors from different firms who had been trained in and used either SSA or TFA.  SSA auditors were from one US firm that used SSA and the TFA group was from Canadian graduate accounting students who had auditing experience through co-operative working arrangements completed during their junior and senior years from international firms using TFA.  Participants were asked to review background information and provide initial RMM at the overall level as well as for four individual accounts. Then participants were asked to learn about a client’s business processes, evaluate key performance indicators, and document the level of business risk. Finally, they were asked to evaluate RMM for the same four accounts and overall and to document the reasons for their decisions.

    Findings:
    • Auditors who were trained in SSA and were provided information in the SSA format integrated business risk into their judgments about RMM.
    • Auditors who were not trained in SSA or did not use the SSA format did not integrate business risk into their judgment about RMM as effectively.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement
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  • Jennifer M Mueller-Phillips
    Managing Audits to Manage Earnings: The Impact of Diversions...
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 06.06 Earnings Management 
    Title:
    Managing Audits to Manage Earnings: The Impact of Diversions on an Auditor’s Detection of Earnings Management.
    Practical Implications:

    Diversions can have important practical implications beyond the setting of deliberate earnings management. Managers may divert auditors from higher risk areas to accounts that they believe are not at risk of misstatement. The findings suggest that auditors would be susceptible to these diversions as well. However, to the extent that errors can occur anywhere, managers might mistakenly direct auditors’ attention to an area with errors, which could backfire on managers. Even more broadly, managers may inadvertently direct auditors’ attention from an account that materially misstates earnings to another account that does not. No matter the cause of the diversion, the results demonstrate that such diversions significantly influence an auditor’s detection of a material misstatement of earnings elsewhere in the financial statements. 

    Citation:

    Luippold, B. L., Kida, T., Piercey, M. D., & Smith, J. F. 2015. Managing audits to manage earnings: The impact of diversions on an auditor’s detection of earnings management. Accounting, Organizations & Society (41):39-54.

    Keywords:
    earnings management, audit management, decision making, material misstatements
    Purpose of the Study:

    This study discusses an aspect of earnings management called audit management. The authors define audit management as a client’s strategic use of diversions to decrease the likelihood of auditors discovering managed earnings during the audit. Evidence from prior studies suggests that managers strategically attempt to conceal earnings management. This study investigates whether managers who manipulate earnings can successfully employ diversions to influence auditors’ detection of unusual fluctuations during analytical review. That is, the authors investigate whether diversionary statements made by the client (i.e., identifying areas of risk in the financial statements to lure the auditor away from managed earnings) affect an auditor’s detection of managed earnings contained elsewhere in the financial statements.

    Managers may be motivated to divert auditors to areas that contain, or do not contain, other errors. If managers point auditors to ostensibly risky areas that are clean, auditors may conclude that the client’s accounts are likely to be accurate in other areas as well. Conversely, management may want to direct auditors to areas that contain other errors, thinking that these other errors may occupy their attention, leading auditors to feel satisfied that they are detecting misstatements, resulting in auditors feeling less compelled to discover other errors. However, auditors are also trained to practice professional skepticism, and the diversion to the other errors should elevate their sensitivity to the risk of material misstatement in the remainder of the financial statements, resulting in greater overall audit effort and a greater likelihood that they would find the earnings manipulation. The authors therefore investigate the impact of management intentionally directing auditors to both clean accounts and accounts containing errors.

    Design/Method/ Approach:

    A representative from each of the Big Four and other audit firms identified auditors with sufficient knowledge to perform the task. Seventy-six auditors, with an average of four years of audit experience, took part in the study. The experiment required that auditors complete analytical review procedures on the financials statements of a hypothetical client. The study employed a 2x2 experimental design. The evidence was collected prior to February 2015.

    Findings:

    The results suggest that diversions to clean accounts and diversions to accounts containing other errors have different effects on auditors’ detection of earnings management. The authors find that auditors’ detection of earnings management was worst when they were diverted to clean financial statement accounts, and best when they were diverted to accounts containing other errors, with earnings management detection in between these levels when no diversions were used (whether other errors were present or not). Overall, these results suggest that if management directs auditors to accounts that contain errors, the discovery of those errors heightens their sensitivity to errors in other areas of the audit. However, if auditors are directed to clean accounts, the use of diversionary statements can deter auditors from finding earnings management. Managers can potentially exploit an audit management tactic as simple as a diversion to a clean area because such a diversion reduces auditors’ effectiveness at detecting earnings management elsewhere in the financial statements.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Earnings Management
  • Jennifer M Mueller-Phillips
    Materiality Guidance of the Major Public Accounting Firms
    research summary posted July 19, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments 
    Title:
    Materiality Guidance of the Major Public Accounting Firms
    Practical Implications:

    Knowledge of how materiality guidance is integrated into a firm’s methodology is important for accounting and auditing researchers as well as for practitioners, regulators, and educators. The last published research that examined the major firms’ policies on materiality occurred in 1998.The results of this study provide important insights into implementation of materiality standards and valuable information for future research and education.

    For more information on this study, please contact Aasmund Eilifsen, aasmund.eilifsen@nhh.no.

    Citation:

    Eilifsen, A., and W. F. Messier Jr. 2015. Materiality Guidance of the Major Public Accounting Firms. AUDITING: A Journal of Practice & Theory 34 (2):3-26.

    Keywords:
    Materiality, tolerable misstatement, misstatements, group audits
    Purpose of the Study:

    Materiality is a key concept for both auditors and managers, as well as for users of financial statements. Audit standard setters have recently issued standards related to materiality. Firms translate such auditing standards into their methodologies. This paper provides evidence on the relative consistency of the materiality guidance among the top eight firms. More specifically, it shows how firms determine multiple levels of quantitative materiality, the firms’ guidance on the incorporation of qualitative factors in determining and evaluating materiality, their guidance on handling detected and undetected misstatements and, finally, how the firms’ guidance determines materiality levels in group audits. The authors aim to provide possible answers to concerns raised by prior researchers and information helpful in designing future research.

    Design/Method/ Approach:

    The materiality guidance for profit-oriented entities of eight of the largest U.S. public accounting firms was analyzed along six dimensions:

    • Benchmarks for determining overall materiality
    • Percentages applied to benchmarks for determining overall materiality
    • Determination of tolerable misstatement
    • Amounts used to determine "clearly trivial" misstatements
    • Use of materiality to evaluate misstatements
    • Use of materiality on group audits.

    Each firm reviewed the coding of its guidance for accuracy and completeness. The firms’ guidance was provided to the researchers through a partner contact who held a senior position in each firm’s assurance/audit group. Firm contacts were sent a research proposal that provided the motivation for the study, the research questions, and the deliverables. The proposals were sent out in Fall 2011 with approval and completion in Spring 2012; coding and firm review occurred in Summer and Fall 2012. At the time of the study, these were the eight firms subject to annual inspections by the PCAOB.

    Findings:
    Overall, the findings indicated relative consistency of the materiality guidance among the eight firms. Specifically:
    • Quantitative benchmarks (e.g., income before taxes, total assets or revenues, and total equity) used to determine overall materiality and the related percentages applied to those benchmarks are reasonably consistent across the eight firms.
    • Seven firms use a percentage of overall materiality for determining tolerable misstatement that fits in a 50 to 75 percent range; one firm uses a range of 70 to 90percent.
    • Seven of the firms establish a clearly trivial misstatement to be 3 to 5 percent of overall materiality; one firm uses a range of 5 to 8 percent.
    • All of the firms provide detailed guidance on the evaluation of detected misstatements including consideration of qualitative factors.
    • Applying materiality on group audits closely parallels the guidance provided in the standards.
    • There are differences in how the firms consider the possibility of undetected misstatements when evaluating uncorrected detected misstatements.
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Audit Scope & Materiality Judgements

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