Posts

Posts

  • Jennifer M Mueller-Phillips
    Does Earnings Quality Affect Information Asymmetry? Evidence...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.05 Evaluating Accruals/Detection of Abnormal Accruals, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does Earnings Quality Affect Information Asymmetry? Evidence from Trading Costs
    Practical Implications:

    The quality of reported in earnings is influenced by a firm’s fundamentals. To the extent investors differ in their ability to process this information, poor earnings quality can lead to information asymmetry, which can be costly. For these reasons, standard-setters and regulators are concerned about the quality of accounting information and its consequences for capital markets. This study provides empirical support for the concerns articulated by regulators that an important adverse consequence of poor earnings quality is increased information asymmetry and reduced liquidity.

    For more information on this study, please contact Nilabhra Bhattacharya.
     

    Citation:

    Bhattacharya, N., H. Desai, and K. Venkataraman. 2013. Does Earnings Quality Affect Information Asymmetry? Evidence from Trading Costs. Contemporary Accounting Research 30 (2).

    Keywords:
    financial reporting; earnings quality; information asymmetry
    Purpose of the Study:

    An important attribute of the quality of accounting information is the extent to which earnings (accruals) map into cash flows. Poor mapping of accruals into cash flows reduces the information content of reported earnings and results in lower-quality earnings. If investors differ in their ability to process earnings related information, then poor earnings quality can result in differently informed investors and thereby exacerbate the information asymmetry in financial markets. Regulators and standard-setters view a reduction in information asymmetry to be an important benefit of improved earnings quality. This study examines whether poor earnings quality is associated with higher information asymmetry in capital markets.

    Design/Method/ Approach:

    The authors examined the association between earnings quality and information asymmetry during non-earnings announcement periods. Additionally, they tested whether earnings quality is associated with the increase in adverse selection risk around earnings release. The initial sample of firms tested included all NSYE and NASDAQ firms with available data on the CRSP, COMPUSTAT, and Trades and Quotes (TAQ) databases. The firm data was measured for the years 1997 through 2006. Information asymmetry was measured as reflected in the adverse selection component of the trading cost.  Descriptive statistics were used to gather empirical results.

    Findings:
    • The inverse relation between earnings quality and the increase in information asymmetry around earnings releases is observed for all measures of earnings quality.
    • The association between earnings quality and the increase in information asymmetry is more pronounced for smaller firms.
    • Managerial choices that cause accruals volatility to be too high or too low relative to industry norms increase information asymmetry.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Corporate Matters
    Sub-category:
    Earnings Targets & Management Behavior, Evaluating Accruals/Detection of Abnormal Accruals
  • Jennifer M Mueller-Phillips
    How Do Auditors Behave During Periods of Market Euphoria?...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism, 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    How Do Auditors Behave During Periods of Market Euphoria? The Case of Internet IPOs
    Practical Implications:

    Due to the potential for future market bubbles, the findings of this study may be of interest to audit regulators and standard setters. These finding suggest mixed conclusions regarding the Big 5’s behavior during periods of market euphoria. The presence of going concern opinions varies inversely with variables that represent client viability and auditor self-interest. Evidence that points to a decrease in the predictive value of Big 5 opinions signed during the Internet IPO bubble may also have consequences for investors.
     
    For more information on this study, please contact Andrew J. Leone.
     

    Citation:

    Leone, A. J., S. Rice, J. P. Weber, and M. Willenborg. 2013. How Do Auditors Behave During Periods of Market Euphoria? The Case of Internet IPOs. Contemporary Accounting Research 30 (1).

    Keywords:
    auditors’ opinions; going concerns; initial public offerings; online information services
    Purpose of the Study:

    The study of periods of market euphoria is a long-standing topic of interest to economists. Theorists specify conditions under which market participants and institutions cause bubbles to form. This study looks at how auditors behave during these periods of euphoric market conditions, specifically around the time of the wave of Internet companies’ IPOs in the late 1990s and early 2000s. The goal was to discover how audit decisions change with fluctuations in the external marketplace. The authors address whether auditors are maintaining their responsibility to act in the public’s best interest during these unique market conditions, and how going concern decisions of these Internet IPO companies might vary based on these conditions.

    Design/Method/ Approach:

    The authors obtained a sample of 756 Internet IPO filings from 1996 to 2000 using an online database, as well as a sample of non- Internet IPO registrants. Using descriptive statistics, the authors tested these samples for determinants that could lead auditors to shift their going concern decision criteria during euphoric market conditions.

    Findings:
    • The presence of going concern opinions varies with variables that proxy for both economic reasons and for less independence and skepticism by the Big 5.
    • Some evidence points to associations between costs to investors and a decrease in Big 5 going concern opinions during the bubble.
    • Big 5 firms were not a major cause of the Internet IPO bubble, but large audit firms did little to slow it from inflating.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Auditor Judgment, Client Acceptance and Continuance
    Sub-category:
    Auditors’ Professional Skepticism, Business Risk Assessment (e.g. industry - IPO - complexity), Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Audit risk Assessments Using Belief versus Probability
    research summary posted October 29, 2013 by Jennifer M Mueller-Phillips, 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, 08.04 Auditors’ Professional Skepticism in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Audit risk Assessments Using Belief versus Probability
    Practical Implications:

    The primary contribution of the paper is the presentation of four alternative concepts or definitions of audit risk. The feasibility and impact on auditor judgments of auditors applying these approaches to audit risk assessments are tested in an experimental setting where a second aspect of auditing – how assertions are framed – is also examined. Both the risk assessment approach and assertion framing had a significant impact on risk assessment both before and after audit evidence was evaluated. Importantly, auditors who were given a negatively stated audit assertion tended to be more skeptical than those who were given a positively framed assertion. This result has possible audit effectiveness and efficiency implications. 

    Citation:

    Fukukawa, H., and T. Mock. 2011. Audit risk assessments using belief versus probability. Auditing: A Journal of Practice and Theory 30 (1): 75-99.

    Keywords:
    auditors’ risk assessments; belief functions; probability; assertion framing effects
    Purpose of the Study:

    To present and experimentally compare alternative approaches to defining audit risk based on probability theory and the theory of belief functions and the effects of these approaches and of assertion framing on audit judgment. The risk measures studied were:

    1. Belief that an assertion is false
    2. Plausibility that an assertion is false, which is the sum of the belief that an assertion is false and the explicitly measured ambiguity and thus is the most conservative measure
    3. Probability that an assertion is false
    4. Cobb-Shenoy transformed belief that an assertion is false

    The first two approaches are belief-based, while the third is a probability-based approach. The logical connection between probability and belief assessments is used to define and operationalize the forth measure.

    Additionally, this study experimentally tests the effects of positive and negative  assertion framing on risk assessment and whether or not these effects are contingent on the approach to risk assessment and the evidence presented.

    Design/Method/ Approach:

    An experiment was conducted using practicing auditors drawn from Big 4 firms in Japan. Each participant was randomly assigned to one of four conditions where the factors manipulated were assertion framing and approach to risk assessment. The participants were presented with tasks for which they made a series of audit risk assessment judgments related to assertions presented about trade accounts receivable.

    Findings:

    The authors found the risk assessment approach effects to be significant with the belief-based risk assessments being smallest, the plausibility assessments being largest, and the probability assessments and the Cobb-Shenoy transformed belief assessments being in-between. Most of the paired comparisons between these measures were statistically significant. These results imply that any audit methodology that focuses on any one of these risk assessment measures is likely to result in substantially different risk assessments and potentially significant effects on audit efficiency and effectiveness.

    The authors also found evidence of significant audit assertion framing effects. Firstly, auditors who were given a negatively stated audit assertion tended to be more skeptical than those who were given a positively framed assertion. Also, the results showed that auditors are prone to confirm a given assertion regardless of whether it is stated positively or negatively. The pervasive framing effects are more significant after audit evidence is presented, more significant when stronger audit evidence is presented, and are influenced by the risk assessment approach. The existence of such assertion framing effects clearly may directly affect audit effectiveness and efficiency.

    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Auditors’ Professional Skepticism
  • Jennifer M Mueller-Phillips
    Assessing Risk with Analytical Procedures: Do...
    research summary posted October 29, 2013 by Jennifer M Mueller-Phillips, 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Assessing Risk with Analytical Procedures: Do Systems-Thinking Tools Help Auditors Focus on Diagnostic Patterns?
    Practical Implications:

    The diagrams used in this study contained identical information about changes in accounts; however, auditors who used a diagram that illustrated information in a way that explicitly outlined associations among accounts came to different conclusions about risk than those who used a simple business process diagram. Changing the way information is presented to auditors during the planning phase of an audit could help auditors develop more reliable risk assessments and could significantly improve the audit practice. 

    For more information on this study, please contact Ed O’Donnell.
     

    Citation:

    O’Donnell, E., and J. Perkins. 2011. Assessing Risk with Analytical Procedures: Do Systems-Thinking Tools Help Auditors Focus on Diagnostic Patterns? Auditing: A Journal of Practice and Theory 30 (4): 273-283.

    Keywords:
    analytical procedures; causal-loop diagrams: pattern recognition; risk assessment.
    Purpose of the Study:

    Auditors assigned to an assurance engagement must perform analytical procedures to identify any situations that could increase the risk of material misstatement in accounts. However, even when auditors perform adequate and appropriate procedures to assess risk, auditors often fail to recognize conditions that increase the risk of misstatement. This can occur when evidence manifests through inconsistent fluctuation of related accounts instead of manifesting through inconsistent fluctuations for a single account. This study addresses this auditor weakness by evaluating whether the way information is presented in the diagrams used to perform analytical procedures affects an auditor’s assessment of risk during the planning phase of an audit engagement. The authors suggest that an alternative way of presenting information could potentially allow auditors to more appropriately recognize and respond to patterns of changes in accounts. The two different types of information presentation compared in this study are:

    • Causal-loop diagram- a system-thinking tool that explicitly illustrates associations among process components.
    • Business-process diagram- a diagram that provides equivalent information than that presented in a causal loop diagram but presents it in a different format without explicit illustrations.
       
    Design/Method/ Approach:

    The authors collected the evidence for this study prior to November 2011. The lab experiment was conducted using auditors with audit experience ranging from 20 to 84 months, with an average of 41.7 months. The auditors were randomly assigned to a task that entailed either identifying fluctuations or explaining fluctuations by performing analytical procedure on given financial information with seeded inconsistent fluctuations in related accounts. Half of the participants in each task used the business process diagram while the other half used the causal loop diagram to reach a conclusion.

    Findings:
    • Compared to participants in the experiment who used the business process diagram, those who used the causal-loop diagram found the evidence about patterns in inconsistent fluctuations among related accounts more important and relevant to risk.
    • Compared to participants in the experiment who used the business process diagram, those who used the causal- loop diagram concluded that there was a higher level of misstatement risk given the inconsistent fluctuations in related accounts.
    • The findings suggest that changing the way information is organized and presented to auditors can increase their pattern focus when they perform analytical procedures during the planning phase and could potentially improve their assessment of misstatement risk.
    • Results from this study should be evaluated with respect to the limitations inherent in the laboratory experiment. It is possible that the auditors using the different diagrams could have come to the same conclusion about risk had they had as much evidence as is typically gathered from analytical procedures in real engagements. Future research should address this issue to come to a definitive conclusion about the usefulness of systems-thinking audit tools with respect to assessing misstatement risk.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement
  • Jennifer M Mueller-Phillips
    Individual Auditors’ Identification of Relevant Fraud S...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 08.0 Auditing Procedures – Nature, Timing and Extent in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Individual Auditors’ Identification of Relevant Fraud Schemes
    Citation:

    Simon, C. A. 2012.  Individual auditors’ identification of relevant fraud schemes.  Auditing: A Journal of Practice & Theory 31 (1), 1-16.

    Keywords:
    fraud schemes; management’s goals
    Purpose of the Study:

    Previous research has identified that auditors often have difficulty either assessing fraud risk or responding to it properly through effective audit procedures.  This study investigates two methods that are expected to reduce these difficulties. The first method, consideration of management’s goals, is predicted to allow auditors to integrate the effects of these goals with gathered audit evidence (such as analytic procedures) in order to determine whether they are consistent.  The second method, forming expectations independent of client’s current numbers, prevents auditors from “anchoring” their expectations on the current numbers and considering fraudulent activities that contribute these numbers.  In addition, utilizing both methods is predicted to have a joint effect beyond each method’s individual effect, since independently setting expectations after considering management’s goals will result in expectations that are even more likely to reflect consideration of potential fraudulent activity.

    Design/Method/ Approach:

    An experiment was conducted prior to 2011 using auditors with an average of 32 months of experience (most of who were from a single Big 4 firm).  Participants were first given background information about a client (based on an actual fraud investigated by the SEC) followed by fraud red flags that were present or absent and financial ratios for the company’s prior year-end and current year third quarter.  About half of the participants were asked to form expectations before they see the current year-end ratios, while the other half are not asked to form expectations.  Also, half of the participants (randomized differently than for the previous manipulation) were asked to write goals that could lead management to commit fraud, then to list the fraud red flags and analytic results that were consistent with these goals.  Participants then assess overall fraud risk, list potential fraud schemes, then list audit procedures to address the schemes they listed.

    Findings:
    • Auditors who were instructed to focus on management’s goals identified more schemes that were relevant to the fraud (those the SEC noted in its enforcement action)
    • Documenting expectations did not contribute to the identification of relevant schemes
    • Identification of relevant schemes lead to procedures that would be more effective in catching the fraud
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    How Do Audit Seniors Respond to Heightened Fraud Risk?
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 08.0 Auditing Procedures – Nature, Timing and Extent in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    How Do Audit Seniors Respond to Heightened Fraud Risk?
    Practical Implications:

    Less-experienced auditors tend to respond to risk by indiscriminately increasing sample size; when management utilizes a specific scheme to commit fraud, this method is far less effective than tailoring procedures to target a particular sample where fraud is more likely to occur.  The authors suggest that training on recognizing cues that may suggest specific fraud schemes (especially early in an auditor’s career) and when targeting a particular high-risk sample is appropriate (as opposed to simply increasing sample size) would help auditors to recognize when aspects of an engagement imply higher risk of a particular fraud method or scheme and address it properly by targeting their testing to directly address the fraud risk.

    For more information on this study, please contact Jacqueline Hammersley.
     

    Citation:

    Hammersley, J. S., K. M. Johnstone, and K. Kadous.  2011.  How Do Audit Seniors Respond to Heightened Fraud Risk?  Auditing: A Journal of Practice & Theory 30 (3), 81-101.

    Keywords:
    audit planning; fraud detection; fraud risk factors; audit seniors; risk assessments.
    Purpose of the Study:

    A number of studies have looked at methods of improving the assessment of fraud risk and the resulting selection of audit procedures to address this risk.  However, most of these studies use managers, whereas seniors are often responsible for putting together the audit plan.  Although managers review this plan, the initial selection of procedures by seniors can significantly impact the final audit plan.  Therefore, this study examines seniors’ assessment of fraud risk and how they modify a standard audit plan to combat this risk.

    In addition, this study looks at multiple levels of fraud risk. Although all the seniors are given a case based on an actual fraud from an SEC Accounting and Auditing Enforcement Release, some of them are informed that a material weakness in the revenue recognition cycle (although unrelated to the fraud) was detected in the current year in order to determine whether seniors responded to this risk in terms of an elevated risk assessment.  Finally, this study not only investigates the effectiveness of the procedures selected, but also their efficiency; this is able to capture whether the seniors’ procedures may not only be ineffective at catching the fraud, but also inefficient (procedures that add time to the audit, but would not catch the fraud).
     

    Design/Method/ Approach:

    The authors conduct an experiment using seniors from a Big 4 firm.  Evidence was collected prior to 2010.  The seniors were given a case with background and financial information on the company as well as auditing assessments of materiality and the control environment.  The background information included a description of a marketing plan that management was using to fraudulently recognize revenue.  About half of the participants were informed that a material weakness had been identified in the revenue recognition cycle, while the other half were informed that internal controls testing was ongoing, but had not detected anything yet.  All participants were then asked to identify risk factors from the case, judge the revenue cycle risks, modify a standard audit plan to respond to the risks, and assess the need to consult with a risk management partner.

    Findings:
    • Auditors who receive information about a material weakness assess both fraud risk and the need to consult with a risk management partner higher than auditors who receive no information about a material weakness.
    • However, auditors receiving information about a material weakness do not identify more risk factors focused on the fraud than auditors in the control condition.
    • In addition, auditors receiving information about a material weakness develop audit programs that are no more effective for fraud detection purposes but are more inefficient than those who do not receive this information.  This appears to be due to the general implication of risk causing auditors to increase sample size indiscriminately, but not targeting the specific fraud.
    • Auditors who identified more fraud risks were more likely to modify procedures in a way that would have a better chance at detecting the fraud.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Do changes in audit actions and attitudes consistent with...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism, 10.0 Engagement Management, 10.04 Interactions with Client Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Do changes in audit actions and attitudes consistent with increased auditor scepticism deter aggressive earnings management? An experimental investigation
    Practical Implications:
    • Regulators and standard setters have been concerned that we do not know which audit actions most likely detect fraud.  An understanding of what audit procedures are likely to discourage managers from committing fraud is valuable. 
    • Specifically, the study shows that changes in the nature and extent of audit procedures combined with increased skepticism via critical inquiry are helpful in deterring potentially fraudulent behavior. 
    • Similar changes in audit procedures also affect management’s judgment about the ethicality of potentially fraudulent behavior. 
       
    Citation:

    Chen, Q., K. Kelly, and S. Salterio. 2012. Do changes in audit actions and attitudes consistent with increased auditor scepticism deter aggressive earnings management? An experimental investigation. Accounting, Organizations and Society 37 (2): 95-115.  

    Keywords:
    Fraud, Audit Procedures, Professional Skepticism, Earnings Management
    Purpose of the Study:

    Recent years have brought increased focus on the financial statement audit as not just a means of detection but a deterrent to fraud.  The link between detection and deterrence is made in practice because an increase in the ability to detect fraud on the part of the auditor (if widely known) should also lead to an increase in the ability of the audit process to deter fraud.
    The current study seeks to identify whether different audit procedures and attitudes toward management deter aggressive earnings management that is possibly fraudulent.  Using the experimental research approach allows the authors to focus on a scenario where the increase in deterrence is not due to an increase in the probability of detection but is most likely due to the specific changes in the audit approach tested. 
     

    Design/Method/ Approach:

    Corporate managers were placed in different experimental conditions to examine differences in their assessments about potentially fraudulent behavior.  Participants were told they were the manager of a firm for which rotational audits are performed.  In the current year, the manager’s division was not being audited, but they were made aware of the audit procedures being performed in other divisions.  In one condition, the procedures were the same as last year (SALY).  In another condition, the extent or quantity of evidence collected would be increased.  In the third condition the nature of evidence collected was increased (i.e. confirmations rather than internal documentation).  Within each of these three conditions half of the participants would also note an increase in auditor skepticism via more critical inquiry procedures while the other half would not.  Managers were then asked to assess a level of potential earnings management in their division as well as the ethicality of any potential earnings management.  The experiment was web-based.

    Findings:
    • When managers find out about a change in the nature of audit work being performed at other divisions, they respond by reducing earnings management in their own division as compared to the condition where procedures were the same as last year or where the change in procedure is an increase in audit evidence only. 
    • Managers exhibited this behavior even though the changes in procedures did not affect their division. 
    • Combining a more skeptical auditor attitude toward a manager with a change in the nature of audit evidence, the extent of evidence collected, or a change in the nature of the evidence, reduces earnings management as compared to the same as last year condition
    • An increase in evidence collected alone, or more critical inquiry alone does not significantly deter earnings management relative to the condition where procedures were the same as last year.
    • The results of management’s assessment of the ethicality of potential earnings management mirrors the results for the planned level of earnings management described above.  These results hold, even after considering manager ethical disposition.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Engagement Management, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Auditors’ Professional Skepticism, Earnings Management, Interactions with Client Management
  • Jennifer M Mueller-Phillips
    Risk-Based Auditing, Strategic Prompts, and Auditor...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.06 Earnings Management, 08.0 Auditing Procedures – Nature, Timing and Extent in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Risk-Based Auditing, Strategic Prompts, and Auditor Sensitivity to the Strategic Risk of Fraud
    Practical Implications:

    This study has implications for accounting firms as well as audit standard setters.  The results suggest that prompting auditors to consider how management might anticipate and exploit the auditor’s risk assessments and resource allocations may help decrease the number of undetected misstatements.  That is, prompting auditors to consider management’s strategic attempts to conceal fraud may direct the auditor’s attention to ostensibly low-risk accounts where fraud may have been intentionally concealed.  This research also suggests that improved audit effectiveness in terms of the increased detection of fraudulent reporting can be obtained without a corresponding loss in audit efficiency.

    For more information on this study, please contact Kendall Bowlin.
     

    Citation:

    Bowlin, K. 2011. Risk-Based Auditing, Strategic Prompts, and Auditor Sensitivity to the Strategic Risk of Fraud. The Accounting Review 86 (4): 1231-1253.

    Keywords:
    audit resource allocation; strategic reasoning; fraud risk; risk-based auditing; experimental economics.
    Purpose of the Study:

    Risk based auditing instructs the auditor to focus audit attention and resources on accounts that are deemed to be high-risk for a given audit engagement.  However, because fraud is strategic in nature and not random, management may intentionally target low-risk accounts for concealing fraudulent activity.  If auditors fail to consider the potential that management may intentionally target low-risk accounts for perpetrating fraud, the auditor may fail to detect the fraud due to a lack of audit procedures for the low-risk audit areas.
    This study uses an experiment to determine if:

    • Management is likely to act strategically by targeting low-risk accounts to conceal misstatements.
    • Auditors fail to detect misstatements in low-risk accounts because audit resources have been allocated to high-risk accounts.
    • If prompting auditors to consider management’s strategic concealment of fraud results in fewer undetected misstatements and changes in audit resource allocation.
       
    Design/Method/ Approach:

    132 accounting students enrolled in upper-division classes participated in a computer based simulation analogous to an audit engagement whereby students were paired such that one participant represented a manager and the other an auditor.  In the game, two buckets representing general ledger accounts were filled with 100 marbles (200 total) by a machine.  Participants were told that one of the buckets was susceptible to an odd-colored marble (representing a misstatement) being included by the machine during the filling process by chance.  The bucket with the chance misstatement occurrence represents a high-risk account existing during the audit process.  Additionally, the manager could override the machine filling either bucket to strategically and intentionally include an odd-colored marble in either of the buckets, representing fraud. 

    The auditor participant was provided a finite number of marbles they could pull from both buckets combined in search of the odd-colored (misstatement) marble.  This guessing distribution is analogous to the allocation of audit resources in an actual audit engagement.  One group of auditors had 101 guesses while another group of auditors could use up to 181 guesses.  After the manager had made their override decision and the auditor had made their resource allocation decisions, the computer informed the participants if a misstatement had been detected by the auditor. 

    In the game, the manager was rewarded for successfully having an undetected misstatement and auditors were penalized for failing to identify misstatements.  Additionally, auditors were incentivized to use few available resources when searching for misstatements.  Finally, some auditors were prompted to consider management’s strategic nature by reporting what they believed the manager assumed about the auditor’s resource allocation, and what the manager would likely do to in response to the anticipated allocation of audit resources.  The remaining auditors received no such prompt.
     

    Findings:
    • In the audit simulation game, managers anticipate that the auditor will allocate more resources to the high-risk account and override existing processes to intentionally include the misstatement in the low-risk account.
    • Auditors who were not prompted to consider how management might strategically anticipate the auditor’s resource allocation process used significantly fewer resources in searching for misstatements in the low risk account resulting in undetected misstatements.
    • Auditors who were prompted to state what they believed the manager assumed about the auditor’s resource allocation and what the manager would likely do to in response to the anticipated allocation of audit resources allocated more of their available, unused resources to the low-risk account but did not allocate more unused resources to the high-risk account.  This suggests that the prompt did not merely increase resource consumption in all audit areas, but only in the low-risk account.  This result held in both the low available resource group as well as the high available resource group.  The increased allocation of unused resources to the low-risk account resulted in fewer undetected misstatements.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Productivity Growth in the Public Accounting Industry: The...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 05.0 Audit Team Composition, 05.04 Staff Hiring, Turnover and Morale, 05.05 Diversity of Skill Sets e.g., Tenure and Experience, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.09 Impact of Technology on Audit Procedures in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Productivity Growth in the Public Accounting Industry: The Roles of Information Technology and Human Capital
    Practical Implications:

    Given the positive effects that human capital and IT accumulation had on productivity growth, the findings of this study imply that firms seeking to improve their revenues per employee could do so by investing in more IT and human capital. The potential effects of these investments on audit quality could be beneficial when determining the level of investment to make. However, firms should keep in mind the possibility of diminishing results once a certain level of IT and human capital is accumulated. This study also has implications for the debate in the United States surrounding the Sarbanes- Oxley Act which prohibits certain non-audit services by public accounting firms. The debate stem from a concern of the effects of non-audit services on independence but this study displays the benefits that could arise if non-audit services were allowed.

    For more information on this study, please contact Hsihui Chang.
     

    Citation:

    Chang, H., J. Chen, R. Duh, and S. Li. 2011. Productivity growth in the public accounting industry: the roles of information technology and human capital. Auditing: A Journal of Practice and Theory 30 (1): 21-48.

    Keywords:
    productivity growth; efficiency change; technical progress; IT capital accumulation; human capital accumulation; Big 4; non-audit services.
    Purpose of the Study:

    The audit industry has changed dramatically over the last two decades. These changes have brought on increased competition among firms which has created immense pressure for audit firms to minimize their costs while maximizing productivity. For many public accounting firms, the way to manage productivity growth and enhance service delivery came in the form of investments in information technology and human capital. Investments in information technology can increase productivity through automation of routine auditing tasks, improvements in audit team collaboration and communication, as well as through an increased level of experience with information systems which can improve auditor performance in engagements to help clients integrate their company information systems. High quality human capital, which is usually indicated through education levels and work experience and results in both technical and tacit knowledge, contributes to the productivity growth of a firm through higher quality services for clients.

    This study breaks down human capital and information technology (IT) into four drivers of productivity growth among public accounting firms; efficiency change, technical progress, IT capital accumulation, and human capital accumulation. The authors assessed both the simultaneous effects of human capital and IT as well as the individual contributions of the four distinct components of these factors on productivity growth. Some firms also chose to boost productivity through engaging in more non- audit services. Although most studies focus on the effects that non-audit services have on auditor independence, this study focuses on how non- audit services can contribute to productivity growth.
     

    Design/Method/ Approach:

    The authors analyzed data on revenues, employees, IT expenditures, and human capital for a sample of public accounting firms in Taiwan from 1993 to 2003. The data was obtained from the Annual Survey of Accounting Firms in Taiwan published by the Department of Statistic of Taiwan’s Ministry of Finance. The authors chose Taiwan as a proper setting for this study because its publications included more advantageous data than that of the United States published in Accounting Today’s annual surveys.

    Findings:
    • Public accounting firms experienced growth in productivity, specifically, labor productivity evidenced through revenue per employee. 
    • This growth, in order of least contribution to greatest contribution, resulted from efficiency improvement, technical progress, human capital accumulation, and IT capital accumulation. Thus, the primary drivers were human capital and IT accumulation.
    • There was a significant difference in productivity growth between Big 4 and non- Big 4 firms. This difference was primarily attributable to greater technical progress and IT capital accumulation among the Big 4. Additionally, there was no difference in human capital accumulation between Big 4 and non- Big 4 firms.
    • Although the advance of technology provides all accounting firms with opportunities to improve productivity, not all firms exploit these opportunities equally. The Big 4 invested more heavily in IT systems and were rewarded with higher productivity growth.
    • Firms with a greater growth in non-audit services had higher productivity than other firms because they accumulated higher IT and human capital over the sample period.
    • Early movers into non-audit services tended to have higher changes in IT capital accumulation.
    • Both early moving firms into non-audit services and firms that emphasized growth in non-audit services presented a direct relationship with productivity growth higher than that of firms which focused on traditional audit services.
       
    Category:
    Audit Team Composition, Auditing Procedures - Nature - Timing and Extent, Internal Control
    Sub-category:
    Diversity of Skill Sets (e.g. Tenure & Experience), Impact of Technology on Audit Procedures Confirmation – Process and Evaluation of Responses, Non-audit Services, Staff Hiring - Turnover & Morale
  • Jennifer M Mueller-Phillips
    Internal Audit Sourcing Arrangements and Reliance by...
    research summary posted September 26, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.01 Scope of Testing, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Audit Sourcing Arrangements and Reliance by External Auditors
    Practical Implications:

    The authors note a couple of implications for practitioners resulting from this study.  First, given the fact that external auditors assess internal audit quality and rely upon the work similarly for outsourced and cosourced internal audit functions, it may be worthwhile for companies to consider engaging some level of independent outside service provider to work along with their in-house internal auditors for high risk areas. 
        Second, having the same 3rd party internal audit service provider also provide tax services results in less reliance upon the work performed by internal audit, even though those services are approved by the audit committee and performed by different individuals.  Therefore, external audit increases their audit effort, thereby implying that external audit must see this additional service provision to be detrimental to the internal audit service provider’s objectivity. 
     
    For more information on this study, please contact Naman K. Desai.
     

    Citation:

    Desai, N. K., G. J. Gerard, and A. Tripathy. 2011. Internal Audit Sourcing Arrangements and Reliance by External Auditors. Auditing: A Journal of Practice & Theory 30 (1):149-171.

    Keywords:
    cosourcing; external auditor reliance; internal audit; sourcing
    Purpose of the Study:

      The purpose of this study is to investigate potential internal audit (IA) sourcing arrangements (in-house, outsource, and cosource) and to determine how that impacts an external auditor’s evaluation of the IA function’s competency, objectivity, and technical skills. The extent to which the audit team will rely upon work performed by the internal auditors can also be determined this way.  This study also looks at whether tax services provided by the IA service provider impacts the extent of reliance for outsourced or cosourced IA.
    This study is important because the Institute of Internal Auditors makes no preference between any of these sourcing arrangements.  Prior research has shown that outsourcing the IA function results in higher ratings of objectivity and more reliance upon their work when inherent risk is high (but no differences when inherent risk is low).  However, no studies test how cosourcing arrangements are evaluated.  This question is important to answer since a cosourced arrangement is a blend of in-house and outsourced internal auditors, which indicates that results could go either way. 
     

    Design/Method/ Approach:

    The authors conducted an experiment including experienced CPAs from Big 4 and regional firms prior to October 2007.  The design results in only 5 groups – in-house, outsource, or cosource without mention of tax services and outsource or cosource with the service firm also providing tax services.  External auditors were asked to provide ratings related to internal audit’s quality, reliance on internal audit work, audit risk, planned external audit effort, and likelihood that IA would give in to management regarding potential findings.

    Findings:
    • The authors find that in high risk areas, external auditors’ rate outsourced and cosourced internal auditors as having higher levels of quality than in-house internal audit.
    • They similarly find that external audit is more likely to rely upon the internal audit work performed if it is performed by outsourced or cosourced IA.
    • Further, the authors find no differences in quality or reliance ratings between outsourced and cosourced IA. 
    • However, when outsourced or cosourced internal audit service providers also provide tax services (which are performed by individuals other than those who perform the internal audit work) external auditors perceive the quality of the internal audit work to be lower.  As a consequence, they rely less upon the internal auditor’s work and instead increase their own external audit efforts. 
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Governance, Internal Control
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Reliance on Internal Auditors, Scope of Testing