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  • Jennifer M Mueller-Phillips
    Auditing Related Party Transactions: A Literature Overview...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 13.0 Governance in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditing Related Party Transactions: A Literature Overview and Research Synthesis.
    Practical Implications:

    In this paper, the authors link academic research and other pertinent literature to issues raised in the PCAOB briefing paper on auditing related party transactions. Overall, the authors believe that the findings in academic research and the significance of related party transactions in recent prominent fraud cases are consistent with the PCAOB’s reconsideration of auditing of related party transactions.

    Citation:

    Gordon, E. A., E. Henry, T. J. Louwers, and B. J. Reed. 2007. Auditing Related Party Transactions: A Literature Overview and Research Synthesis. Accounting Horizons 21 (1): 81-102.

    Keywords:
    related party transactions, arm’s length transactions, corporate governance, financial disclosure
    Purpose of the Study:

    Related party transactions are difficult to audit for a number of reasons.  

    • Related parties and transactions warranting examination may be difficult to identify.
    • Auditors must rely on management to provide detailed information on related parties and related party transactions.
    • Despite the increased internal control requirements imposed by the Sarbanes-Oxley Act of 2002, internal controls have difficulty tracking related party transactions. This difficulty arises because of the wide variety of parties and types of transactions and because some transactions may not be given accounting recognition, e.g., receipt of free services from a related party.

    The authors examine research relevant to auditing related party transactions to contribute to the PCAOB project on this topic and to provide other policy makers, auditors, and academics with an overview of relevant literature. Specifically, they report on the challenges associated with the identification, examination, and disclosure of related party transactions. Additionally, they address issues and research evidence related to nondisclosure and reliance on management assertions, risk assessment, materiality, fraud detection, the effect of related party transactions on corporate governance, and international auditing issues.

    Design/Method/ Approach:

    To prepare PCAOB Standing Advisory Group (SAG) members for discussion of these issues, the PCAOB staff prepared a briefing paper posing 13 broad questions for consideration by the SAG. The authors contribute to the PCAOB project by reviewing pertinent literature and providing appropriate insights from academic research relevant to auditing related party transactions. They highlight instances where existing research addresses the questions raised in the briefing paper. 

    Findings:

    The primary conclusions from the literature review are:

    • The definition of related parties varies across regulatory bodies.
    • Related party transaction disclosures are present in the Securities and Exchange Commission (SEC) filings of most publicly held companies.
    • While listed as a fraud risk factor in authoritative literature, related party transactions do not appear to be more common in companies committing fraud than in companies in which no fraud has been detected. Accordingly, but in opposition to authoritative guidance, survey research indicates that the presence of related party transactions alone does not appear to significantly increase external auditors’ client risk assessments.
    • Although related party transactions in isolation may not be a significant indicator of fraud, when fraud does exist, the presence of related party transactions is one of the top reasons cited for audit failures. The willingness of auditors to tolerate greater misstatement in footnotes may help partially explain this apparent contradiction.
    • Related party transactions should be assessed in the context of the company’s overall governance structure, particularly given the importance of managements’ assertions about the existence and nature of these transactions.
    • Related party transactions often impact the corporate governance of the company by creating gray directors, i.e., directors who are neither insiders nor totally independent of the company. Whether gray directors differentially impact a board’s monitoring effectiveness may depend on the specific board committee (audit, compensation) or may depend on the specific type of gray director.
    Category:
    Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Auditor Communications with the Audit Committee and the...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.02 Board/Financial Experts, 13.05 Board/Audit Committee Oversight in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Communications with the Audit Committee and the Board of Directors: Policy Recommendations and Opportunities for Future Research.
    Practical Implications:

    The review identifies insights for practice and opportunities for research on communication issues between the auditor, the audit committee, and the board. The authors strongly believe that the academic and the practice communities must have a continual dialogue so that standards reflect research, and research is directed to issues with the greatest potential to positively affect public policy. These implications should interest the PCAOB, the SEC, other standard-setters, and regulators that focus on issues related to corporate governance and financial reporting quality.

    Citation:

    Cohen, J., L. M. Gaynor, G. Krishnamoorthy, and A. M. Wright. 2007. Auditor Communications with the Audit Committee and the Board of Directors: Policy Recommendations and Opportunities for Future Research. Accounting Horizons 21 (2): 165-187.

    Keywords:
    board of directors, communication between audit committees and external auditors, corporate governance, financial reporting quality, internal control reports
    Purpose of the Study:

    In 2004 the Public Company Accounting Oversight Board (PCAOB) began considering a standard to improve guidance on the communication process between external auditors and audit committees. The Sarbanes-Oxley Act of 2002 expands and emphasizes the role of audit committees in ensuring the quality of reported financial results. This increased responsibility requires improved and expanded dialogue between audit committees and external auditors.

    In this paper, the authors review the extant academic literature to address relevant issues pertaining to communications between external auditors and audit committees on matters relevant to the integrity of the financial reporting process as well as to the PCAOB-developed discussion questions (DQs). Specifically, they examine literature regarding communications pertaining to overall financial reporting quality, internal controls, the external auditor’s job performance, the form of communications (oral or written), and communications pertaining to the Management’s Discussion and Analysis (MD&A) section of the annual report. For each major area, they discuss the implications of the academic research for standard-setters and identify future research opportunities for the academic community.  

    Design/Method/ Approach:

    The literature review primarily features research published in academic accounting and auditing journals. In an effort to capture the latest research availableas well as research on emerging topics, such as many of those precipitated by the passage of SOXthe authors also include working papers submitted to major archiving services. The authors searched electronic databases such as Ingenta, ABI/Inform, and American Accounting Association (AAA) Electronic Publications using keywords or combinations of keywords related to the various topics and subtopics discussed in this paper. They also searched Social Science Research Network (SSRN) and scholar.google.com to identify relevant working papers.

    Findings:
    • Financial Reporting Quality:
      • Frequent communications with a well-informed, financially sophisticated audit committee and communications among the audit committee, the auditor, and the full board improve financial reporting quality.
    • Internal Controls:
      • The nature and the extent of communications between the auditor and the audit committee should be sensitive to whether a control weakness or deficiency relates to entity level controls or account-level controls, given the differentially serious implications of these two types of weaknesses.
      • Firm-specific factors (e.g., financial distress, company size) should influence communications and may require the auditor to report directly with the board on matters related to internal control.
      • The audit committee and the external auditor should discuss the quality of the internal audit function and the extent to which the external auditor is able to rely on the work performed by internal audit.
      • The audit committee should discuss with external auditors their policy to protect whistle-blowers.
    • External Auditor Performance:
      • It it is important for the auditor to communicate to the audit committee all relationships with the client, the fees and nature of all services provided, and the extent to which any nonaudit services are beneficial to the audit.
      • The auditor should report all issues and proposed adjustments to the audit committee and the process used for resolving contentious issues.
      • The auditor should also report to the board its evaluation of the quality, effectiveness, and authority of the audit committee in discharging its responsibilities.
    • Other Issues:
      • A review of the literature suggests that the MD&A should be more emphasized in the discussions between the audit committee and the auditors.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Oversight, Board/Financial Experts
  • Jennifer M Mueller-Phillips
    The effect of an Audit Judgment Rule on audit committee...
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism, 13.0 Governance, 13.05 Board/Audit Committee Oversight in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The effect of an Audit Judgment Rule on audit committee members’ professional skepticism: The case of accounting estimates.
    Practical Implications:

    The findings of this study have important implications for practice. Although prior research has suggested that an audit judgment rule may improve audit quality, findings from this research suggest that audit quality may decrease. This is seen indirectly by the audit committee members’ belief that accounting estimates become less conservative and due diligence decreases when there is an audit judgment rule. However, this was not directly tested, and future research is needed to determine whether audit judgment rules are beneficial or not.

    Citation:

    Kang, Y.J., A.J. Trotman, and K.T. Trotman. 2015. The effect of an Audit Judgment Rule on audit committee members’ professional skepticism: The case of accounting estimates. Accounting, Organizations and Society 46: 59-76.

    Keywords:
    audit judgment rule, professional skepticism
    Purpose of the Study:

    The purpose of this study is to examine how a proposed audit judgment rule impacts the professional skepticism of the members of an audit committee. Prior research has suggested that an audit judgment rule be implemented that requires courts and inspectors to not second-guess auditors’ reasoned judgments when they are made in good faith and in a rigorous manner. Currently, the concern is that auditors are engaging in defensive auditing and fearful of using innovative approaches to auditing accounting estimates. By examining the audit committees reaction to the proposed rule, the researchers are able to examine how audit committees believe this change impacts audit quality and how it impacts the behavior of the audit committee.

    Design/Method/ Approach:

    Data for this paper was collected prior to March 2015 by using an experiment with audit committee members from Australia. All participants had been on an audit committee in the past, and on average they had been on audit committees for 10.33 years.

    Findings:

    With the introduction of the audit judgment rule, there was an increase in perceived accountability in ensuring the reasonableness of the financial statements from the audit committee members. This was due to a belief that accounting estimates become less conservative and due diligence decreases. This increase in perceived accountability did not necessarily lead the audit committee members to act more professionally skeptical by asking more probing questions. However, the audit committee was more comfortable when they used innovative techniques in developing their accounting estimates. This was due to a belief that innovation leads to improved audit quality. Additional analysis demonstrates that former audit partners showed greater skepticism (by asking more probing questions) than other audit committee members.

    Category:
    Auditing Procedures - Nature - Timing and Extent, Governance, Standard Setting
    Sub-category:
    Auditors’ Professional Skepticism, Board/Audit Committee Oversight, Changes in Audit Standards
  • Jennifer M Mueller-Phillips
    Rotational internal audit programs and financial reporting...
    research summary posted October 21, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Rotational internal audit programs and financial reporting quality: Do compensating controls help?
    Practical Implications:

    Results from this study suggest that rotating internal auditors into operational management programs reduces financial reporting quality. Companies that utilize a rotational internal audit program should be aware of these possible unintended consequences. Companies utilizing these programs should consider implementing several compensating controls (listed in the findings section), as the authors have found that these controls can reduce or even eliminate (if used together) the negative consequences of rotational internal audit programs.  

    Citation:

    Christ, M.H., A. Masli, N.Y. Sharp, and D.A. Wood. 2015. Rotational internal audit programs and financial reporting quality: Do compensating controls help? Accounting, Organizations and Society 44: 37-59.

    Keywords:
    internal auditing, financial reporting quality, audit committee oversight, controls
    Purpose of the Study:

    The purpose of this study is to examine unintended consequences of rotational internal audit programs. Specifically, the authors inspect how moving internal auditors out of the internal audit function and into operational management can impact financial reporting quality. In addition, the authors examine how compensating controls can mitigate the unintended consequences.

    Design/Method/ Approach:

    The authors initially utilize semi-structured interviews with audit executives and audit committee chairmen to identify how the rotational internal audit programs impact financial reporting quality. Using the information gathered, the authors test hypotheses utilizing archival data from various firms for the years 2000 to 2005.

    Findings:

    Overall, the authors find that the practice of rotating internal auditors into operational management positions is related to lower financial reporting quality. Specifically, it increases Accounting Risk (that evaluates the risk of misreporting by identifying suspicious patterns in accounting data). However, the authors find that several compensating controls can reduce this negative effect. Specifically, the authors find the effect is reduced when companies only rotate staff internal audit positions, have a more effective audit committee, and when management asks the internal audit function to have a greater role in the financial reporting process. Findings also demonstrate that including all three of these compensating controls can eliminate the unintended consequences.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Internal auditor role and involvement in controls and reporting
  • Jennifer M Mueller-Phillips
    The Effects of Internal Audit Report Type and Reporting...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 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:
    The Effects of Internal Audit Report Type and Reporting Relationship on Internal Auditors' Risk Judgments.
    Practical Implications:

    This study’s results are important to regulators thinking about requiring issuance of an internal audit report and practitioners planning how to respond to such proposals. The authors suggest that the assurance internal audit report, which leads to more conservative risk assessment when internal auditors mainly report to the audit committee, may prove rather costly and unpopular among internal auditors. Meanwhile, the descriptive internal audit report, which prior research found to be useful to investors, does not make internal auditors more conservative, but it may prove less costly and more popular among internal auditors. Ultimately, these findings suggest that regulators need to discuss any internal audit report proposals with key stakeholders, including internal auditors, before getting too far into the rule making process. 

    Citation:

    Boyle, D. M., F. T. DeZoort, and D. R. Hermanson. 2015. The Effects of Internal Audit Report Type and Reporting Relationship on Internal Auditors' Risk Judgments. Accounting Horizons 29 (3): 695-718.

    Keywords:
    internal audit, descriptive report, assurance report, reporting relationship, accountability
    Purpose of the Study:

    External stakeholders want information to help them better understand corporate governance at the companies they follow. Although disclosure about many elements of corporate governance is currently available, little is known about the internal audit function. Such information asymmetry may be decreased via the issuance of an internal audit report. In fact, a few organizations have voluntary started issuing internal audit reports to external stakeholders. However, nothing is known about whether and how different forms of these reports impact internal auditors’ judgments. These judgments may also be impacted by whether the internal auditors mainly report to management or the audit committee. The purpose of this study is to discover:

    • How do descriptive internal audit reports (i.e., reports describing the “composition, responsibilities, accountability, activities, and resources” of the internal audit function) impact internal auditors’ fraud risk and control risk assessments?
    • How do assurance internal audit reports (i.e., reports containing the internal auditors’ opinion of the organization’s “internal control effectiveness”) impact internal auditors’ fraud risk and control risk assessments?
    • How do different types of reporting structure (e.g., reporting directly to management vs. the audit committee) impact internal auditors’ fraud risk and control risk assessments?

    The authors hope to find answers to these questions in order to provide regulators with insights that can be used when considering potential regulation of the internal audit function.
     

    Design/Method/ Approach:

    The authors collected their evidence prior to August 2013 via a case emailed to highly experienced IIA members working at public and nonpublic companies. In this case, the authors manipulated the presence of a descriptive internal audit report, presence of an assurance internal audit report, and whether the internal auditor reported to management or the audit committee. Participants were asked to make fraud risk and control risk assessments, as well as explain whether and why they support or do not support the issuance of descriptive and assurance internal audit reports.

    Findings:
    • Compared to their non-reporting peers, internal auditors who provide descriptive internal audit reports do not make more conservative fraud risk or control risk assessments.
    • Compared to their non-reporting peers, internal auditors providing assurance internal audit reports make (do not make) more conservative fraud (control) risk assessments.
    • Internal auditors providing assurance internal audit reports do not make more conservative fraud risk or controls risk assessments than peers providing descriptive internal audit reports.
    • Internal auditors reporting mainly to the audit committee make more conservative fraud risk or control risk assessments than peers reporting mainly to management.
    • Internal auditors providing assurance internal audit reports who report mainly to management (the audit committee) have the least (most) conservative control risk assessments. 
    • Of internal auditors not providing assurance internal audit reports, those reporting mainly to management or mainly to the audit committee make equally conservative control risk assessments.
    • Both public and nonpublic internal auditors show moderate support for descriptive internal audit reports, with support from nonpublic internal auditors marginally higher than from public internal auditors. Participants believe that while descriptive internal audit reports may enhance the prestige of the internal audit function and enhance corporate governance, they not be relevant to external stakeholders and may interfere with internal audits’ true role.
    • Compared to support for descriptive internal audit reports, support for assurance internal audit reports is lower. Participants believe that although assurance internal audit reports may enhance corporate governance, they may open internal audit to scapegoating, interfere with internal audits’ true role, lead to replication of external auditors’ work, and take away the flexibility that lets internal audit focus on important areas that the external auditors consider out of scope.
    • Internal auditors expect descriptive (assurance) internal audit reports to cost about 17.5% (59.3%) of an internal audit department’s current budget.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Governance
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Reliance on Internal Auditors
  • Jennifer M Mueller-Phillips
    External Auditor Evaluations of Outsourced Internal...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 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:
    External Auditor Evaluations of Outsourced Internal Auditors.
    Practical Implications:

    These results have implications for both audit research and practice as well as policy makers and firms deciding on whether to outsource the internal audit function. From a research perspective, this study is the first to examine how external auditors view various internal audit outsourcing arrangements. Further, the results indicate a potential cost of internal audit outsourcing that has not been previously considered. That is, if outsourced internal auditors provide other services, the cost of the external audit could increase, which potentially interferes with some of the expected cost savings of AS No. 5.

    Citation:

    Brandon, D. M. 2010. External Auditor Evaluations of Outsourced Internal Auditors. Auditing: A Journal of Practice & Theory 29 (2): 159-173. 

    Keywords:
    auditor independence, external auditing, nonaudit services, outsourced internal auditing
    Purpose of the Study:

    In the last several decades many companies began outsourcing the internal audit function (IAF) to public accounting firms. The prevalence of outsourcing is likely to continue given current exchange requirements to establish and maintain an IAF. Further, lack of an IAF could be considered a significant internal control deficiency or even a material weakness. The primary concern over external auditors providing nonaudit services appears to be the potential negative effects of the fees from those services on the external auditor’s objectivity. This concern was so pervasive that part of the Sarbanes-Oxley Act prohibits external auditors from performing certain nonaudit services for external audit clients. The Panel on Audit Effectiveness acknowledges the role of internal audit in maintaining good corporate governance and encourages the cooperation between internal and external auditors. Public accountants can utilize the client-specific expertise possessed by strong internal audit departments to increase external audit efficiency (resulting in cost savings that could be passed on to the auditee) and also provide a higher level of assurance. These benefits are of particular interest given concerns over the cost of complying with Section 404 of the Sarbanes-Oxley Act (SOX).

    This study investigates some implications of an outsourced internal auditor providing nonaudit services.

    Design/Method/ Approach:

    The 89 participants for the study were experienced practicing auditors. Fifty-six participants were obtained via contact partners at the respective firm. The contact partners were asked to distribute the instruments to auditors who typically evaluate internal auditors. The remaining participants were obtained through an in-house training session. 89 auditors participating, approximately 64 percent were CPAs and had an average of 4.7 years of audit experience. The evidence was gathered prior to September 2007.

    Findings:

    Results indicate that certain external auditor judgments and decisions are negatively affected when an outsourced internal auditor also provides consulting services, while other judgments (long touted by proponents of auditor-provided nonaudit services as benefits) are not. Specifically, inconsistent with proponents of auditor-provided nonaudit services, competence perceptions do not appear to be improved by the provision of consulting services. Consistent with arguments of opponents of auditor-provided nonaudit services, external auditor perceptions of internal auditor objectivity appears to be impacted negatively by the provision of consulting services. Further, consistent with previous research, these results appear to be tempered by the staffing of the team providing the consulting services.

    Other results indicate reduced planned reliance on outsourced internal auditors also providing other services. External auditors appear reluctant to rely on outsourced internal auditors providing additional services, regardless of staffing decisions. Results also indicate differences in audit fee adjustments. Specifically, participants would recommend greater audit fee increases when consulting services are provided, again regardless of the outsourcing arrangement.

    Category:
    Governance, Independence & Ethics
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Non-audit Services
  • Jennifer M Mueller-Phillips
    The effects of disclosure type and audit committee expertise...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The effects of disclosure type and audit committee expertise on Chief Audit Executives’ tolerance for financial misstatements.
    Practical Implications:

    The results suggest that internal auditors contribute to decreased reliability of disclosed amounts. It appears that the incentives of external auditors and internal auditors are closely aligned on this issue. In general, both of these parties seem to feel less responsibility for disclosed, relative to recognized amounts. The results indicate that financial reporting location has significant effects on internal auditors’ decisions to correct misstatements. Specifically, internal auditors are more willing to waive disclosed misstatements relative to recognized misstatements. Contrary to expectations, the results do not indicate that increased audit committee expertise and associated increases in audit committee members’ perceived powers cause internal auditors to be less willing to waive misstatements.

    Citation:

    Norman, C. S., J. M. Rose, and I. S. Suh. 2011. The effects of disclosure type and audit committee expertise on Chief Audit Executives’ tolerance for financial misstatements. Accounting, Organizations & Society 36 (2): 102-108.

    Keywords:
    audit committee expertise, misstatements, Chief Audit Executives, audit committee, financial executives
    Purpose of the Study:

    External audit partners are more willing to waive misstatement corrections for disclosed than for recognized amounts. This willingness to allow misstatements may increase management’s incentives to manipulate disclosed amounts and increase the levels of error and bias in disclosed information. While external auditors are more willing to waive disclosed amounts, relative to recognized amounts, internal auditors may require management to adjust misstatements regardless of their reporting locations. If internal auditors do not tolerate misstatements that are disclosed, this will increase the reliability (i.e., decrease the random error and bias) of disclosed amounts and decrease the likelihood of management manipulation of disclosed amounts. As a result, the impact to practice of external auditors’ willingness to waive misstated disclosures could be mitigated or even eliminated by internal audit oversight.

    The authors examine Chief Audit Executives’ and deputy Chief Audit Executives’ decisions to require adjustments of misstatements that are either recognized or disclosed. Chief Audit Executives (CAEs) may require equivalent adjustments for recognized and disclosed amounts, and act to counter the actions of management and external auditors. Understanding the decision processes of CAEs will help to inform regulators and standard setters of the underlying factors that drive financial statement reliability.

    Design/Method/ Approach:

    The participants are 73 Chief Audit Executives (CAEs) and deputy CAEs. CAEs and deputy CAEs are the ultimate decision makers in internal audit. None of these participants are from outsourced internal audit departments. The average number of years of internal audit experience is 13.71. The study was completed on paper and provided to participants in sealed envelopes by one of the study’s authors. All participants completed the materials in their professional offices under controlled conditions in the presence of one of the authors. The evidence was gathered prior to 2011.

    Findings:

    The results of this study indicate that reporting location has a significant effect on internal auditors’ decisions. Specifically, CAEs and their deputies require lesser amounts of misstatement correction of disclosed amounts relative to recognized amounts. While increased audit committee expertise increases audit committee members’ perceived power over management, the authors do not find that CAEs require greater misstatement corrections when the audit committee has more financial expertise, relative to less expertise. It appears that internal auditors may not have enough concern about disclosed misstatements to warrant a decision to exercise the power they derive from audit committee expertise. The results suggest that internal auditors, like external auditors and managers, act to decrease the perceived and actual reliability of disclosed information. Further, increasing the power of the internal audit function does not mitigate this problem. The authors find reason for serious concerns about the accuracy of disclosed amounts, relative to recognized amounts.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Earnings Targets & Management Behavior, Internal auditor role and involvement in controls and reporting
  • Jennifer M Mueller-Phillips
    Serving Two Masters: The Association between Audit Committee...
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.05 Board/Audit Committee Oversight, 13.06 Board/Audit Committee Processes, 13.07 Internal auditor role and involvement in controls and reporting in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Serving Two Masters: The Association between Audit Committee Internal Audit Oversight and Internal Audit Activities.
    Practical Implications:

    The results speak to the need for regulators to consider the incentives of the various stakeholders when determining policy. Should policy makers consider expanding or restricting specific oversight roles, they should consider the concomitant effects on the internal audit function, and the differential incentives faced by the audit committee and executive management. In addition, as audit committees and managers jointly work or oversee the work of internal auditors, the results suggest that these two oversight participants should consider how their respective incentives potentially bias the focus of the internal audit department away from a mix of activities that optimally address the greater business risks of the company. Likewise, as external auditors assess the organizational status of the internal audit department, they may also wish to consider the apparent focus of internal audit as a potential indication of oversight control.

    Citation:

    Abbott, L. J., S. Parker, and G. F. Peters. 2010. Serving Two Masters: The Association between Audit Committee Internal Audit Oversight and Internal Audit Activities. Accounting Horizons 24 (1): 1-24.

    Keywords:
    internal auditing, audit committees, best practices, internal auditors
    Purpose of the Study:

    This study examines the association between the activities performed by the internal audit function (hereafter, IAF) and the extent of audit committee oversight of the IAF. Two primary concerns motivate this study. First, relatively little regulatory or best practices guidance relates to the distribution of IAF activities, and virtually no current research has been done about these activities. The authors believe this topic to be important because current New York Stock Exchange listing rules require registrants to maintain an IAF, increasing the pervasiveness of internal audit. The second motivation concerns the relatively incomplete set of audit-committee related regulations. In particular, the Sarbanes-Oxley Act of 2002 (SOX) requires audit committee oversight of internal controls over financial reporting and also mandates reporting on a registrant’s internal controls. However, SOX is silent on internal audit, a key participant in both the financial reporting process and the internal control structure. Moreover, SOX does not address internal audit’s reporting relationship with the audit committee or the audit committee’s duties concerning internal audit resources.

    Design/Method/ Approach:

    The survey questionnaire was mailed to Fortune 1000 companies, after excluding banks. Consistent with much prior internal audit research, the survey was directed to CIAs. The first survey was sent in July 2006 and resulted in a total of 72 usable responses. A follow-up mailing was conducted in September 2006 and produced an additional 62 usable responses. This lead to the final sample size of 134 observations.

    Findings:

    The authors find that the percentage of the IAF budget devoted to internal-controls-based activities is positively related to the measure of the audit committee’s oversight. In particular, audit committees with greater IAF oversight are associated with larger percentages of IAF hours being allocated toward internal controls activities. Moreover, the results suggest that a significant number of Fortune 1000 companies have audit committees that appear to have little oversight of the IAF. This speaks to the relevance and timeliness of the recommendations of numerous parties concerning audit committee internal audit termination/hiring rights and budgetary controls.

    The authors also document significant differences in the allocation of IAF budgets across different activities, an area with very little prior research. They find that the majority of the IAF budget is devoted to internal controls activities, but the remainder, allocated to non-controls activities, is considerable. The evidence indicates that outsourcing arrangements are quite prevalent, but are also quite specific. In particular, the majority of outsourcing hours were spent on Section 404- related activities, with a lesser portion devoted to assisting the external auditor with the financial statement audit. The results suggest that an audit committee’s demand for better internal controls may lead to greater IAF focus on internal controls. 

    Category:
    Governance
    Sub-category:
    Board/Audit Committee Oversight, Board/Audit Committee Processes, Internal auditor role and involvement in controls and reporting
  • Jennifer M Mueller-Phillips
    Materiality Judgments and the Resolution of Detected...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.01 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees.
    Practical Implications:

    The results of this study shed light on the complex interplay between analyst following, the pressure that managers face to manage earnings, the pressure that auditors face to protect their reputations in the post-SOX environment, and the important role that audit committees can play in settings in which managers may act strategically to achieve desired financial reporting outcomes.

    Citation:

    Keune, M. B., and K. M. Johnstone. 2012. Materiality Judgments and the Resolution of Detected Misstatements: The Role of Managers, Auditors, and Audit Committees. Accounting Review 87 (5): 1641-1677.

    Keywords:
    audit committees, audit fees, error correction, materiality, stock analysts
    Purpose of the Study:

    Auditors detect and inform client managers and audit committees of misstatements, and these agents must reach agreement about whether managers will correct the misstatements prior to issuing the financial statements. Managers may waive correcting misstatements if auditors and audit committees conclude that the misstatements do not render the financial statements materially incorrect. Yet, the Securities and Exchange Commission (SEC) and others have asked the rhetorical question: If a misstatement is immaterial, then why not correct it? Given the absence of bright-line criteria for assessing materiality, judgments about resolving misstatements may be strategic to achieve desired financial reporting outcomes. Analysis of the role of managers, auditors, and audit committees in misstatement materiality judgments is therefore important because it can aid understanding of observed audit and financial reporting outcomes that can affect users.

    In this study the authors make use of regulation concerning the resolution of detected misstatements contained in Staff Accounting Bulletin No. 108 (SAB 108). The implementation of SAB 108 provides disclosure data on detected misstatements that were previously judged immaterial and were not corrected in the financial statements until the release of the new guidance. The authors use the SAB 108 disclosures to measure both the qualitative and the quantitative materiality of misstatements during the periods in which they remained uncorrected.

    Design/Method/ Approach:

    The data-collection period covers 10-Qs filed from November 15, 2006 to February 28, 2007 and 10-Ks filed from November 15, 2006 to February 15, 2008, and the analyses examine waived misstatements that existed in the financial statements during the period January 1, 2003 to September 30, 2006. To identify these misstatements, the authors read SAB 108 disclosures to find companies that corrected misstatements under SAB 108. 

    Findings:
    • The authors find that managers are generally more likely to waive qualitatively material misstatements as analyst following increases, but this effect is primarily present when audit fees are relatively low.
    • They find auditors are less likely to allow managers to waive quantitatively material misstatements as audit fees increase.
    • The authors also find a negative interaction between audit fees and analyst pressure on the likelihood that auditors will allow managers to waive qualitatively material misstatements.
    • Specifically, auditors’ incentives to protect their reputations weaken the effect of managerial incentives associated with the pressure created by analyst following; auditors are less likely to allow managers to waive qualitatively material misstatements as audit fees increase.
    • The authors find that audit committees with greater financial expertise are less likely to allow managers to waive qualitatively or quantitatively material misstatements than are audit committees with less expertise.
    Category:
    Corporate Matters, Governance, Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Board/Audit Committee Oversight, Earnings Management, Earnings Management, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Reaching Key Financial Reporting Decisions: How Directors...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 12.0 Accountants’ Reports and Reporting, 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.06 CFO Tenure and Experience in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Reaching Key Financial Reporting Decisions: How Directors and Auditors Interact.
    Practical Implications:

    The author of this article believes that this book should be on the must read list of researchers interested in audit committees and financial reporting, regardless of their research approach. For qualitative researchers, the book not only provides valuable insights into the on-process dynamics in reaching financial reporting decisions, but it is also a textbook example of how a researcher may conduct multiple case studies in accounting and gain access to key individuals in organizations to obtain private information about the financial reporting process. For empirical and experimental researchers, the book provides explanations that could be useful in developing their theoretical framework and raises many issues that could be researched in the future. The book should also be of interest to regulators, auditors, accountants, and students who are interested in the financial reporting process and the impact of recent regulation on this process.

    Citation:

    Bédard, J. 2012. Reaching Key Financial Reporting Decisions: How Directors and Auditors Interact. Accounting Review 87 (5): 1819-1820.

    Keywords:
    auditing, financial reporting decisions, CFOs, audit committees
    Purpose of the Study:

    The book, Reaching Key Financial Reporting Decisions: How Directors and Auditors Interact by Vivien Beattie and Stella Fearnley, explores how chief financial officers (CFOs), audit committee chairs, and audit engagement partners resolve issues that have given rise to interactions, discussions, or negotiations, between two of these three participants. It is a follow-up of Behind Closed Doors (Beattie et al. 2001), which received the Deloitte/American Accounting Association’s Wildman Medal in 2007. The book provides an update of the 1999 results in the 2007/2008 U.K. regulatory environment that, as the U.S. one, has undergone significant change since 1999. The book consists of two parts.

    Reading each case is very interesting; it provides the reader with information that normally stays behind “closed doors.” The advantage of a book, compared to a journal article, is that there is more space to provide detailed information about the cases. With approximately 30 pages per case, the reader has a good understanding of each case. Even then, sometimes the author wanted to know more about the interaction issues.

    Design/Method/ Approach:

    This article is a book review. 

    Findings:

    The last part of the book presents the cross-case analysis of the 50 interactions using the framework developed in Beattie et al. They find that the key influence on the interaction outcomes has changed significantly since the previous study. The influence of the general company/audit firm context and specific context of the interaction is greatly reduced, while the national regulatory regime now has the strongest influence on the interaction (events, strategies, outcomes, and consequences). In the new regulatory environment, it appears that the higher threats from various regulatory agencies as seen by the CFO, audit partners, and audit committee chairs encourage compliance with accounting and auditing standards.  

    Whether readers need to read Behind Closed Doors to understand this new book depends on their interests. If readers are interested in how directors and auditors currently interact in reaching financial reporting decisions, the current book would be self-sufficient. However, if readers are interested in how the process has evolved over time, reading Behind Closed Doors would be useful.

    Category:
    Accountants' Reporting, Corporate Matters, Governance
    Sub-category:
    Board/Audit Committee Oversight, CFO Tenure & Experience