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  • Jennifer M Mueller-Phillips
    How Do Auditors Address Control Deficiencies that Bias...
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.01 Scope of Testing, 07.02 Assessing Material Weaknesses, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.01 Substantive Analytical Review – Effectiveness 
    Title:
    How Do Auditors Address Control Deficiencies that Bias Accounting Estimates?
    Practical Implications:

    For practice, the authors provide evidence about the relation between control deficiencies and substantive tests in the integrated audit. A significant minority of senior auditors attempt to identify bias in an accounting estimate with increased sampling from the biased estimation process, though they have been told that the estimation process is biased. The authors provide theory consistent empirical evidence that auditors often reach questionable, optimistic judgments about the capability of audit evidence to address control deficiencies. Auditors will often revert to what they know best, and it is difficult to get people to look beyond the familiar, regardless of experience level.

    Citation:

    Mauldin, E. G., & Wolfe, C. J. 2014. How Do Auditors Address Control Deficiencies that Bias Accounting Estimates? Contemporary Accounting Research 31 (3): 658-680.

    Keywords:
    accounting estimates, scarcity, control deficiencies, internal control
    Purpose of the Study:

    According to professional standards, auditors must integrate the internal control and financial statement audits. Revised risk assessment standards were issued, in part, to improve the integration of controls into the financial statement audit. However, PCAOB inspections find that auditors sometimes do not appropriately change the nature, timing, and/or extent of their substantive tests in response to clients’ internal controls. Auditors often have difficulty modifying substantive tests when responding to identified control deficiencies.

    To shed light on the underlying reasons for this difficulty, the authors of this design a contextually rich experimental case and examine how auditors map a control deficiency into modifications of substantive tests. The authors examine control deficiencies that cause errors of omission in an estimation process, resulting in an incomplete and biased estimation process. The focus is on whether auditors recognize the insufficiency of reviewing the biased estimation process and how they select alternative tests to replace or supplement such review.

    Design/Method/ Approach:

    Eighty-seven auditors attending one Big 4 firm’s national training for experienced audit seniors participated in the study. The authors employ a between-participants experimental design with two treatments. The authors describe the treatments in sequence within the experimental task. They then randomly assign participants to experimental treatments and ask them to complete a case study. The evidence was collected prior to September of 2014.

    Findings:
    • A significant minority of senior auditors (33 percent) attempt to identify bias in an accounting estimate with increased sampling from the biased estimation process. Further, they do this after being told that the estimation process is biased.
    • Seeing the falsely favorable substantive test results, on average, does not influence auditors’ tendency to increase sample size.
    • A supplemental sample of 14 managers produces a pattern of responses similar to the main results.
    • When the bias is from externally prepared documents, the authors find that about one-half the auditors (54 percent) choose the more efficient alternative test, adjusting the estimate using documents.
    • When the bias is from management judgment inputs, the authors find that most auditors (63 percent) choose to adjust the estimate using documents, even though this alternative is less effective than developing an auditor-generated estimate.
    • The observed results are not driven by lack of experience with percentage-of-completion accounting.
    • Together, the results suggest that auditors often make inefficient or ineffective alternative test choices depending on the source of omission caused by the control deficiency.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Internal Control
    Sub-category:
    Assessing Material Weaknesses, Scope of Testing, Substantive Analytical Review – Effectiveness
  • Jennifer M Mueller-Phillips
    Training Auditors to Perform Analytical Procedures Using...
    research summary posted February 24, 2015 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.01 Substantive Analytical Review – Effectiveness, 09.0 Auditor Judgment, 09.03 Adequacy of Evidence 
    Title:
    Training Auditors to Perform Analytical Procedures Using Metacognitive Skills
    Practical Implications:

    This research furthers the understanding of auditors’ judgment performance in four important ways. We show that

    • Effective training in metacognitive skills increases auditors’ diagnostic reasoning by enabling them to control and direct their thinking.
    • Training in both divergent and convergent thinking provides significantly better results than only learning to think divergently. Because the former are better able to piece together all necessary facts.
    • The key to performance improvement due to training in both divergent and convergent thinking is a reduction in a psychological mechanism called “consistency checking.” Auditors trained to use both tend to avoid premature elimination of explanations, instead subjecting explanations they generate to subsequent, explicit evaluation. An important implication of this is that for auditors who try to do both kinds of thinking simultaneously rather than sequentially the best explanation for a problem might not be generated or might be prematurely discarded.
    • In the same amount of time that participants in the other training conditions took to arrive at their inferior answers, auditors trained to use both divergent and convergent thinking chose one of the correct solutions more often, generated better explanations, and eliminated more potentially time-wasting invalid explanations.

    For more information on this study, please contact David Plumlee.

    Citation:

    Plumlee, R. D., B. Rixom, and A. Rosman. 2015. Training auditors to perform analytical procedures using metacognitive skills. The Accounting Review 90 (1): 351-369.

    Keywords:
    metacognition; divergent thinking; convergent thinking; training; analytical procedures; ill-structured tasks.
    Purpose of the Study:

    Auditors encounter many ill-structured tasks. Due, in part, to their greater technical knowledge, partners and managers perform these tasks better than less experienced auditors. Partners and managers also have in their memories a diverse set of problem solutions gained from their experience that they can retrieve as needed to organize and solve ill-structured problems. Less experienced auditors do not have access to these additional experiences and may benefit from a more structured approach to thinking while solving ill-structured tasks. We believe that training less experienced auditors in in metacognition—consciously thinking about one’s thought process—will help close the performance gap. We chose to train less experienced auditors to use a sequential thought process comprised of two metacognitive skills: divergent thinking, where they generate explanations for unusual evidence, followed by convergent thinking, where they evaluate explanations generated and eliminate those judged infeasible. Training less experienced auditors in the proper use of these skills was expected to provide them with the problem-structuring knowledge that managers and partners acquire through their frequent encounters with ill-structured situations. 

    Design/Method/ Approach:

    Auditors with approximately two years of experience were randomly assigned to receive training in either divergent and convergent thinking skills, only divergent, or neither (a control). The training included four separate self-paced online sessions over two weeks. At the end of each session, we measured participants’ comprehension of the training and their ability to apply the specific skills addressed in that session. The fourth session synthesized the previous sessions and included a comprehensive analytical review case to measure whether the training resulted in better performance.

    Findings:

    We found that

    • In response to evidence inconsistent with their expectation, auditors who completed both divergent and convergent thinking training increased both the number and quality of explanations for that evidence. They focus more on generating explanations when performing divergent thinking instead of trying to sort out which alternatives ‘‘make sense.”
    • Training in both skills resulted in a greater ability to generate and ultimately choose one of the two viable explanations in the final case. Auditors trained to use both types of thinking had a fourfold higher likelihood of identifying a logically viable explanation compared to those receiving divergent thinking training alone—and a vastly better likelihood than those having neither type.
    • In a supplemental study, we asked participants about the process they used when generating explanations in the final case. Training in only one of these metacognitive skills leads decision makers to eliminate explanations while they are being generated, possibly eliminating a correct explanation.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Auditor Judgment
    Sub-category:
    Adequacy of Evidence, Substantive Analytical Review – Effectiveness
  • Jennifer M Mueller-Phillips
    Design and Evaluation of a Continuous Data Level Auditing...
    research summary posted February 15, 2015 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.01 Substantive Analytical Review – Effectiveness, 08.08 Projecting Interim Testing Conclusions Year End, 08.09 Impact of Technology on Audit Procedures 
    Title:
    Design and Evaluation of a Continuous Data Level Auditing System
    Practical Implications:

    This paper is intended to prompt auditors to take advantage of easier access to population data in today’s digital business environment. By abandoning sampling auditors can develop much more sophisticated models of behavior that can identify anomalies in ways that were not possible before. Auditors can also be more creative in how they treat data, be it in aggregating it across organizational subunits or in larger and smaller time units. Most innovative of all, auditors and/or managers have the ability to continually update their expectation models by investigating errors and anomalies in real time and correcting them, so that the model is not based on flawed data. We find that such error correction greatly improves the accuracy of analytical procedures. Perhaps the most important finding, however, is that almost all the various expectation models we used gave similarly strong results which implies that what really matters is the size of the data set. Once auditors move away from sampling they will find that population data provides great statistical power when developing analytical procedures that reduces the reliance on finding just the right such procedure.

    For more information on this study, please contact Alexander Kogan.

    Citation:

    Kogan, A., M. Alles, M. Vasarhelyi and J. Wu. 2014. Design and Evaluation of a Continuous Data Level Auditing System. Auditing: A Journal of Practice and Theory. 33 (4): 221-245.

    Keywords:
    continuous auditing (CA), analytical procedures (AP), population data, auditing practice.
    Purpose of the Study:

    The purpose of this paper is to demonstrate how audit practice may change when auditors have access to real time population data, how to use real world data to develop APs for CA, and compare different analytical procedures in a CA context. In the paper we develop a framework for a continuous data level auditing system and uses a large sample of procurement data from a major health care provider to simulate an implementation of this framework. The first layer of the framework monitors compliance with deterministic business process rules and the second layer consists of analytical monitoring of business processes. A distinction is made between exceptions identified by the first layer and anomalies identified by the second one. The unique capability of continuous auditing to investigate (and possibly remediate) the identified anomalies in ‘‘pseudo-real time’’ (e.g., on a daily basis) is simulated and evaluated.

    Design/Method/ Approach:

    Our simulated implementation of the data-oriented CA system focuses on the procurement-related BPs and utilizes the data sets extracted from the data warehouse of a healthcare management business with many billions of dollars in assets and close to two hundred thousand employees. The data sets include all procurement cycle daily transactions from October 1st, 2003 through June 30th, 2004.  The number of transaction records for each activity ranges from approximately 330,000 to 550,000. Since we have access to population data, the first step is to undertake tests of details to detect violations of key controls. Once that is done we turn to determining whether there are anomalies that do not violate any established controls but which may be nonetheless indicative of potential problems.

    The implementation of the analytical procedure component of the CA system requires creation of the models of expected behavior to enable anomaly detection which we label “continuity equations” (CE). We use advanced statistical models to extract CE from the data, and then by seeding errors we determine how effectively the CE model identifies anomalies. We also investigate the effect of conducting AP on data aggregated in either time or geographically and also the implication of error correction.

    Findings:

    Our research shows that when auditors have access to population data there can be significant changes in the role and sequence of audit procedures. Since data access is not a constraint, tests of detail can be carried out first on the complete population data to find exceptions to controls and for transaction verification. Then APs can be used, again, on the complete population data, to find anomalies. This paper shows that while there are differences in the predictive ability and detection performance of various CE models, all models perform reasonably well and no single model performs better on all aspects. From this two important conclusions can be drawn: First, the choice of a particular model across the candidate CE models is less important than the fact that all models yield fairly effective AP tests.  Our second conclusion from the fact that all the CE models yield reasonably effective analytical procedures is that when auditors have access to complete transaction data, the richness of that disaggregate data combined with the reorganization of auditing workflow to implement pseudo-real time error correction makes BP problem detection robust across a variety of expectation models. In other words, it is the nature of the data that serves as audit evidence that is the primary driver of audit effectiveness, with the selection of the specific AP a second order concern—not because the audit benchmark is not important, but because auditing at the process level makes anomalies stand out much more obviously in the data.

    Category:
    Auditing Procedures - Nature - Timing and Extent, Auditor Judgment
    Sub-category:
    Evaluation of Errors - Statistical and Non-statistical, Impact of Technology on Audit Procedures Confirmation – Process and Evaluation of Responses, Substantive Analytical Review – Effectiveness
  • Jennifer M Mueller-Phillips
    Auditors’ Reactions to Inconsistencies between Financial a...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.01 Substantive Analytical Review – Effectiveness 
    Title:
    Auditors’ Reactions to Inconsistencies between Financial and Nonfinancial Measures: The Interactive Effects of Fraud Risk Assessment and a Decision Prompt
    Practical Implications:

    The findings suggest that auditors need improvement in the use of NFMs when performing substantive analytical procedures. Also, the findings of this study suggest that a relatively simple and efficient prompt regarding the use of NFMs can improve auditor substantive testing in the important area of revenue recognition. The evidence suggests that auditors are more likely to respond appropriately to a prompt when fraud risk is assessed at high levels. This demonstrates that decision-makers should carefully assess the level of fraud risk that will result in the desired behavior from in-charge senior auditors.

    For more information on this study, please contact Joe Brazel (jfbrazel@ncsu.edu).

    Citation:

    Brazel, J. F., K. L. Jones, and D. F. Prawitt. 2014. Auditors' Reactions to Inconsistencies between Financial and Nonfinancial Measures: The Interactive Effects of Fraud Risk Assessment and a Decision Prompt. Behavioral Research in Accounting 26 (1): 131-156.

    Keywords:
    Analytical procedures, audit, fraud risk, nonfinancial measures
    Purpose of the Study:

    Professional standards, auditing texts, and prior research suggest that external auditors can use nonfinancial measures (NFMs) to verify their clients’ reported financial information. These sources also suggest that an inconsistency between a company’s financial performance and related NFMs represents a potential red flag for financial statement fraud. However, recent research indicates that auditors’ attention to NFMs is insufficient to detect inconsistencies between financial data and NFMs. This paper addresses this concern by investigating factors that affect auditors’ use of NFMs when auditing financial statement data. Specifically, the paper investigates whether auditors’ reliance on NFMs and development of revenue expectations are affected by the following factors:

    • The consistency/inconsistency of NFMs and related financial data
    • The use of a prompt to encourage auditors to use NFM to calculate a revenue expectation
    • The level of fraud risk assessed during planning

    The authors motivate their hypotheses using the Heuristic-Systematic Model from the psychology literature. This model suggests that the contextual features of a judgment affect how an individual processes information. The authors use this theory to suggest that auditors who are prompted to use NFMs might be more likely to use NFMs to set revenue expectations under high fraud risk compared to low fraud risk.

    Design/Method/ Approach:

    The research evidence used in this study was gathered in 2009. In this study, the authors use in-charge senior auditors from a Big 4 firm to complete two experimental tasks. In both experiments, the participants were given access to client information and were asked to develop an expectation for a client’s revenue balance.  The second experiment introduces an NFM prompt and manipulates fraud risk.

    Findings:
    • The authors find that a minority of auditors use NFMs as an information source for performing analytical procedures and report that auditors do not increase their reliance on NFMs when the NFMs point to a fraud red flag in revenue figures.
    • The authors find that the presence of high fraud risk alone does not affect the auditors’ NFM reliance or revenue expectations.
    • The authors find that auditors are more likely to rely on NFMs and question the client’s revenues balance when prompted about how NFMs can be used to develop a revenue expectation.
    • The influence of the prompt on auditor reliance on NFMs and account balance expectations is stronger when fraud risk is assessed as high.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Substantive Analytical Review – Effectiveness
  • Jennifer M Mueller-Phillips
    How a Systems Perspective Improves Knowledge Acquisition and...
    research summary posted September 19, 2013 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.01 Substantive Analytical Review – Effectiveness, 11.0 Audit Quality and Quality Control, 11.05 Training and General Experience 
    Title:
    How a Systems Perspective Improves Knowledge Acquisition and Performance in Analytical Procedures
    Practical Implications:

    This experiment provides evidence that training in a systems perspective could help auditors analyze complex relationships between accounting data. This could be used to set appropriate analytics expectations and, more importantly, provide a credible way to determine whether management’s representations are well-grounded or not.  This method also appears to require less mental effort to implement, since it moves the complicated relationship structure out of memory and onto a model.  Given the added complexity of many estimates in today’s companies, systematic methods of processing information like a systems perspective may help to simplify the analysis of the estimates.

    For more information on this study, please contact Billy Brewster.
     

    Citation:

    Brewster, B. E.  2011.  How a systems perspective improves knowledge acquisition and performance in analytical procedures.  The Accounting Review 86 (3), 915-943.

    Keywords:
    analytical procedures; knowledge organization; learning; mental models
    Purpose of the Study:

    Understanding complicated relationships with multiple links between information is difficult, as people have limited memory to keep all the relationships straight.  This problem is evident in setting analytics expectations, as there are many reasons why accounting numbers change from year to year (and the reasons are often related to each other in varying, nonlinear ways).  In order to avoid a “reductionist” perspective where pieces of information are considered in isolation and linearly, auditors may be able to construct a better mental model of the situation by using a “systems perspective”.  This involves considering how all the parts of a system are related as well as their behavior from how they interact.  Using a systems perspective (compared to a reductionist perspective) is predicted to be more accurate, more efficient, better able to detect management representations that are inconsistent with the evidence, and better able to integrate new information into their expectations accurately.

    Design/Method/ Approach:

    In an experiment conducted prior to 2008, undergraduate accounting students (juniors/seniors) are given training in evaluating stocks and flows (systems perspective) or business risks (reductionist perspective).  They then learn about an audit client and its industry which has a particularly complicated relationship between multiple factors over time and the resulting product price.  Using the technique they were taught, they then graph the product price over time.  The students are then provided management’s estimate of the price and evaluate its credibility.  Finally, the participants learn new information about the industry and are asked to factor it into their price evaluation.

    Findings:
    • When compared to a computer simulation of how the product price should change over time, participants who used a systems perspective were closer to the simulation than those using a reductionist perspective
    • Those using a systems perspective did not need to exert as much mental effort to perform their evaluations
    • Using a systems perspective made it more likely to identify inconsistent management representations of the product price
    • When encountering new information, a systems perspective allows participants to incorporate the information more appropriately than a reductionist perspective
       
    Category:
    Audit Quality & Quality Control, Auditing Procedures - Nature - Timing and Extent
    Sub-category:
    Substantive Analytical Review – Effectiveness, Sustainability ServicesTraining & General Experience
  • Jennifer M Mueller-Phillips
    The Impact of Initial Information Ambiguity on the Accuracy...
    research summary posted September 10, 2013 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.01 Substantive Analytical Review – Effectiveness 
    Title:
    The Impact of Initial Information Ambiguity on the Accuracy of Analytical Review Judgments
    Practical Implications:

    The practical implication of this research for auditors is that it is best to avoid making initial hypotheses until after they obtain a comprehensive perspective of the data. Auditors should instead treat early stages of the decision process as a fact-finding exercise.

    Citation:

    Luippold, B.L. and T.E. Kida. 2012.  The Impact of Initial Information Ambiguity on the Accuracy of Analytical Review Judgments.  Auditing: A Journal of Practice and Theory. (31) 2:113–129.

    Keywords:
    analytical review, hypothesis testing, initial information ambiguity, auditing
    Purpose of the Study:

    This study seeks to determine the extent to which initial information ambiguity affects analytical review judgments. That is, this paper examines whether the impact of initial information ambiguity persist even after the ambiguity is gone.

    Design/Method/ Approach:

    Around 2010 94 participants, who were mainly staff level auditors, participated in an experiment with a seeded error wherein they were required to perform preliminary analytical procedures. The participants were separated by condition into different levels of information ambiguity to perform preliminary analytical procedures and all were then given the full data to make a final judgment.

    Findings:

    The main finding of this paper is that initial information ambiguity affects an auditor's ability to detect financial statement errors at the end of the analytical review process. Specifically, if auditors develop initial hypotheses using ambiguous information sets, they are less likely to identify errors causing fluctuations in financial data even after they search through all of the client's relevant information

    Category:
    Auditing Procedures - Nature - Timing and Extent
    Sub-category:
    Substantive Analytical Review – Effectiveness
  • 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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  • The Auditing Section
    The Importance of Account Relations when Responding to...
    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:
    The Importance of Account Relations when Responding to Interim Audit Testing Results
    Practical Implications:

    The results of the study are important, as they demonstrate that relations among different financial statement accounts should be considered when examining how auditors respond to changes in risk of misstatements.  Specifically, auditors do appear to respond to increases in the risk of material misstatement of one account by also increasing planned audit hours in related accounts.  The results also highlight the fact that auditors’ responses to changes in audit risk are insensitive to fee pressure; specifically, the increase in budgeted audit hours when encountering a serious misstatement is similar whether fee pressure is low or high.  Moreover, the author suggests that the concept of relatedness of accounts explored in this paper could be extended to tests of internal controls – for example, information about the effectiveness of one internal control could be informative about strength or importance of related internal controls

    Citation:

    Vandervelde, S. 2006. The Importance of Account Relations when Responding to Interim Audit Testing Results. Contemporary Accounting Research. 23(3): 789 – 821.

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

    Both U.S. and international auditing standards mandate auditors to adapt audit procedures as the risk of the audit engagement changes.  As many financial statement accounts are interrelated (e.g., accounts payable and inventory), it is important for auditors to consider the relations between accounts when engaging in audit planning procedures and adjusting audit procedures for changes in risk.  This study tests auditors’ responses to risk changes discovered during interim testing (potential fraud, error, or no problem).  The study also explores the following two potential reasons why prior research has generally concluded that auditors are not very responsive to risk changes:

    • Profit pressures may cause auditors to avoid increasing audit testing, in order to keep the engagement audit fees at the level initially agreed upon.  To address this potential explanation in the experiment, the author examines whether auditors’ still increase planned audit hours in the presence of more severe misstatements even when audit profit pressure is high.
    • An auditor’s response to risk changes may not be detected when accounts are analyzed in isolation rather than considering the relations between accounts (that are inherent in the double-entry format of recording transactions). For example, an auditor may address an increase in risk of accounts payable by performing additional testing of inventory receipts. To address this potential explanation in the experiment, the author examines how auditors’ responses to risk increases in an account differ, depending on whether the accounts are related vs. unrelated. 
    Design/Method/ Approach:

    The research evidence was collected prior to 2004. The author uses a group of audit senior associates from both Big 4 and non-Big 4 audit firms to complete a simulated audit budgeting task from a website. Participants are first asked to read background information on the audit client, including the prior year audit budget and realized audit hours.  Then, participants are asked to prepare an
    initial budget for audit hours allocated to five financial statement accounts.  Next, participants view the results from interim testing procedures (where the potential fraud, error, or no problem arises) and are then asked to indicate the amount of audit hours they would budget for the year-end audit work, representing their response to the change (or no change) in risk. 

    Findings:
    • Auditors’ planned audit hours for an account increase as the interim audit procedure results indicate that the account has more serious problems (i.e., potential fraud is the most serious, error is moderately serious, and no problem is least serious).
    • As the severity of a potential account misstatement increases, the associated increase in budgeted audit hours is greater when relatedness between accounts is high than when relatedness is low. 
    • The increase in budgeted audit hours in response to the interim testing results indicating a serious misstatement is the same under both low and high fee pressure, indicating that auditors’ response to increased risk is insensitive to high fee pressure.
    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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  • The Auditing Section
    Why Do Auditor’s Over-Rely on Weak Analytical Procedures? T...
    research summary posted April 13, 2012 by The Auditing Section, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.01 Substantive Analytical Review – Effectiveness, 09.0 Auditor Judgment, 09.03 Adequacy of Evidence 
    Title:
    Why Do Auditor’s Over-Rely on Weak Analytical Procedures? The Role of Outcome and Precision
    Practical Implications:

    Analytical procedures are used frequently and increasingly are relied upon as substantive evidence. Based on this study, auditors are insensitive to the impreciseness of the analytical procedure when the results are favorable and may be a cause for over-reliance on weak evidence.  Performing a stronger, more precise analytical procedure caused participants in the favorable outcome situation to become more aware of the weakness of the initial procedure and re-evaluate their evidence strength rating. Further, evidence suggests that having auditors consider the possible weaknesses of an analytical procedure prior to performing the procedure will cause them to rate the strength of the evidence from a weak analytical procedure lower. Overall, this suggests a need to better train auditors in performing and interpreting analytical procedures.

    In a discussion of Glover et al.’s paper, McDaniel asks whether the findings may indicate that auditors in the unfavorable outcome (i.e. there is a material difference) are under-relying on the evidence rather than that auditors in the favorable outcome (no material difference) are over-relying on the evidence. Glover et al. respond that the over-relying of the evidence is of concern to regulators and the alternative does not explain all of the results.  McDaniel also notes that the case study was of a company in the financial industry but that the participants were not required to have any financial industry experience. Glover et al. note that the interest income item is the issue which is not specific to the industry or complicated.  McDaniel also notes concerns about a potential “anchoring” effect as the participants performed their analytical procedures based on prior year working paper results.  In response, Glover et al. discuss this feature of an audit. 

    Citation:

    Glover, S. M., D. F. Prawitt, and T. J. Wilks. 2005.  Why Do Auditor’s Over-Rely on Weak Analytical Procedures?  The Role of Outcome and Precision.  Auditing: A Journal of Practice & Theory 24 (Supplement):  197-220.  

    McDaniel, L. 2005.  DISCUSSION OF Why Do Auditor’s Over-Rely on Weak Analytical Procedures?  The Role of Outcome and Precision.  Auditing: A Journal of Practice & Theory 24 (Supplement):  221-228. 

    Glover, S. M., D. F. Prawlitt, and T. J. Wilks. 2005. REPLY TO DISCUSSION OF Why Do Auditor’s Over-Rely on Weak Analytical Procedures?  The Role of Outcome and Precision.  Auditing: A Journal of Practice & Theory 24 (Supplement):  229-232.

    Keywords:
    outcome; evidence quality; substantive analytical procedures; evidence assessment;
    Purpose of the Study:

    In 2000, a Public Oversight Board panel viewed audit work papers and determined that 20% of the time substantive analytical procedures were weak and provided insufficient evidence to support the conclusion. This study aims to look at one of the possible reasons why auditors’ over-rely on weak, unreliable analytical procedures.  The authors hypothesize that auditors do not consider their existing knowledge about the quality of the procedure when the outcome indicates that the balance is “fairly stated.”

    Design/Method/ Approach:

    The authors performed two experiments prior to 2005 where a material misstatement exists and a “weak, unreliable” (highly aggregated) analytical procedure is used.  In experiment 1, senior associates from one Big 4 accounting firm were asked to perform an interest revenue analytical procedure at the annual grand total level and compare the results to the client’s unaudited balance.  The balance is manipulated so that some participants’ results indicate there is no significant difference (i.e. favorable outcome) and the other participants’ results indicate that there is a significant difference (i.e. unfavorable outcome).  Participants evaluated the strength of the analytical procedure and concluded regarding a misstatement.  Additional disaggregated computations (interest revenue calculations broken down by type of loan and performed quarterly vs. annual basis) were then provided. Participants responded to the procedure strength of the aggregated analytical procedure.  In experiment 2, different senior associates from one Big 4 accounting firm were asked to document the weaknesses of the analytical procedure prior to performing the procedure.

    Findings:

    Experiment 1

    • Auditors attribute more evidential strength to the results of weak analytical procedures if the results indicate no material difference than the identical procedure where the results indicate a material difference.  In addition, auditors in the  avorable outcome are more likely to assign a lower risk of material misstatement and assess the balance as fairly stated, than those in the unfavorable outcome.
    •  After viewing the stronger, disaggregated analysis, auditors in the favorable outcome were more likely to revise their prior conclusion but auditors in the unfavorable outcome did not. Further, auditors in the favorable outcome were also more likely to downgrade their evidential strength assessment of the initial analytical procedure.
    • Altogether, the authors believe this indicates a potential for over-reliance on weak high level analytical procedures and that in situations where analytical procedures indicate no significant difference, auditors are less likely to realize their procedure may produce imprecise expectations and deem it to be a stronger procedure than it really is.

    Experiment 2

    • Auditors who were told to consider the potential weaknesses of the analytical procedure before performing the analysis were more likely to rate the strength of the evidence as lower than those who were not.
    • The prompt to consider potential weaknesses did not reduce the evidential strength assessment as much as requiring the additional analytical procedure in Experiment 1.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Auditor Judgment
    Sub-category:
    Adequacy of Evidence, Substantive Analytical Review – Effectiveness
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