This study has implications for public accounting firms engaging in GHG engagements. Team training that establishes an understanding of the knowledge and role of the team members from differing disciplines might help to alleviate over-reliance on peer-provided evidence. In the context of multidisciplinary assurance teams, establishing and adhering to audit firm quality control mechanisms relating to evidence collection, evaluation, and review are of particular importance. Accounting firms may also need to pay particular attention in fostering an assurance environment that encourages objective evidence processing.

 Kim, S., W. J. Green, and K. M. Johnstone. 2016. Biased Evidence Processing by Multidisciplinary Greenhouse Gas Assurance Teams. Auditing: A Journal of Practice and Theory 35 (3): 119-139.

Due to the increased attention being paid to the environment as well as how humans are impacting the environment, there exists growing demand for a range of corporate social responsibility information. In order to be most efficient, assurors conduct greenhouse gas (GHG) assurance engagements using multidisciplinary teams containing varying technical expertise, with some possessing financial audit-related expertise and others possessing science or combined science/financial-related expertise. The purpose of this study is to investigate how auditors respond to the discipline-specific expertise of other team members in undertaking GHG assurance. 

The authors test this by conducting an experiment in which traditional auditor participants respond to a simulated multidisciplinary team and examine whether the auditors bias their weighting of evidence based on if the senior assuror has a science background as opposed to a financial background. 

• The authors find that the assuror participants bias their processing of audit evidence by conforming to the science senior’s explanation, despite the fact that, in this setting, no science-related expertise is needed to compile or evaluate the evidence and other available evidence items contradict the science senior’s explanation.
• The authors find that the results also support the mitigating role of the reviewer’s expertise on the effect of the science senior’s explanation. Specifically, the participants who learned the explanation of a science senior place less weight on the science-related evidence items once they learn that the reviewer has financial assurance expertise.
• The authors also find evidence that this biased weighting of evidence and the mitigating role of the reviewer’s expertise translate into the final assurance judgments.

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Based on the interviews and problems identified, the authors conjecture that potentially suboptimal auditing methods are being used to evaluate complex estimates which are an important and growing part of the financial statements. This may be negatively impacting audit quality. More specifically, auditors over-rely on management estimates because they lack the knowledge and incentives to behave otherwise. This possibility has direct consequences for auditor professional skepticism because increasing professional skepticism may be less effective unless auditors are also given the requisite knowledge to properly use it. These problems are reinforced by auditing standards and regulators which generally outline/criticize the current auditing methods without suggesting new or better ones.  

Griffith, E., J. Hammersley, and K. Kadous. 2015. Audits of Complex Estimates as Verification of Management Numbers: How Institutional Pressures Shape Practice. Contemporary Accounting Research 32 (3): 833-863.

Complex estimates are increasingly important to financial statements and of growing concern to both regulators and investors. While auditors have well-established procedures for auditing more objective account balances (i.e., valued at historical cost), little is known about the process auditors use to evaluate more subjective, complex estimates. This article conducts interviews with experienced audit personnel to determine how auditors evaluate such estimates, determines the problems with such approaches, and uses “institutional theory” to theorize the reason such problems exist and persist. The authors consider the influence of both audit firms themselves and regulators (i.e., information from PCAOB inspection reports) on auditors’ complex estimate audit procedures.

The authors conducted semi-structured phone interviews with experienced audit personnel. Participants are from 6 large accounting firms with at least manager level experience. Interviews were conducted between October and November 2010. The authors analyzed the audit process steps discussed by participants for complex estimates and coded these steps according to the PCAOB auditing standards related to accounting estimates (AU 342 and 328).  For steps that could not be appropriately classified into ones discussed by the auditing standards, the authors developed additional classifications.

While auditing standards allow for different approaches to evaluating complex estimates (e.g., testing management process, preparing independent estimate, etc.), the authors find that auditors usually just test management’s process (i.e., verifying inputs such as historical cost, understanding who and how estimate is generated, testing controls surrounding process, and testing sensitivity of assumptions used).  

Based on institutional theory, the authors theorize two key reasons that auditors mainly use management process verification when auditing complex estimates instead of other (potentially more creative and skeptical) approaches. The reasons are:

• Both audit firm policies and professional standards generally emphasize management process verification techniques over other potential techniques. Additionally, regulators (i.e., PCAOB) reinforce/encourage this behavior because inspection findings largely focus on problems with auditing management’s process instead of suggesting alternative, superior auditing methods.
• Audit firms employ valuation specialists who have the necessary knowledge to more critically analyze complex estimates. This fact means that financial statement auditors generally do not have the necessary knowledge to critically analyze management’s models or develop an independent expectation. When auditors do use such specialists, they over-rely on their work.
• Given the lack of guidance regarding complex estimates, firms tend to use practices that have been previously legitimized. For auditing of complex estimates, verification (which works well to audit less subjective accounts) is used to audit more subject complex estimates. Auditing standards also mainly emphasize verification.
• Given inspection pressures, firms find it safer and more legitimate to mimic each other’s policies and procedures for auditing complex estimates instead of develop new ones.

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The heightened epistemic motivation induced by principles-based accounting standards then ultimately increases auditors’ demands for audit evidence. Thus, the results suggest the important influence of accounting standards on auditors’ motivations and consequent program planning decisions. The findings provide valuable information to regulators in their evaluation of how or whether to move forward with potential IFRS adoption or convergence of U.S. GAAP with IFRS. In a principles environment, audit firms must take measures to guard against this potential bias, e.g., review of proposed audit programs and results of tests.

Peytcheva, M., Wright, A. M., & Majoor, B. 2014. The Impact of Principles-Based versus Rules-Based Accounting Standards on Auditors' Motivations and Evidence Demands. Behavioral Research In Accounting 26 (2): 51-72.

There has been considerable discussion about the effects of principles-based versus rules-based accounting standards on financial reporting quality, particularly given the debate concerning the adoption of, or convergence with, International Financial Reporting Standards (IFRS) in the United States. Auditing research has investigated the effects of different accounting standards on auditors’ decisions to constrain aggressive reporting by clients. Missing from this literature is evidence on how the type of accounting standard influences auditors’ cognitive motivations and demand for audit evidence. This study addresses this gap in the literature, which is important since the financial statements are the joint product of management’s and the auditor’s actions.

This is the first study to examine the effects of the type of accounting standard on auditors’ cognitive motivations and information search patterns.  The authors address an important, and missing, piece of the puzzle: are there fundamental differences in the psychological processes employed by auditors who face principles versus rules accounting guidance? If there are differences, are auditors’ motivations under principles-based accounting standards driven by simple self-interest as opposed to a desire to understand the economic substance of the transaction at hand?

The theoretical model is tested using an experiment with 104 auditors from the U.S. and 48 auditors from The Netherlands. The experiment manipulates the type of accounting standard between participants at two levels: rules-based or principles-based. The evidence was gathered prior to January 2014.

Findings from this experiment suggest that principles-based versus rules-based standards lead to significant differences in the judgment processes of professional auditors. In turn, greater process accountability induces higher epistemic motivation in auditors—a desire to obtain a rich and thorough understanding of the problem at hand. High levels of epistemic motivation stimulated by principles-based accounting standards then induce a greater demand for both total desired evidence and diagnostic audit evidence. These findings suggest that, while bright-line rules and thresholds can limit cognitive effort, accounting standards based on broad principles are likely to evoke systematic and thorough information processing, thereby leading auditors to strive for a rich and accurate understanding of the issues under consideration.

The results also indicate that, although auditors exposed to IFRS over a prolonged period (e.g., Dutch auditors) may experience lower process accountability and epistemic motivation when working with principles-based standards than U.S. auditors, principles-based accounting standards still induce greater epistemic motivation than rules-based accounting standards in these auditors, suggesting a greater desire to obtain a rich understanding of the matter at hand.

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The increasing use of uncertain fair value measurements and other estimates in financial statements place an increasingly difficult burden on auditors, who are required to provide a high level of positive assurance that financial statements—including those containing items subject to enormous inherent estimation uncertainty such as those described above—are fairly stated in all material respects. The authors state that auditors are doing their best within the requirements imposed by standard setters and regulators, but also suggest that it is time for those who set and regulate standards to consider ways to more clearly convey where extreme estimation uncertainty exists within financial statements, and to reconsider auditors’ ability to provide positive, high level audit assurance on these inherently uncertain estimates.

For more information on this study, please contact Steven M. Glover.

Christensen, B. E., S. M. Glover, and D. A. Wood. 2012. Extreme Estimation Uncertainty in Fair Value Estimates: Implications for Audit Assurance. AUDITING: A Journal of Practice & Theory 31 (1):127-146.

The prevalence of fair value and other estimates in financial statements, as well as their inherent estimation uncertainty, has increased dramatically in recent years. Auditors are placed in a difficult position, as no amount of auditing can remove the underlying estimation uncertainty in reported values that are determined by management-derived estimation models that are hypersensitive to small changes in inputs. Despite the increase in uncertainty, the content of the audit report and the information conveyed on the face of the financial statements have changed relatively little. The study discusses how recent events have seemingly resulted in higher expectations and tighter constraints, thus placing a potentially unrealistic burden on auditors, essentially requiring them to provide a product that may be beyond their reach. Finally, the study questions whether auditing and financial reporting standards provide for effective conveyance of the uncertainty contained in financial statements.

The study uses estimates reported by Wells Fargo and General Motors to illustrate how changes in estimation model inputs impact fair value point estimates. The authors compare estimation uncertainty in the point estimates, as reported by management, to audit materiality for the financial statements taken as a whole.  The level of estimation uncertainty highlights potential challenges that auditors face in providing assurance on account balance estimates with uncertainty ranges that often are many times larger than materiality for the financial statements taken as a whole.

Analysis of disclosures from Wells Fargo and GM show that:

• Changes to the interest rate input as small as 3.70 and 27.04 basis points (bps) in 2008 and 2007, respectively, would yield material swings in the reported value of Wells Fargo’s mortgage-backed securities—changes that directly impact other comprehensive income. Such small changes are within a reasonable range of interest rates.
• A 75 bps change to GM’s expected return on pension plan assets resulted in an overstatement of pretax earnings by $510 million and an understatement of the pension obligation by over 42 times audit materiality.

The Wells Fargo and GM cases highlighted in the study demonstrate the extreme estimation uncertainty in some significant accounting estimates. Hypersensitivity to small changes in unobservable inputs, the large number of such inputs, the large number of estimates in the financial statements of complex entities that involve such inputs, and the level of management discretion involved in accounting estimates all add to the burden placed on auditors in providing assurance surrounding these estimates.

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Given the extent of audit evidence collected by young staff auditors, the findings of this study have direct implications for workpaper and audit quality. The mismatch of age, experience, and knowledge between staff-level auditors and client management can result in a potentially intimidating situation for the staff-level auditor, and impact decisions made in collecting information and conducting testwork. These results provide new evidence regarding the impact of auditor-client interactions on audit quality. This suggests that firms may want to consider how to manage these social mismatches of their staff.

For more information on this study, please contact G. Bradley Bennett.
 

Bennett, G. B., and R. C. Hatfield. 2013. The Effect of the Social Mismatch between Staff Auditors and Client Management on the Collection of Audit Evidence. The Accounting Review 88 (1): 31–50.

This study analyzes social interactions between staff-level auditors and client management to determine how differences in perceptions may influence decisions regarding the collection of audit evidence. During fieldwork, staff-level auditors have extensive interaction with client management, and evidence suggests these auditors are often socially “mismatched” with client management, in terms of their experience, age, and accounting knowledge. Concerns exist over these staff-level auditors’ desires to avoid the interactions and how it may affect the amount of audit evidence collected. The authors of this study attempt to determine the overall effects of these relationships.

Surveys were conducted to gather evidence about audit staff interactions with client management. The results of these studies were used to develop and experiment. Graduate auditing students with approximately 2.5 months average internship experience over one busy season were considered an appropriate and practical proxy for staff-level auditors with minimal experience. Participants in the experiment included 138 Master’s of Accountancy students, 52 percent female and 48 percent male, from a large state university in the Southeast. Participants in the experiment were put into a simulated work environment and asked to review accounts receivable confirmations in which additional information was needed from the client’s controller. Results of the experiment were used to determine the participant’s perception of the audit client and their ability to collect sufficient audit evidence.

• Social differences between staff-level auditors and client management reduce the likelihood that staff-level auditors will request additional audit evidence via face-to-face meetings with the audit client.
• Client’s explicit behavior to intimidate the auditor does not necessarily result in a difference in auditor behavior.
• Allowing participants to request evidence via email increased the likelihood that such evidence was requested.
• Participants often document their findings in such a way as to minimalize the chance of a reviewer identifying the issue.
   

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