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    The Importance of Account Relations when Responding to...
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012, 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 
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    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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