These findings demonstrate that, although the profession is calling for more skepticism, the underlying culture may inhibit such behavior if auditors are punished for being skeptical when it turns out there is no misstatement. In relation to consultation prior to skeptical behavior, an internal firm-level training that makes evaluators more aware of outcome bias may be more effective than a subordinate-driven solution if encouraging skeptical behavior. 

Brazel, J. F., S. B. Jackson, T. J. Schaefer, and B. W. Stewart. 2016. The Outcome Effect and Professional Skepticism. The Accounting Review 91 (6): 1577 – 1599. 

The level of audit quality on audit engagements hinges on the amount of professional skepticism exercised by auditors. This viewpoint has led to a renewed focus on addressing auditors’ failure to exercise sufficient levels of skepticism.  Highly skeptical auditors increase the likelihood that material misstatements are detected, but exercising skepticism may also come at a cost when additional work is performed to obtain sufficient and appropriate evidence. The authors experimentally test whether outcome effects exist in supervisors’ evaluations of skeptical behavior. Specifically, does outcome information affect the evaluation of an auditor’s decision to investigate a matter as though the auditor should have “known all along” whether a misstatement existed? 

The authors utilize an experiment in which practicing audit seniors were asked to evaluate the performance of a hypothetical staff auditor on his or her engagement. They also administered a survey to investigate auditors’ perceptions of how the outcome of investigating an inconsistency affects how they are evaluated. 

• The authors find strong support for the prediction that the outcome of an investigation will affect auditors’ performance evaluations. Despite the fact that the staff auditors exhibited the same skeptical judgments and actions, the outcome effect causes their evaluations to provide lower performance evaluations to staff who do not identify a misstatement versus staff who do identify a misstatement.
• The authors observe that the outcome of the investigation influences the perceived benefit of the investigation, which, in turn, influences whether the evaluator frames the cost of the investigation as lost time or a normal cost of the audit.
• The authors’ survey results suggest that the participants anticipate that outcome effects will be present in the evaluations of auditors who engage in skeptical behavior.
• In addition, although one might think that consultation could provide an easy fix for outcome bias in evaluations, the authors find that even when subordinates consult with their supervisors prior to engaging in skeptical behavior and receive permission to proceed, supervisors are unable to purge outcome bias from their evaluations of audit staff.  

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Given that REM often causes significant auditor discomfort, the authors’ paper provides broader REM and auditor comfort-related questions pertaining to the effects of management’s focus on short-term results, the extent to which REM is a problem that can or needs to be fixed, and the possibility that REM is a gateway to more serious forms of accounting manipulation. 

Commerford, B. P., D. R. Hermanson, R. W. Houston, and M. F. Peters. 2016. Real Earnings Management: A Threat to Auditor Comfort? Auditing: A Journal of Practice and Theory 35 (4): 39 – 56. 

The authors address two overarching questions that have not received very much attention to date. First, “To what extent does real earnings management (REM) affect auditor comfort?” Second, “What strategies do auditors rely on in trying to reach a state of comfort when the client engages in REM?” Auditing standards that relate to REM are vague and limited and, despite evidence showing that REM is becoming increasingly common, little research considers auditors’ perceptions of REM and how they respond to it. The authors wish to fill this void by writing this paper. 

The authors conduct in-depth interviews with experienced auditors to examine how auditors respond to an emerging issue in the post-SOX period, the increasing use of real earnings management to achieve financial reporting objectives. 

• The authors find that auditors are aware of REM and often identify it through formalized audit protocols, including analytical procedures, discussions with management, ad/or their knowledge of the business.
• The authors find that formal audit procedures play a role in identifying sources of discomfort but also find references to body senses and the use of emotive language related to feelings of discomfort.
• The authors find that most of the interviewees have concerns about REM, largely because they believe it indicates management’s desire to meet short-term targets, implying poor management tone, which could signal other, less acceptable earnings management methods. 

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  These results have important implications for audit practice, as the author shows that the specific techniques used by auditors to gather evidence for building knowledge structures are essential to resisting client influence. This paper also shows that in spite of the responsibility of understanding complex business environments and any resulting indicators, evidence finds that even experienced decision makers have difficulty learning in dynamically complex environments. Improving judgment and decision making in these settings requires enhancing auditors’ development of systems-based mental models.

Brewster, B. 2016. The Effect of Client Lies on Auditor Memory Resistance and False memory Acceptance. Auditing: A Journal of Practice and Theory 35 (3): 33-50.

Professional auditing standards direct auditors to critically evaluate and verify all client-provided information, in the hope that auditors will resist any client lies that cannot be directly corroborated. Traditional psychology research supports this conjecture because warning individuals about the ambitions of communicators typically bolsters resistance via a suspicious mindset. However, the author believes that features of the audit environment create scenarios in which the auditor is susceptible to client lies, especially blatantly incorrect ones. In particular, if auditors are unable to refute client lies through existing evidence-related memories, they will succumb to a memory error called the misinformation effect. If correct, this would mean that after exposure to a client lie, an auditor’s cognitive processing is tainted, and he/she would gravitate toward the client-provided false memories instead of his/her own true evidence-based memories when subsequently retrieving related information. As a result, the author examines the conditions that moderate auditor resistance toward and susceptibility to believing client-provided lies. 

The author completed a study with professional auditors from an international accounting firm with an average work experience of 44 months. He asked them to complete an experimental task, holding one group static and allowing the other to be dynamic. 

• The author finds no significant differences between dynamic or static KPI understanding type conditions when participants evaluated their comprehension of the industry overview and the tutorial.
• The author finds that auditors who develop poorly constructed memories of industry-related evidence will favor falsely implanted client communication more than their own real memories during recall.
• The author finds that the data shows that auditors with better developed, more rigid, and more accessible memories are resistant to favoring falsely implanted client communication more than their own memories and are more likely to identify the client-provided falsehood.
• The author finds that those who succumbed to the misinformation effect were equally as confident in their own real memories as the auditors who resisted.
• The author’s findings are consistent with prior research that speculated that auditors with insufficient mental models regarding complex evidence are more likely to have their knowledge manipulated by the client.

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The results of this study are important because the authors believe that the reduction in the use of appropriately rigorous substantive analytical procedures could diminish overall audit quality, and that the utilization of their approach could keep this from occurring. 

Glover, S.M., D.F. Prawitt, and M.S. Drake. 2015. Between a Rock and a Hard Place: A Path Forward for Using Substantive Analytical Procedures in Auditing Large P&L Accounts: Commentary and Analysis. Auditing: A Journal of Practice and Theory 34 (3): 161-179.

Substantive analytical procedures (SAPs) have been one of the common substantive procedures applied to income statement accounts for decades; however, there is a growing trend for public company auditors to forego substantive analytical procedures on large income statement accounts due to criticisms from regulatory inspectors that such procedures are not capable of providing useful substantive evidence. This paper hopes to comment on the concern that discouraging the application of appropriately rigorous substantive analytical procedures may diminish overall audit quality. The authors consider whether rigorous substantive analytical procedures can be designed to provide useful evidence at moderate and low levels of assurance for large income statement accounts even when the significant-difference threshold exceeds overall materiality. It is the belief of the authors that such procedures can provide strong evidence that financial statements are free of massive fraud or unintentional misstatement, and that the moderate or low assurance obtained by such procedures can be combined with assurance from other audit procedures to yield high overall assurance. The authors hope to illustrate how to achieve moderate or low assurance and explain how their approach is consistent with auditing theory and auditing standards. Overall, the primary purpose of this paper is to raise awareness of a practice concern and resulting trend that may have negative effects on audit quality and to provide thought leadership on how the profession may be able to leverage the benefits of SAPs.

Public company revenue data and analyst forecast errors are used to illustrate the practical difficulties and inherent limitations of seeking high assurance from a substantive analytical procedure. Possible ways to conceptualize thresholds are outlined and public company data is used to demonstrate the use of substantive analytical procedures to provide moderate or low assurance.

• The authors find that audit theory, the audit risk model, and recent auditing standards suggest that, when combined with other audit procedures, substantive analytical procedures can provide useful complementary evidence when they provide only moderate or low assurance.
• The authors find that little or no guidance exists regarding what constitutes moderate or low assurance when conducting the types of substantive analytical procedures that are typically used in practice.
• Analysis suggests that if auditors can improve expectations via disaggregation, then substantive analytical procedures should be able to be developed to provide some assurance that revenue and other large income statement accounts are fairly stated.

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The authors believe that when armed with knowledge of how management may intentionally or unintentionally introduce error into their FVMs, auditors will be better able to take steps to adjust for this error. Currently, professional skepticism is the best way to combat this problem. Researchers and policy makers within firms need to grapple with the possibility that existing audit team structure and incentives may not be compatible with audits that require more and more specialized valuation knowledge.

Martin, R. D., J. S. Rich, and T. J. Wilks. 2006. Auditing Fair Value Measurements: A Synthesis of Relevant Research. Accounting Horizons 20 (3): 287-303.

In order to contribute to the PCAOB project on auditing fair value measurements (FVMs), the authors synthesize and discuss the implications of academic research that should be relevant to auditors, standard-setters, and academics who increasingly deal with the complexities of auditing FVMs. The authors structure their synthesis of prior research along two dimensions:

1. An emphasis on the auditor’s need to understand how FVMs are prepared, including an awareness of the potential pitfalls and biases inherent in preparing FVMs, and
2. The audit steps and procedures necessary to verify and attest to FVMs, including an awareness of the potential biases inherent in auditing FVMs.

Structuring the synthesis along the aforementioned dimensions, the authors first focus on the generation of FVMs because they believe auditors cannot exercise due care in the audits of FVMs without a thorough understanding of the underlying valuation techniques and inputs used in assessing FVMs. They focus second on research related to verification and attestation procedures for FVMs, even though very little research directly examines the auditing of FVMs.

• FVMs frequently incorporate forward-looking information reflected in market place exchanges as well as judgments about the applicability of those market inputs to company-specific conditions.
• Future events and conditions cannot be predicted with certainty, so an element of judgment is always involved.
• Specialists are often required to audit FVMs.
• The structures of audits teams may inhibit the utilization of knowledge of such specialists in today’s audit firms. 
• A number of errors and biases likely affect prepares’ valuation judgments, and auditors should be aware of those.
• Auditors may rely on internal controls over FVM estimation process.
• Auditors must be able to identify key assumptions and inputs in the FVM process.

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