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  • Jennifer M Mueller-Phillips
    Does Charismatic Client Leadership Constrain Auditor...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 09.01 Audit Scope and Materiality Judgments in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does Charismatic Client Leadership Constrain Auditor Objectivity?
    Practical Implications:

    The potential threat of constrained auditor objectivity due to charismatic leadership is one that has not previously been addressed before. Therefore, auditors should be proactive in making sure they are aware of this threat while working on various audit engagements. Additionally, audit firms should pay attention because it is unlikely that there are any mitigating strategies in place to combat the threat within the firm. 

    Citation:

    Svanberg, Jan, and P. Ohman. 2017. “Does Charismatic Client Leadership Constrain Auditor Objectivity?”. Behavioral Research in Accounting. 29.1 (2017): 103.

    Keywords:
    auditing; auditor objectivity; charismatic client leadership; client identification
    Purpose of the Study:

    An auditor’s objectivity can be negatively affected by various financial or social characteristics of the client. This study examines whether or not auditor objectivity is constrained by perceived charismatic leadership of management. The initial assumption is that perceived charismatic client leadership will in fact negatively affect auditor objectivity. This threat is particularly concerning because it can rapidly materialize and is unable to be addressed by auditor rotation. Previous studies have focused on the financial size of clients as an indicator of possible problematic relationships between the auditor and client. If the initial assumption in this study is correct than this will suggest that charismatic leadership plays a role in auditor objectivity along with the financial size of the firm. 

    Design/Method/ Approach:

    The sample consists of 1,000 Swedish auditors randomly selected using a Revisorsnamnden register. There was a 19.9% response rate to a questionnaire that was sent out on September 2013. The majority of respondents were male partners or managers. The questionnaire was a cross-sectional survey where auditors were asked to recall their largest client’s leader, and then to assess the extent to which the leader is charismatic. A regression model was then used to test the hypothesis.

    Findings:

    Overall, the authors find that there is a positive relationship between constrained auditor objectivity and the extent to which the auditor perceives the client leaders as charismatic. This suggests that client identification is not necessarily the only social factor leading to constrained objectivity.     

    Additionally, the authors find the following:

    • Stronger levels of professional identification are not associated with more objective judgment.
    • Auditors for Big 4 firms are more objective when compared to auditors in smaller audit firms.
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Prior Dispositions/Biases/Auditor state of mind
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • Jennifer M Mueller-Phillips
    Joint Impact of Materiality Guidance and Justification...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Joint Impact of Materiality Guidance and Justification Requirement on Auditors’ Planning Materiality
    Practical Implications:

    The features that the authors examine, guidance structure and need of justification, vary among the Big 4 public accounting firms, and the authors show that variations in these features result in systematic differences in auditors’ planning materiality judgments. They specifically show that in circumstances where auditors’ reliance on structured guidance is inappropriate, a justification requirement can mitigate this dysfunctional effect. 

    Citation:

    Audsabumrungrat, J., S. Pornupatham, and H. Tan. 2016. Joint Impact of Materiality Guidance and Justification Requirement on Auditors’ Planning Materiality. Behavioral Research in Accounting 28 (2): 17 – 27. 

    Keywords:
    planning materiality, structured guidance, and justification.
    Purpose of the Study:

    The authors of this study investigate whether the requirement to document a justification can overcome auditors’ overreliance on decision aids in a context where their use can lead to dysfunctional outcomes. They examine this issue in a planning materiality setting because planning materiality influences the effectiveness of the overall audit process. The decision aid they examine in this study relates to structured guidance to be used in materiality assessments. Public accounting firms have developed structured guidance to assist their staff in making planning materiality judgments and to increase judgment consistency within the firms, but variations exist in the use of such guidance. They also examine justification, which is the need to provide a rationale or reason to support one’s decisions. 

    Design/Method/ Approach:

    The authors test their prediction experimentally with audit managers from three Big 4 public accounting firms in Thailand. They employ a planning materiality assessment setting where merely following the steps documented in the structured guidance without making adjustments for client-specific factors can lead to less conservative materiality assessments. 

    Findings:
    • The authors find that audit managers make less conservative and less appropriate planning materiality assessments in the presence of structured materiality guidance, but this detrimental effect is mitigated by the need to justify their judgments.
    • Participants’ materiality assessments across all conditions are higher than that made by the expert panel, suggesting that participants are not making overly low assessments that have efficiency implications. 
    Category:
    Auditor Judgment
    Sub-category:
    Audit Scope & Materiality Judgements
  • Jennifer M Mueller-Phillips
    Commentary on Auditing High-Uncertainty Fair Value...
    research summary posted October 16, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 09.06 Adequacy of Disclosure in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Commentary on Auditing High-Uncertainty Fair Value Estimates.
    Practical Implications:

    PCAOB Chairman James Doty recently announced plans to convene a task force on audits of fair value measurements, as well as plans to change the auditor’s report to provide more useful, relevant, and timely information to users of public company financial statements. The authors hope their commentary is helpful to standard-setters’ deliberations, and the authors believe it should be useful to auditing scholars, both as a supplemental reading in auditing courses and a source of ideas to help guide future research designs on auditor and user judgment and decision making for high uncertainty FVA estimates.

    Citation:

    Bell, T. B., and J. B. Griffin. 2012. Commentary on Auditing High-Uncertainty Fair Value Estimates. Auditing: A Journal of Practice & Theory 31 (1): 147-155.

    Keywords:
    disclosure, fair value estimate, inherent measurement uncertainty, materiality
    Purpose of the Study:

    Debate over the relevance and reliability of fair value accounting (FVA) dates back at least seven decades, as evidenced by excerpts presented above from MacNeal’s 1939 accounting classic, Truth in Accounting. In recent years, accounting and auditing standard-setters in the U.S. and abroad have issued a number of authoritative pronouncements that, collectively, indicate institutional embracement of FVA. However, today’s business transactions, terms of contractual arrangements, and structures of financial instruments and other assets and liabilities are more varied and complex. Against this backdrop, continuing controversy over the usefulness and verifiability of high-uncertainty fair value estimates centers primarily on estimates and associated disclosures pertaining to assets and liabilities that are not traded in active markets, i.e., estimates involving the use of Level 2 and Level 3 inputs in the FASB’s fair value hierarchy in Fair Value Measurement.

    This commentary addresses challenges faced by standard-setters, preparers, users, and auditors pertaining to high-uncertainty fair value estimates. The authors briefly describe the financial reporting environment and the difficulty of obtaining reasonable assurance for fair value estimates with high levels of inherent measurement uncertainty. They then discuss some characteristics of an effective accountability framework for fair value accounting.

    Design/Method/ Approach:

    This article is a commentary.

    Findings:

    The authors discuss interdependencies between FVA disclosures and auditing attributes, within the context of an accountability framework for FVA, and propose a combination of changes to these institutional features whose joint effects should (1) improve transparency to users of the inherent (i.e., irreducible) level of measurement uncertainty in high-uncertainty FVA estimates and disclosures, (2) enhance the value to users of the audit of such estimates and disclosures, and (3) help standard-setters improve the clarity of related auditing standards.

    The authors propose additional disclosures on management’s estimation processes, assumptions, and historical estimation accuracy that they believe provide the best avenues for improving the verifiability of decision-useful information on inherent measurement uncertainty. Also, the authors suggest a modified audit report conveying that only negative assurance has been obtained for high-uncertainty FVA estimates, reasons why, and an overview of the procedures performed by the auditor, which should provide a more faithful representation of the true nature and extent of assurance provided to users.

    Category:
    Auditor Judgment
    Sub-category:
    Adequacy of Disclosure, Audit Scope & Materiality Judgements
  • Jennifer M Mueller-Phillips
    Auditor Independence in Fact: Research, Regulatory, and...
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Independence in Fact: Research, Regulatory, and Practice Implications Drawn from Experimental and Archival Research.
    Practical Implications:

    The analysis suggests that a holistic synthesis of the independence literature requires one to carefully consider methodological choices underlying a given study. Such an understanding is necessary to appreciate the context and meaning of the reported findings in relation to the greater body of literature and ongoing concerns of regulators.

    Citation:

    Church, B. K., Jenkins, J. G., McCracken, S. A., Roush, P. B., & Stanley, J. D. 2015. Auditor Independence in Fact: Research, Regulatory, and Practice Implications Drawn from Experimental and Archival Research. Accounting Horizons 29 (1): 217-238.

    Keywords:
    auditor independence, independence in fact, independence regulation, auditor judgment
    Purpose of the Study:

    The essence of factual independence encompasses the auditor’s ability and willingness to suppress bias and report honestly. A lack of independence can lead to biased judgments, indicating a failure in the audit process, but such failures do not necessarily reduce the quality of audit outputs. Process failures increase the likelihood that the quality of audit outputs is lowered; however, this relationship is by no means one-to-one. Notwithstanding various safeguards intended to enhance auditor independence in fact, regulators including the PCAOB have continued to express concerns that auditors, at times, are failing to maintain an appropriate level of independence. In this paper, the authors provide an analysis of selected academic studies related to auditor independence to offer readers a foundation on which to evaluate the substantial body of research in the area and to understand the mixed findings reported in experimental and archival studies. The authors discuss issues surrounding the research designs and methods used in prior work, highlighting challenges that face researchers. 

    Design/Method/ Approach:

    This paper analyzes information from selected academic studies related to auditor independence. 

    Findings:

    In this paper, the authors explore specific experimental and archival research relevant to the effects of independence on (1) auditors’ judgments and decisions that underlie the audit process and (2) observable audit outputs. The examination of experimental studies suggests that cognitive and motivational biases have the potential to impair independence and, consequently, weaken the audit process. By comparison, the examination of archival studies fails to definitively link test variables (i.e., auditor fees and lengthy auditor tenure) with evidence of compromised independence. Taken as a whole, the findings suggest that, although judgmental biases may hinder the audit process, such biases do not necessarily degrade audit outputs. 

    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Audit Scope & Materiality Judgements
  • Jennifer M Mueller-Phillips
    The Effects of Uncertainty and Disclosure on Auditors'...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions.
    Practical Implications:

    The findings suggest that auditors view disclosure as lessening their responsibility for the possible misstatement of recognized amounts, and that they are less likely to require adjustment to the body of the financial statements when preparers supplement recognized fair values with footnote disclosure. Auditors respond to uncertainty differently in the fair value setting than in earlier research on nonfair value materiality decisions. The author contributes to the understanding of how professional standards are implemented as auditors decide whether to adjust fair value measurements.

    Citation:

    Griffin, J. B. 2014. The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions. Journal Of Accounting Research 52 (5): 1165-1193.

    Keywords:
    audit adjustments, disclosure, fair value, materiality, uncertainty, subjectivity, imprecision
    Purpose of the Study:

    Standard setters increasingly prefer that assets and liabilities be measured at fair value, though implementing fair value measurement sparks considerable debate. Measuring fair values in the absence of reliable market prices is difficult because the estimation process often depends on relatively subjective information inputs and generates imprecise ranges of possible outcomes. Investor advocates warn that preparers could use this uncertainty to bias fair value estimates. Auditors must assess the reasonableness of their clients’ measurements and, when they deem misstatements material, require their clients to adjust fair value estimates before reporting them in the financial statements. Regulators’ efforts to address the uncertainty associated with fair value estimates may have the unintended consequence of changing how auditors view their fiduciary duty to the investing public, especially in the case of requiring their clients to adjust fair value estimates.

    The author experimentally examines how two types of uncertainty addressed by regulators, subjectivity and imprecision, and one reporting choice encouraged by regulators, supplemental footnote disclosure, influence auditors’ decisions to require fair value adjustments. Subjectivity affects the reliability of the inputs used to prepare accounting information. In measuring fair values under SFAS No. 157, Level 1 items involve little subjectivity because highly reliable inputs (e.g., active market prices) are available, while Level 2 and Level 3 items involve progressively greater levels of subjectivity because they depend on less reliable inputs (e.g., information from comparable situations or the reporting entity’s own assumptions). Imprecision reflects the degree of variability in possible future outcomes.

    Design/Method/ Approach:

    The author conducts a 2 x 2 x 2 between-participants experiment to examine how subjectivity, imprecision, and supplemental footnote disclosure affect auditors’ adjustment decisions in a fair value measurement setting. Participants from Big Four firms were chosen randomly; 106 practicing auditors with an average of 8.9 years of experience participated in the experiment. The experiment takes participants approximately 15 minutes to complete. The evidence was gathered prior to January 2012.

    Findings:

    Subjectivity and imprecision interact to increase the likelihood that auditors will require their clients to adjust recognized fair value estimates. Increasing the imprecision of possible fair value outcomes amplifies the likelihood that auditors will require adjustment of estimates that rely on more subjective information inputs. Auditors are most likely to require clients to adjust fair value estimates when subjectivity and imprecision are both high. Auditors are most likely to require adjustments when uncertainty is highest and their clients’ discretion is greatest.

    The supplemental footnote disclosure negates this interaction. Although subjectivity and imprecision interact to increase the likelihood that auditors will require an adjustment when supplemental disclosure is absent, the dollar amount of the adjustment depends on imprecision alone. Consistent with standards, auditors use the lower boundrather than the midpointof the range of possible misstatement outcomes to calculate the size of their required adjustments.

    Category:
    Auditor Judgment
    Sub-category:
    Audit Scope & Materiality Judgements
  • Jennifer M Mueller-Phillips
    Materiality Guidance of the Major Public Accounting Firms
    research summary posted July 19, 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:
    Materiality Guidance of the Major Public Accounting Firms
    Practical Implications:

    Knowledge of how materiality guidance is integrated into a firm’s methodology is important for accounting and auditing researchers as well as for practitioners, regulators, and educators. The last published research that examined the major firms’ policies on materiality occurred in 1998.The results of this study provide important insights into implementation of materiality standards and valuable information for future research and education.

    For more information on this study, please contact Aasmund Eilifsen, aasmund.eilifsen@nhh.no.

    Citation:

    Eilifsen, A., and W. F. Messier Jr. 2015. Materiality Guidance of the Major Public Accounting Firms. AUDITING: A Journal of Practice & Theory 34 (2):3-26.

    Keywords:
    Materiality, tolerable misstatement, misstatements, group audits
    Purpose of the Study:

    Materiality is a key concept for both auditors and managers, as well as for users of financial statements. Audit standard setters have recently issued standards related to materiality. Firms translate such auditing standards into their methodologies. This paper provides evidence on the relative consistency of the materiality guidance among the top eight firms. More specifically, it shows how firms determine multiple levels of quantitative materiality, the firms’ guidance on the incorporation of qualitative factors in determining and evaluating materiality, their guidance on handling detected and undetected misstatements and, finally, how the firms’ guidance determines materiality levels in group audits. The authors aim to provide possible answers to concerns raised by prior researchers and information helpful in designing future research.

    Design/Method/ Approach:

    The materiality guidance for profit-oriented entities of eight of the largest U.S. public accounting firms was analyzed along six dimensions:

    • Benchmarks for determining overall materiality
    • Percentages applied to benchmarks for determining overall materiality
    • Determination of tolerable misstatement
    • Amounts used to determine "clearly trivial" misstatements
    • Use of materiality to evaluate misstatements
    • Use of materiality on group audits.

    Each firm reviewed the coding of its guidance for accuracy and completeness. The firms’ guidance was provided to the researchers through a partner contact who held a senior position in each firm’s assurance/audit group. Firm contacts were sent a research proposal that provided the motivation for the study, the research questions, and the deliverables. The proposals were sent out in Fall 2011 with approval and completion in Spring 2012; coding and firm review occurred in Summer and Fall 2012. At the time of the study, these were the eight firms subject to annual inspections by the PCAOB.

    Findings:
    Overall, the findings indicated relative consistency of the materiality guidance among the eight firms. Specifically:
    • Quantitative benchmarks (e.g., income before taxes, total assets or revenues, and total equity) used to determine overall materiality and the related percentages applied to those benchmarks are reasonably consistent across the eight firms.
    • Seven firms use a percentage of overall materiality for determining tolerable misstatement that fits in a 50 to 75 percent range; one firm uses a range of 70 to 90percent.
    • Seven of the firms establish a clearly trivial misstatement to be 3 to 5 percent of overall materiality; one firm uses a range of 5 to 8 percent.
    • All of the firms provide detailed guidance on the evaluation of detected misstatements including consideration of qualitative factors.
    • Applying materiality on group audits closely parallels the guidance provided in the standards.
    • There are differences in how the firms consider the possibility of undetected misstatements when evaluating uncorrected detected misstatements.
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Audit Scope & Materiality Judgements
  • Jennifer M Mueller-Phillips
    Investors’ Response to Revelations of Prior Uncorrected M...
    research summary posted April 1, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.03 Impact of New Accounting Pronouncements, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 11.0 Audit Quality and Quality Control, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Investors’ Response to Revelations of Prior Uncorrected Misstatements
    Practical Implications:

    The results of this study are important in realizing the investor’s perception of audit quality as it relates to SAB No. 108 disclosures. Investors respond negatively to the quantification of prior period misstatement disclosures. The investor also distinguishes between misstatements that are waived by previous auditors and misstatements waived in the current year. Investors react negatively to misstatements that are disclosed in the current year. The investors also react to the importance of the client as it relates to the misstatements that are waived. Investors understand and react to the correlation between client importance, waived misstatements, and client retention. The results are important to understand that investors react to disclosures made under SAB No. 108.

    Citation:

    Omer, T. C., M. K. Shelley, and A. M. Thompson. 2012. Investors' Response to Revelations of Prior Uncorrected Misstatements. AUDITING: A Journal of Practice & Theory 31 (4):167-192.

    Keywords:
    materiality decisions; Staff Accounting Bulletin No. 108; client importance; audit quality; misstatements.
    Purpose of the Study:

    Staff Accounting Bulletin (SAB) No. 108 requires the disclosure of prior-period waived misstatements as well as the use of multiple methods of quantifying misstatements. The rollover method quantifies misstatement on a current year income statement effect, while the iron curtain method quantifies misstatement based on the balance sheet effect. The two methods can differ in terms of the resulting misstatement amounts. The authors of this study examine:

    • Investor responses to the new disclosures under SAB No. 108. Previously waived misstatements that were deemed immaterial by one quantifying method, but then deemed material by the other must now be disclosed.
    • Investor responses to misstatements waived by a predecessor auditor compared to misstatements waived by a current year auditor.
    • Investor perceptions of audit quality based on the new disclosures.
    • Whether client importance is a factor in relation to SAB No. 108 disclosures. 
    Design/Method/ Approach:

    The authors identified 420 firms that disclosed misstatements under SAB No. 108 using EDGAR and Morningstar Document Research. Of these firms, a sample of 272 firms were chosen to complete market return tests on the data. Multivariate regression analysis was employed on firm disclosures from filings made after November 15, 2006. 

    Findings:
    • The authors find that investors respond negatively to SAB No. 108 disclosures. The findings provide evidence that the information affects how the investor views the financial statement information and biases perceptions of audit quality.
    • The authors find that cumulative abnormal returns exist in relation to misstatements initially waived by current auditors. The findings suggest that investors react negatively to waived misstatements by auditors in the current year. Investors distinguish these misstatements from those of waived misstatements by predecessor auditors.
    • The authors find a negative trend of cumulative abnormal returns associated with the investor’s perception of client importance. The findings suggest that investors react according to the perception that misstatements are waived for important clients in order to retain their business. 
    Category:
    Accountants' Reporting, Audit Quality & Quality Control, Auditor Judgment, Standard Setting
    Sub-category:
    Audit Scope & Materiality Judgements, Changes in Reporting Formats, Changes in Reporting Formats, Impact of New Accounting Pronouncements
  • 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
    Group Audits, Group-Level Controls, and Component...
    research summary posted December 1, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Group Audits, Group-Level Controls, and Component Materiality: How Much Auditing Is Enough?
    Practical Implications:

    The proposed component materiality method helps the group auditor develop and document a rational plan for achieving the group assurance objective that is rooted in applicable auditing standards and decision theory.

    The significant differences in results between the proposed method and the alternatives suggest the need for guidance more definitive than that provided by current auditing standards. Indeed, the authors’ approach could be a useful metric for evaluating the efficacy of methods that do not have as comprehensive a supporting theory.

    Field deployment of the proposed method requires software support. A specific implementation is available as an Excel app at http://raw.rutgers.edu/GUAMcalc.

    For more information on this study, please contact Trevor Stewart at trsny@verizon.net.

    Citation:

    Stewart, Trevor R., and William R. Kinney, Jr. 2013. Group Audits, Group-Level Controls, and Component Materiality: How Much Auditing Is Enough? The Accounting Review 88 (2): 707-737.

    Keywords:
    Aggregation, audit assurance, Bayes’ rule, component materiality, group audits, group-level controls, ISA 600, auditor judgment, materiality and scope decisions
    Purpose of the Study:

    Auditing standards mandate that group auditors determine and implement appropriate component materiality amounts, which ultimately affect group audit scope, reliability, and value. However, standards are virtually silent about how these amounts should be determined, indicating merely that they should be less than group materiality but may be greater than proportionate. For example, if group materiality is $1 million and there are five equal size components, then component materiality should be between $200K and $1 million for each component; but how to determine the right amount in that range is not indicated. Various methods used in practice vary widely, lack theoretical support, and may either fail to meet the group audit objective or do so at excessive cost. The authors develop a rigorous method, describe its properties, and compare the component materiality amounts thus derived and the resulting relative audit costs and achieved levels of assurance with those of other methods. 

    Design/Method/ Approach:

    The authors’ method determines component materiality as a function of group materiality, the group auditor’s assurance objective, and relative component sizes and audit costs. The method formally incorporates group auditor knowledge of group-level structure, controls, and context as well as component-level constraints imposed by statutory audit or other requirements. Application of the method yields component materiality amounts that achieve the group auditor’s overall assurance objective by finding the minimum cost solution on an efficient materiality frontier. To continue the simple five-equal-size-component example, the proposed method indicates that component materiality amounts should be no greater than $330K in order to achieve reasonable assurance at the group level relative to group materiality of $1 million. But these amounts may be increased significantly depending on additional factors that the method accommodates.

    The authors’ starting point is the group auditor’s overall objective of achieving reasonable assurance about whether the group financial statements as a whole are free from material misstatement. This overall objective is disaggregated down to the component level and component materiality amounts are determined such that component auditors will do enough work to meet those component objectives. Thus, by design, if the component auditors use component materiality as determined by the group auditor and their audits go as planned, then component objectives will be met and, on aggregation, so will the overall group audit objective.

    Audit assurance is a probabilistic concept, where probability is a measure of the auditor’s degree of professional belief—a subjective notion embraced by Bayesian probability theory. The key to the authors’ method is a Bayesian group audit model that generalizes and extends the single-component audit risk model to aggregate and disaggregate assurance across multiple components. 

    Findings:
    • A conceptually sound, standards-based planning approach to determining component materiality is developed from the insight that component materiality amounts should be those that result in component assurance that aggregates to the desired overall group assurance. Bayesian probability theory provides the philosophical and mathematical framework.
    • The proposed method yields component materiality amounts and achieved group assurance that, depending on circumstances, may differ substantially from other methods. Those methods may be ineffective in meeting professional standards, inefficient in the use of resources, or both ineffective and inefficient.
    • The auditor’s prior (pre-audit) assurance based on group-level controls can facilitate substantially increased component materiality amounts, thereby reducing component auditor work and cost. Indeed, numerical results suggest group-level controls and structured subgroups of components are central to efficient group audits.
    • Aggregate component audit costs can be reduced by optimizing component materiality to incorporate contextual factors, such as group structure, differing component sizes, component audit costs, and component-level constraints imposed by statutory audit and other requirements.
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Materiality & Scope Decisions
  • Jennifer M Mueller-Phillips
    Financial Statement Disaggregation Decisions and Auditors’ T...
    research summary posted April 28, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 10.0 Engagement Management, 10.02 Materiality and Scope Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Financial Statement Disaggregation Decisions and Auditors’ Tolerance for Misstatement
    Practical Implications:

    The findings of this study are relevant to financial reporting standard-setters and regulators interested in the effects of financial statement presentation standards on the reliability of the information presented, to auditing standard-setters and regulators who have a responsibility to clarify auditors’ responsibility for misstatement in disaggregated numbers, and to audit firms that must provide guidance to ensure consensus in their auditors’ judgments. Standard-setters should also consider the fact that FASB has also been considering issues related to balance sheet aggregation or netting of balances. As a consequence, the importance of the effects of aggregation on auditors’ materiality judgments may be broader than the focus of the current study.

    For more information on this study, please contact Robert Libby.
     

    Citation:

    Libby, R., and T. Brown. 2013. Financial Statement Disaggregation Decisions and Auditors’ Tolerance for Misstatement. The Accounting Review 88 (2).

    Keywords:
    audit guidance; disaggregation; IFRS vs. U.S. GAAP; materiality; statement vs. note disclosure
    Purpose of the Study:

    Current IFRS requires significant disaggregation of income statement numbers while such disaggregation is voluntary and much less common under U.S. GAAP. This study examines whether voluntary disaggregation of income statement numbers increases the reliability of income statement subtotals because auditors permit less misstatement in the disaggregated numbers. Auditors require managers to correct discovered financial statement errors only when they are deemed material, and recent evidence suggests that reporting managers leave many immaterial errors uncorrected. Possible effects of management behavior and required disaggregation resulting from U.S. adoption of IFRS or the recommendations of the joint FASB/IASB financial statement presentation project are also discussed.

    Design/Method/ Approach:

    A total of 78 experienced U.S. auditors from three Big 4 firms participate in the study. Of the 78, 76 identify their current position as audit manager, two identify as audit seniors. Most of the participants’ experience is with public, commercial (nonfinancial), for-profit companies. The participants are randomly assigned to the experimental conditions. The experiment involves the participating auditors determining the materiality of a single audit difference involving the underaccrual of occupancy expenses. 

    Findings:

    Disaggregating expense items can reduce the allowable error in the disaggregated amounts, increasing the reliability of the disaggregated amounts as well as the resulting statement subtotals and totals.
    There is significant disagreement among practicing auditors on the relevance of line items as materiality benchmarks and that reporting disaggregated in the notes reduces the effect. This suggests that voluntary disaggregation decreases the average amount of error tolerated in the current financial statements, but at the same time decreases the consensus in audit practice.
    The prior effect is substantially reduced if the disaggregated data are presented in the notes. This results from conscious differences in beliefs about the relevance of line items as materiality benchmarks.
     

    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Audit Scope & Materiality Judgements, Materiality & Scope Decisions