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  • 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
    Strategic analysis and auditor risk judgments
    research summary posted March 11, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Strategic analysis and auditor risk judgments
    Practical Implications:

    The results of this study have important implications:

    • First, the results demonstrate that auditor judgments of the risk of material misstatement at the entity (financial statement) level are linked to the performance and documentation of strategic analysis of strategy positioning and the strategy implementation process
    • Second, this study provides preliminary evidence on the association between performing an analysis of the entity’s strategy implementation process and auditors’ judgments of the strength of the control environment
    • Third, the fact that auditors who performed strategic analysis did not identify a greater number of significant business and financial statement risks than auditors who did not perform strategic analysis warrants further research

    For more information on this study, please contact Natalia Kochetova-Kozloski.

    Citation:

    Kochetova-Kozloski, N., and W. F. Messier Jr. 2011. Strategic analysis and auditor risk judgments. Auditing: A Journal of Practice & Theory 30(4): 149-171.

    Keywords:
    risk assessment; strategic analysis; strategic positioning; strategy implementation.
    Purpose of the Study:

    Conducting a business risk-based audit requires the auditor to develop an understanding of the client and its environment, make risk assessments based on that knowledge, and design appropriate audit procedures to respond to those risks. A significant component of understanding the client and its environment involves conducting a strategic analysis of the client.

    The study investigates whether and how senior auditors’ strategic analysis of a client affects their identification of significant business and financial statement risks, and their risk assessments by addressing these two issues:

    • Whether strategic analysis undertaken by auditors to develop an understanding of the client’s business affects their risk identification
    • How two aspects of strategic analysis (analysis of strategic positioning and the strategy implementation process) influence auditors’ risk assessments
    Design/Method/ Approach:

    The study employed a 3 x 1 between-subjects factorial design with no strategic analysis (‘‘No SA’’) as a control condition, and analysis of strategic positioning (‘‘SA: strategic positioning’’) and analysis of strategy implementation process (‘‘SA: strategic process’’) as treatment conditions.  Experimental materials were delivered to the participants by e-mail or at a national training session. Sixty-seven (67) audit seniors from three Big 4 firms completed the experiment. The experimental materials included a cover letter, Additional Task Instructions, Risk Assessment and Audit Planning and Debriefing Questionnaire.

    Findings:

    The authors find:

    • Auditors who performed guided strategic analysis did not identify more significant business and financial statement risks than auditors who did not perform strategic analysis,
    • Senior auditors who performed strategic analysis of strategic positioning or the strategy implementation process assessed risk of material misstatement at the entity level more consistently with an expert panel than auditors who did not perform such an analysis,
    • Senior auditors’ analysis of the client’s strategy implementation process was associated with assessments of the strength of the control environment that were more consistent with the expert panel than assessments done by auditors who did not perform any strategic analysis or who performed only an analysis of strategic positioning.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment
  • Jennifer M Mueller-Phillips
    The Use of Business Risk Audit Perspectives by Non-Big 4...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Use of Business Risk Audit Perspectives by Non-Big 4 Audit Firms
    Practical Implications:

    The first implication is a call for proportionality and flexibility to adopt an audit approach that meets the client-audit firm context. SMP auditors told us that they struggle with achieving proportionality by not performing some audit procedures such as entity-level analytical procedures for smaller clients, because they feel obliged to perform these procedures to comply with documentation requirements of the auditing standards or of regulators and oversight bodies. Such experiences may result in inefficient, ‘‘check-the-box’’ audits in order to satisfy perceived documentation requirements for review purposes.

    The second implication is that standard setters should be aware that the type and/or scope of the assurance engagement might also vary by jurisdiction. For example, in a jurisdiction with a close book-tax alignment, the clients’ and users’ expectations about the type and scope of assurance may interact with the prescribed standards in shaping audit practice.

    For more information on this study, please contact Niels van Nieuw Amerongen.

    Citation:

    Van Buuren, J., C. Koch, N. v. Nieuw Amerongen, and A. M. Wright. 2014. The Use of Business Risk Audit Perspectives by Non-Big 4 Audit Firms. Auditing: A Journal of Practice and Theory 33 (3): 105-128

    Keywords:
    business risk auditing, small and medium-sized audit practices (SMPs), auditing standards, audit methodology
    Purpose of the Study:

    The purpose of this study is to examine the extent of use of business risk perspectives by Small and Medium-sized audit Practices (SMP) and to investigate the conditions and factors affecting the application of such practices. We neither focus on the degree of compliance with standards nor on the audit quality differences among audit firms. Rather, we want to document variation in practices and, in particular, the relative reliance on Business Risk Audit (BRA) forms of evidence, since current auditing standards allow great flexibility in the choice of audit approaches on an audit engagement.

    Investigating SMPs is expected to provide new insights because SMP auditors face an audit environment that is very challenging in the use of business risk perspectives. For instance, SME clients often do not have formalized entity-level controls for assessing (client) business risks. Also, clients of such firms vary considerably in size and complexity, which may affect the cost-effectiveness of various forms of BRA evidence. We examine whether business risk assessments are proportionally applied. That is, we investigate whether the extent of consideration of business risks is dependent upon cost-effectiveness in the client setting. For instance, for large clients, the complexity of the engagement likely requires a focus on business risks and entity-level evidence, while for small clients, it may be more cost-effective to primarily rely on substantive tests at the assertion-, account or cycle level. In this respect, we consider a continuum of audit approaches, ranging from a substantive-based audit approach to a full-scope business risk audit, to explain differences in the use of business risk perspectives in SMP’s audit planning.

    Design/Method/ Approach:

    To examine these issues, we use a semi-structured interview approach involving 38 highly experienced auditors in Germany and in The Netherlands. This approach allows us to gather rich, detailed data of auditors’ experiences in the field.

    Findings:

    The findings indicate limited application of business risk perspectives by SMPs. Although SMPs regularly assess business risks, they are divided in their experiences and perceptions about the usefulness of business risk perspectives and rarely apply the knowledge of business risks for analytical procedures. We also find that many SMP auditors find it challenging to rely on entity-level controls that are often informal in SMEs or that are established by an owner-manager. Our results suggest that SMP auditors more often choose a systems-based or primarily substantive audit approach, as compared to the broad BRA approach. The findings indicate that the use of business risk perspectives is driven by consideration of the tradeoff between audit effectiveness and efficiency. Auditors with larger and more complex clients apply business risk perspectives more extensively. Further, auditors identify other factors that may affect the use of a business risk audit approach, such as tax-book alignment, enforcement by audit supervisory authorities, prior working exposure to BRA through experience with Big 4 audit firms, audit client tenure, and investments in training and databases.

    Category:
    Risk & Risk Management - Including Fraud Risk, Standard Setting
    Sub-category:
    Assessing Risk of Material Misstatement, Changes in Audit Standards
  • Jennifer M Mueller-Phillips
    Auditor business process analysis and linkages among auditor...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor business process analysis and linkages among auditor risk judgments
    Practical Implications:

    The results of this study have implications for public accounting firms that have adopted business-risk audit methodologies and for regulators that have incorporated ideas and concepts from business-risk audit methodologies into promulgated standards

    • Public accounting firms adopting business-risk methodologies have broadened, deepened, and reemphasized the long-standing requirement in auditing standards to understand the client business so as to use this understanding as a source of information about possible material misstatements to the financial statements.
    • Firms and regulators should be encouraged by the support found in this study for the relationship and connections between, for instance, the significant business risks identified and the magnitude of the assessments of the risk of material misstatement at the entity level; the performance of business process analysis and the conservatism of entity- and process-level assessments of the risk of material misstatement; and the significant business risks identified and the risk of material misstatement at the process level.

    For more information on this study, please contact Natalia Kochetova-Kozloski.

    Citation:

    Kochetova-Kozloski, N., T. M. Kozloski, and W. F. Messier Jr. 2013. Auditor business process analysis and linkages among auditor risk judgments. Auditing: A Journal of Practice & Theory 32(3): 123-139.

    Keywords:
    business process analysis; risk assessment; risk of material misstatement; business risk identification
    Purpose of the Study:

    This research note examines two important and related issues:

    • Whether performance of a business process analysis assists auditors’ identification and assessment of significant business risks and the risk of material misstatement at a core process level.
    • Whether auditors link their entity-level risk assessments to their core business process risk assessments

    Based on review of the current literature, there has been relatively little research that has specifically examined how these two issues affect auditors’ risk-related judgments. Therefore, the current study examines the linkage between business risk identification, taking into account severity of each risk at the entity and process level, and the assessment of the risk of material misstatement at both the entity and process level in a more direct and externally generalizable fashion than was done previously—i.e., by focusing on efficacy of the process described by the auditing standards worldwide. 

    Design/Method/ Approach:

    The study employed a between-subject experimental design to test the hypotheses. The experiment was administered at training sessions of the Big 4 accounting firms held in the United States and Norway. The authors obtained usable responses from one hundred thirty-four (134) audit seniors after they completed a detailed case where performing or not performing a business process analysis was manipulated as a between-subject factor. The case used in this study was a hypothetical grocery retailer - National Foods, located in the Southeastern United States.

    Findings:

    The authors find:

    • A significant positive association between the identification of significant process-level business risks and the identification of significant business risks at the entity level for auditors who performed a business process analysis of the core business process.
    • Performing a business process analysis led to higher assessments of the risk of material misstatement at the core process level.
    • Auditors linked their assessments of misstatement risk at the process level with similar assessments made at the entity level, taking into account significant process-level risks.

    The authors stipulate that taken together, these results suggest that auditors link their entity-level identified business risks and assessments of the risk of material misstatement to risks and related assessments at the process level.

    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Misstatements in Financial Statements: The Relationship...
    research summary posted March 1, 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Misstatements in Financial Statements: The Relationship between Inherent and Control Risk Factors and Audit Adjustments
    Practical Implications:

    The findings provide support for the relationships between inherent and control risk factors and misstatements as proposed by the audit risk model. Our results are informative to audit standard setters and audit firms in designing and structuring their audit approaches, especially the audit manual or the corresponding requirements embedded in firm-specific IT-tools. The findings suggest that an auditor should consider entity-level controls, because the strength of these controls appears to be particularly associated with misstatements. Considering an explicit requirement for auditors to identify, assess, and evaluate entity-level controls would make sense. Additionally, the findings suggest developing additional guidance on the effectiveness of an internal audit department and on whether using the opinions reached in a client’s internal audit. Finally, the findings demonstrate the usefulness of audits. 

    Citation:

    Ruhnke, K. and M. Schmidt. 2014. Misstatements in financial statements: The relationship between inherent and control risk factors and audit adjustments. Auditing: A Journal of Practice and Theory 33 (4): 247–269

    Keywords:
    Audit adjustments, audit risk model, business risk audit approach, International Standards on Auditing (ISA), materiality
    Purpose of the Study:

    The authors analyze whether audit adjustments detected in the course of an audit vary systematically with inherent and control risk factors. Because the audit risk model also proposes these relationships, our analysis has a bearing on the empirical validity of the risk model. Audit adjustments also provide evidence of the usefulness of audits in general.

    Design/Method/ Approach:

    The analysis is based on proprietary data from a large sample of audit adjustments detected in 255 financial statement audits in 2007 conducted by a Big 4 audit firm in Germany. The authors use a series of multivariate regression analyses to study the association between inherent and control risk factors and the number and magnitude of audit adjustments. Client specific planning materiality is incorporated into the design by scaling the absolute magnitude of adjustments by materiality (magnitude of the adjustments relative to client specific materiality). The analyses control for other factors, such as tenure, GAAP, and audit input.

    Findings:

    The mean size of the audit adjustments is 8.5 times larger, and the income-affecting adjustments are 5.0 times larger, than the client specific planning materiality threshold as set by the audit firm. This finding constitutes strong evidence of the corrective function of audits and the usefulness of audits in general.

    Our findings show that audit adjustments vary systematically with inherent and control risk factors, as proposed by the audit risk model. Specifically, we find that the following risk factors (corresponding to variables in the model) have a significant effect on audit adjustments:

    • Inherent risk factors: The number and relative magnitude of audit adjustments, particularly income-affecting adjustments, is lower if the quality of a client’s management (integrity and competence) is higher or the client’s financial position is stronger.
    • Control risk factors: The relative magnitude of audit adjustments is lower if entity-level controls are stronger or if the entity has an effective internal audit function. The number of adjustments is lower if the internal control system is overall stronger.

    Our results are consistent with evidence from the audit quality literature suggesting an auditor’s ability to detect misstatements is lower in the initial years of an engagements but then increases for a certain period of time. 

    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Audit Scope & Materiality Judgements
  • 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
    The Effect of Benchmarked Performance Measures and Strategic...
    research summary posted November 12, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Effect of Benchmarked Performance Measures and Strategic Analysis on Auditors’ Risk Assessments and Mental Models
    Practical Implications:

    From a conceptual perspective, this study provides preliminary insight into how an auditor maps performance to risk.  The mapping is not simple, rather the complexities of audit standards, performance measure benchmarked type and auditor professional skepticism comingle to create a complex mapping of information contained in performance measures to an auditor’s risk assessments. In particular, our results indicate the increasing popular use by auditors of external benchmarks to provide independent evidence of the risks associated with client business units can lead to systematic differences in auditor risk assessments where no such differences in risk are warranted.  However, we find that auditors provided with in-depth strategic analysis were more likely to reach the normatively appropriate conclusion about risk regardless of the presence or absence of benchmarks for subsets of performance measures.  The finding that in-depth strategic analysis facilitates more accurate judgments about risk provides support for professional standards on risk assessment (ISA 315, PCAOB AS No. 8) and may indicate a need for more extensive guidance aimed at assisting auditors in developing an in-depth understanding of the strategic risks of clients. 

    For more information on this study, please contact Robert Knechel or Steve Salterio.

    Citation:

    Knechel, W. R., S. E. Salterio, and N. Kochetova-Kozloski. 2010. The effect of benchmarked performance measures and strategic analysis on auditors’ risk assessments and mental models. Accounting, Organizations and Society 35 (3):316-333.,

    Keywords:
    Audit Judgment, Benchmark, Strategic Analysis, Risk of Material Misstatement, Business Risk, Performance Measurement Systems.
    Purpose of the Study:

    The purpose of this paper is to examine the effect of two complex audit technologies commonly used by auditors, benchmarking of performance measures and strategic analysis, on the risk judgments of auditors carrying out the initial planning of an audit. The analysis of a client’s strategy and related business risks is an integral part of the auditor’s process for evaluating the risk of material misstatements in a client’s financial report.  In general, strategic analysis used in an audit includes assessing the competitive position adopted by the firm, identifying its critical success factors, and evaluating obstacles that might cause a chosen strategy to be less successful than desired.  While the strategic management literature employs such analysis to identify investment or operating opportunities, auditors view threats to client business success as a source of audit risk.  Strategic analysis may be conducted at the corporate level and supplemented with an analysis of individual strategic business units.  Consequently, an auditor will often assess the relative business risks associated with a strategic business unit (SBU) as a precursor to assessing audit risk and allocating audit effort. Management uses strategic based performance measures to control their organizations. Since auditors are required to use analytical procedures to assess the risk of material misstatement (SAS 107; ISA 315), strategic performance measures can also be used by an auditor to highlight situations where problems may exist in management’s strategy that can be a source of audit risk. Furthermore, the existence of independent third party benchmarks of these performance measures may provide further insight into the riskiness of the client’s strategy and the consequent potential for audit risk.

    Design/Method/ Approach:

    We conduct an experiment involving 87 audit seniors from a Big 4 audit firm in Canada in the early 2000’s that utilizes a Balanced Scorecard for organizing and evaluating analytical evidence about the performance of business units within a large client. During the experiment, participants were asked to rate the performance and risk level of two business units in the same organization.  We manipulated (1) the presence or absence of benchmarks for different types of performance measures (unit-specific or common across units) and (2) the extent of strategic analysis available to the auditor (in-depth vs. superficial).  

    Findings:
    • Our first finding is that external benchmarking can cause an auditor to focus on performance measures that are unique to a business unit and disregard performance measures that are common to multiple business units but not benchmarked. 
    • Our second finding is that an in-depth strategic analysis completed prior to assessing a client’s business risk or risk of material misstatement allows an auditor to incorporate more information from performance measures in risk assessments regardless of whether the performance measures are benchmarked.  Strategic analysis facilitates a more balanced and accurate assessment of the risks across the business units being evaluated.
    • Our third finding is that the latter result occurs because in-depth strategic analysis allows auditors to develop a more complete mental model of a client, a result that has been posited by academics and practitioners but not previously demonstrated.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Business Risk Assessment (e.g. industry - IPO - complexity)
  • Jennifer M Mueller-Phillips
    Detecting and Predicting Accounting Irregularities: A...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.02 Fraud Risk Models, 06.05 Assessing Risk of Material Misstatement in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Detecting and Predicting Accounting Irregularities: A Comparison of Commercial and Academic Risk Measures
    Practical Implications:

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

     

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

    Citation:

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

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

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

    Design/Method/ Approach:

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

    Findings:
    • The authors find the commercially developed risk measure AGR is useful as a proxy for the risk of accounting irregularities.
    • In comparisons between AGR and academic risk measures, the authors find that AGR performs as well as or better than academic risk measures in all comparisons.
    • The authors find that among the academic risk measures, accrual estimation errors and unexplained audit fees appear to perform the best.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Fraud Risk Models
  • Jennifer M Mueller-Phillips
    The Interplay of Interpersonal Affect and Source Reliability...
    research summary posted May 26, 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, 09.02 Documentation Specificity, 09.10 Prior Dispositions/Biases/Auditor state of mind in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Interplay of Interpersonal Affect and Source Reliability on Auditors' Inventory Judgments
    Practical Implications:
    • A negative emotional feeling toward a lower competence client contact can result in more conservative judgments and the documentation of more items indicative of increased risk. This would likely result in inefficiencies due to increased testing because risk is perceived to be higher than it would be in an unbiased setting.
    • A positive affective reaction toward a lower competence client led to similar inventory obsolescence ratings and the documentation of more items indicative of decreased obsolescence than a higher competence source. This would likely result in lowered audit effectiveness due to decreased testing because risk is perceived to be lower than it would be in unbiased setting. Additionally, it would be hard for reviewers to remedy this error because the work papers would also have a bias toward lower risk evidence items.
    Citation:

    Bhattacharjee S., K.K. Moreno, T. Riley. 2012. The Interplay of Interpersonal Affect and Source Reliability in Auditors’ Inventory Judgments. Contemporary Accounting Research 29 (4): 1087-1108.

    Purpose of the Study:

    This study investigates how the likability and competence of a client contact may influence auditors’ risk judgments, specifically, in this case, related to inventory obsolescence. Prior literature had established that auditors place greater reliance on information obtained from more highly competent sources. However, little research had considered the role of emotional factors in evidence persuasiveness judgments. Auditors likely believe that they are able to make professional judgments that are independent of emotional feelings about the client. To the extent this is not true, the profession may be interested to know what the effects are and how they can be mitigated if necessary to produce higher quality judgments.

    Design/Method/ Approach:

    This experiment was conducted prior to Winter 2012 when it was published. Participants completed a hypothetical case study in which they assessed the risk of inventory obsolescence during preliminary audit planning after reading company background information and summary unaudited financial information. The participants for this study were 174 auditors from large and regional audit firms where 71.3% held the rank of staff or associate and 28.7% held the rank of senior associate or senior.

    Findings:

    The results of this study show that the influence of client contact personality characteristics on audit judgments depends upon the level of competence that person displays. When the client contact was perceived to be highly competent then emotion or feelings of like/dislike toward the client did not influence participants’ ratings about the likelihood of an inventory obsolescence problem. However, when the client is less competent:

    • Positive emotion reduces judgments of how likely inventory obsolescence is compared to when client is more competent
    • Neutral emotion increases judgments of how likely inventory obsolescence is compared to when client is more competent
    • Negative emotion increases judgments of how likely inventory obsolescence is compared to when client is more competent to an even greater extent than neutral emotion

    Finally, the results show that these judgments influence whether the evidence documented in the work papers contain more items that indicate higher risk of obsolescence or more items that indicate a lower risk of obsolescence. 

    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Documentation Specificity, Prior Dispositions/Biases/Auditor state of mind
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