Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    The Strategic Effects of Auditing Standard No. 5 in a...
    research summary posted June 15, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.03 Impact of New Accounting Pronouncements, 06.0 Risk and Risk Management, Including Fraud Risk, 06.02 Fraud Risk Models 
    144 Views
    Title:
    The Strategic Effects of Auditing Standard No. 5 in a Multi-Location Setting
    Practical Implications:

     This paper examines how the auditor’s evaluation of internal control impacts substantive testing in a two-location setting with correlated internal control strengths. When control strengths are independent, internal control strength pairings have no effect on the manager’s probability choice to commit fraud or on the auditor’s substantive test effort. This study shows how the manager’s opportunity to commit fraud and informational characteristics of internal control tests impact the manager’s probability choice of fraud and the auditor’s choice of substantive test effort.

    Citation:

    Patterson, E.R. and J.R. Smith. 2016. The Strategic Effects of Auditing Standard No. 5 in a Multi-Location Setting. Auditing: A Journal of Practice and Theory 35 (1): 119-138. 

    Keywords:
    strategic auditing, multi-location auditing, and internal control testing
    Purpose of the Study:

    Auditing Standard No. 5, An Audit of Internal Control over Financial Reporting that is Integrated with an Audit of Financial Statements, provides guidance in the required audit of internal controls. The purpose of AS 5 is to reduce the burden of SOX-required control tests by integrating them into a risk-based approach to auditing. From an internal control perspective, fraud risk is considered to increase as controls weaken because weaker controls create an opportunity for a manager to commit fraud. However, the auditor’s risk assessments and resulting audit strategy must include anticipation of the manager’s strategic behavior, which depends on conjectures about the auditor’s strategy. This paper examines how a manger’s knowledge of internal control strengths and weaknesses across different locations affects the auditor’s testing strategy and the manager’s propensity to commit fraud. 

    Design/Method/ Approach:

    A two-stage model is created in which a manager oversees two locations and has the opportunity to commit fraud in either of the two locations alone, or at both locations simultaneously. Three situations are considered: no internal control testing, minimal internal control testing, and full internal control testing. 

    Findings:
    • The authors find that in their setting, the manager has a greater opportunity for fraud when he observes weak controls in both locations because this allows him to choose fraud in any of the locations, including choosing fraud in both locations at once.
    • The authors find that an increased opportunity to commit fraud does not always correspond to an increased fraud risk when the control risks are correlated because correlation alters the auditor’s perception of where fraud opportunities most likely occur, which leads to the manager choosing the probability of fraud for each control strength pairing.
    • The authors find that the average amount of substantive test effort decreases when the auditor tests controls while audit risk is unaffected; thus, control testing has the potential to reduce expected audit costs without negatively affecting audit risk. 
    Category:
    Risk & Risk Management - Including Fraud Risk, Standard Setting
    Sub-category:
    Fraud Risk Models, Impact of New Accounting Pronouncements