Understanding that auditors allocate greater resources to fraud brainstorming when engagement risk is significant fosters brainstorming of a superior caliber corresponds to stronger regulatory compliance. Auditors report that engagement teams are holding fraud brainstorming sessions earlier in the audit, document more detailed risk assessments, plan more specific procedures, and retain more documentation. These characteristics contribute to adequately addressing increased PCAOB regulatory scrutiny. Additionally, brainstorming sessions are highly regarded when they occur in a face-to-face fashion and are attended by multiple levels of firm personnel—whether that is “core” or “non-core” professionals. Fraud brainstorming sessions are executed less mechanically (as determined by PCAOB inspectors) by using fewer checklists and increase the amount of time auditors prepare for brainstorming sessions.
Dennis, S. A., and K. M. Johnstone. 2016. A Field Survey of Contemporary Brainstorming Practices. Accounting Horizons 30 (4): 449–472.
The purpose of this study is to further understand current fraud brainstorming practices minding regulatory climate and its impression of brainstorming practices. The authors seek to understand the auditing profession’s existing framework to effectively brainstorm by evaluating audit team characteristics; attendance and communication; structure, timing, effort; and brainstorming quality. Fraud brainstorming environment is considered with respect to client characteristics; particularly, inherent, fraud, and engagement risks, and if the client is publicly traded or privately held. The authors refer to the characteristics as “partitions”. The partitions allow the study to better examine how each characteristic effects the deployment of resources in response to risk levels and trading status.
The study poses further exploration into the implementation of Statement of Auditing Standards No. 99 and its effect on fraud brainstorming practices. Particularly addressing the Public Company Accounting Oversight Board’s report suggesting auditing professionals were “mechanically” addressing fraud-related auditing standards. SAS 99 sought to blend experienced audit professionals—those with greater client experience—with less-seasoned auditors to brainstorm how a fraud could occur specific to the client. As part of the brainstorming framework, the study seeks to understand if senior-level auditors (partners and managers) and seniors and staff members, along with “non-core” professionals, cultivate meaningful brainstorming sessions.
The authors collected field data from audits conducted between March 2013 and January 2014, per a survey of 77 audit engagements. Information pertaining to the client, audit team, and brainstorming sessions were called upon in the survey. The majority (93 percent) of observations were obtained by two Big 4 firms—7 percent from one non-Big 4 global firm. Each engagement’s partner received instructions for the distribution of the survey to lead managers and lead seniors on the respective engagement while the partner withheld that the survey was for research purposes. A total of 75 managers and 73 seniors participated.
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.
These findings provide insight into the decision-making process of external auditors as they make IAF reliance decisions. In particular, the results show how IAF objectivity interacts with external auditor involvement to have an impact on external auditors’ reliance decisions and how subsequent reliance decisions are affected by negative evidence about the quality of the IAF’s work.
Pike, B. J., L. Chui, K. A. Martin, and R. M. Olvera. 2016. External Auditors’ Involvement in the Internal Audit Function’s Work Plan and Subsequent Reliance Before and After a Negative Audit Discovery. Auditing: A Journal of Practice and Theory 35 (4): 159 – 173.
The purpose of this study is to experimentally examine how external auditors’ involvement in the internal audit function’s (IAF’s) work plan influences their decisions to rely on the work of the IAF and how that involvement affects their audit response in terms of re-performance of the IAF’s work and adjustment to budgeted hours. Furthermore, the authors go beyond the focus on external auditors’ initial reliance/re-performance decisions and evaluate how involvement influences their subsequent reliance and re-performance decisions after the discovery of a negative audit finding.
The authors conduct an experiment with senior-level auditors from a large public accounting firm to investigate how involvement in the IAF’s work plan influences external auditors’ reliance on the IAF both before and after a negative audit finding.
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.
This study is the first to establish IAF characteristics as separate, distinct constructs that act jointly in creating IAF quality; therefore, it contributes to the overall understanding of IAF quality and the determinants of the IAF as an effective internally based financial reporting monitor.
Abbott, L. J., B. Daugherty, S. Parker and G. F. Peters. 2016. Internal Audit Quality and Financial Reporting Quality: The Joint Importance of Independence and Competence. Journal of Accounting Research 54 (1): 3-40.
In 2013, the NASDAQ Stock Market LLC (NASDAQ) proposed a rule change that would require all NASDAQ registrants to maintain an internal audit function (IAF). The New York Stock Exchange (NYSE) has required all registrants to maintain an IAF since 2006. The thinking behind these requirements is that an effective IAF provides the audit committee and other financial reporting stakeholders with critical information pertaining to a company’s risks and internal controls. Corporate governance proponents also emphasize the IAF’s role in enhancing financial reporting quality; however, despite having many proponents the IAF’s role in the financial reporting process is not yet fully understood and empirical evidence concerning the impact of IAF quality is minimal. As a result of this lack of evidence, the authors investigate the potential impact of IAF quality as a joint function of the IAF’s competence and independence. They base this view upon theoretical work stating that external audit quality is a function of the external auditor’s ability (competence) to detect accounting misstatements and willingness (independence) to oblige proper accounting treatments.
In this paper, the authors develop and test a two-factor model of IAF quality as a function of the IAF’s ability to prevent/detect financial misstatements (competence) and its inclination to report the misstatements to the audit committee and/or external auditor (independence). The study uses survey evidence from 189 Chief Internal Auditors from Fortune 1000 companies during fiscal 2009.
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.
This paper suggests that the relationship between account subjectivity and usage of internal audit depends on the relative risk of misstatement. This complex relationship has not been shown in academic literature, nor is it highlighted in audit standards. More specifically, at lower levels of risk of misstatement, increases in subjectivity have no influence on the reliance of internal audit. At moderate risk levels the extent of internal audit reliance increases with subjectivity of the account. At high levels of misstatement internal audit reliance decreases with account subjectivity. This study provides insight into the decision criteria for internal audit reliance and highlight where internal audit usage maybe more prevalent, as well as were further audit guidance may be beneficial.
Bhattacharjee, S., M.J. Maletta, K.K. Moreno. 2016. The Role of Account Subjectivity and Risk of Material Misstatement on Auditors’ Internal Audit Reliance Judgments. Accounting Horizons 30 (2): 225-238.
Reliance on Internal Audit has become an important element of the external audit. Use of Internal Audit can play a significant role in reducing audit costs without sacrificing audit quality. However, the extent of usage of Internal Audit has been shown to be influenced by inherent risk, control risk, and the subjectivity of audit tasks. This paper looks at the interaction between risk assessment and subjectivity to provide insight into the complexities associated with the usage of internal audit. The authors aim to dive deeper into the analysis of internal audit usage, expanding on the dichotomous “low or high risk” assessment by investigating moderate risk scenarios. By analyzing these relationships with a field-based questionnaire, the authors present documentation of how real decisions are based on a complex assessment of the role of internal auditors.
The authors conducted a field-based questionnaire using 68 auditors from a Big 4 firm. These auditors were located in the U.S., but came from different geographic areas. They have an average experience of 46 months and represented 15 different industry specializations. The auditors were asked to choose one public company client and respond to questions regarding demographic information, client characteristics, external audit team characteristics, client misstatement risk, account subjectivity, client internal audit structure, and external audit assessment of internal audit usage.
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.
This study offers insights into why internal auditing is experiencing a shortage of qualified job candidates and offers a potential solution to the problem. The authors find that external auditors have negative perceptions about internal auditing, and these negative perceptions are associated with a (1) decreased desire to apply for internal auditing positions, (2) lower likelihood of recommending an in-house internal auditing career to high-performing students, and (3) higher likelihood of recommending an in-house internal auditing career to mediocre students. Internal auditors can try solving this problem by improving perceptions about internal auditing via a media campaign that raises awareness about the true internal audit career path.
Bartlett, G.D., J. Kremin, K.K. Saunders, and D.A. Wood. 2016. Attracting Applicants for In-House and Outsourced Internal Audit Positions: Views from External Auditors. Accounting Horizons 30 (1): 143-156.
The internal audit function can help organizations strengthen their risk management and corporate governance, yet the demand for qualified candidates to fill internal audit job openings exceeds the supply of interested applicants. Consequently, the internal audit function may find itself short-staffed and/or staffed with lower quality candidates, which may limit its ability to add value to the organization. In order to correct this problem, it is important to fully understand its scope and its root cause(s). Prior research attempting to gain this understanding has focused on investigating how accounting students’ beliefs about internal audit impact their interest to pursue an internal audit career. The authors of this paper extend this research by:
The authors use data from three sources. First, the authors performed an experiment using experienced external auditors—mostly seniors or associates—who were asked whether they would apply for a job described as either an accounting, in-house internal audit, or outsourced internal audit position. Second, the authors performed another experiment using experienced external auditors—mostly managers or directors—who were asked whether they would recommend that a high-performing (mediocre performer) student pursue an external audit, in-house internal audit, or outsourced internal audit career. Third, the authors surveyed high-ranking former/current external auditors who never worked in internal audit about what would make internal auditing a more appealing career for them.
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:
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.