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  • Jennifer M Mueller-Phillips
    The Association between Audit Committee...
    research summary posted September 10, 2013 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Association between Audit Committee Multiple-Directorships, Tenure, and Financial Misstatements
    Practical Implications:

    Auditors should be interested in these findings both for designing an effective engagement and for properly considering risk and liability during the client acceptance stage of the audit. Firms wherein the board contains multiple directors with long tenure are riskier, and auditors should consider that fact when deciding whether to accept the client and when designing the audit.

    Citation:

    Sharma, V.D. and E.R. Iselin.  2012. The Association between Audit Committee Multiple-Directorships, Tenure, and Financial Misstatements. Auditing: A Journal of Practice and Theory. (31) 3: 149–175.

    Keywords:
    audit committee, multiple-directorships, tenure, restatement, misstatement, financial reporting quality
    Purpose of the Study:

    This study seeks to answer questions about whether multiple-directorships and length of tenure on an audit committee have any impact on financial reporting quality as measured by financial restatements.

    Design/Method/ Approach:

    The study uses restatement announcements from the General Accounting Office as well as data on audit committee composition for 1999 to 2001 and 2004 to 2006. It then runs econometric tests on the data to ascertain what relationships exist between restatements and audit committee composition.

    Findings:

    The authors find that (1) multiple-directorships lead to decreased financial reporting quality indicated by an increased number of restatements because directors are "spread too thin" and (2) length of tenure is also positively associated with financial restatements.

    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition
  • The Auditing Section
    The Impact of Roles of the Board on Auditors’ Risk A...
    research summary posted April 16, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 13.0 Governance, 13.01 Board/Audit Committee Composition in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Impact of Roles of the Board on Auditors’ Risk Assessments and Program Planning Decisions
    Practical Implications:

    The results of this study suggest that auditors do take into consideration board roles in their control risk assessments.  In addition, both dimensions of board structure are suggested to affect assigned audit hours. These findings provide additional insights into whether auditors are able to integrate adequately the board roles into their audit planning.  The results have implications for audit firms in better understanding how auditors incorporate the board roles into their risk assessments and audit planning.  Further, the results suggest that, in line with PCAOB AS 2, auditors rely on a more complex set of factors than simply the monitoring role of boards. 

    Citation:

    Cohen, J.C., G. Krishnamoorthy, and A.M. Wright. 2007.  The Impact of Roles of the Board on Auditors’ Risk Assessments and Program Planning Decisions.  Auditing: A Journal of Practice and Theory 26 (1): 91-112.

    Keywords:
    corporate governance; board role; resource dependence; risk assessment; audit planning judgments.
    Purpose of the Study:

    The current study expands our knowledge of the impact of governance structure, by focusing on how two attributes of boards influence the auditors’ risk assessment and program planning decisions. Specifically, the authors examine the influence of resource dependence and agency board roles, both defined below.  

    • A resource dependence role is described as one where the board member has specific experience with either the company or industry that is advantageous to their ability to provide relevant guidance. 
    • An agency role is described as one that provides a strong management monitoring function.  The current study examines whether inherent and control risk assessments are lower when these roles are stronger.  

    Below are the primary objectives that the authors address in this study: 

    • Examine the extent to which resource dependence and agency board roles affect auditors’ inherent risk assessment, control risk assessment, and planned audit hours (used as a proxy for extent of audit testing).
    Design/Method/ Approach:

    The investigation used an experimental questionnaire to obtain data. The questionnaire solicited voluntary responses from audit partners and managers at two large Northeast offices of one Big 4 auditing firm, prior to 2004.  Participants read a case-based experiment concerning a high-tech company, where the board related facts were varied between higher and lower resource dependence and higher and lower agency roles.  The participants then answered questions related to inherent and control risks, resource allocations and personal information.

    Findings:
    • Evidence suggests that auditors do respond to the roles of the board.  Specifically, auditors increase their control risk assessment when the board structure reflects weaker agency or resource dependence.
    • Evidence suggests that auditors do not respond to roles of the board when making inherent risk assessments. Specifically, the strength or weakness of either board characteristic has no impact on auditors’ inherent risk assessment. 
    • When auditors were presented with a board where resource dependence and agency roles were both higher, they decreased the amount of planned audit hours recommended.  Overall then, the evidence suggests that when both resource dependence and agency roles were higher, the control risk assessment and audit effort (i.e., planned audit hours) were lower. In all other combinations of the two board structure characteristics (i.e., high resource dependence-low agency, low resource dependence high agency, and low resource dependence-low agency), planned audit hours were higher.
    Category:
    Risk & Risk Management - Including Fraud Risk, Governance
    Sub-category:
    Assessing Risk of Material Misstatement, Board/Audit Committee Composition
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  • The Auditing Section
    The Effects of Trust and Management Incentives on Audit...
    research summary posted May 7, 2012 by The Auditing Section, tagged 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Effects of Trust and Management Incentives on Audit Committee Judgments
    Practical Implications:

    The results of this study suggest that the judgments of more trusting audit committee members are largely insensitive to indicators of management’s incentives to manage earnings. It appears that high levels of dispositional trust among members of the board of directors can have serious consequences, and high trust is common among audit committee members.  To overcome this possible concern, boards of directors and audit committees may consider training audit committee members to recognize the relationships between incentives and the likelihood of management deception in order to improve audit committee judgment. 

    Citation:

    Rose, A.M., J.M. Rose, and M. Dibben. 2010. The effects of trust and management incentives on audit committee judgments. Behavioral Research in Accounting 22(2): 87-103.

    Keywords:
    Audit committee; management incentives; trust
    Purpose of the Study:

    Audit committee members are entrusted with substantial authority to enhance corporate governance, including overseeing the audit process, hiring and firing auditors, and resolving auditor and management disputes.  However, prior research suggests that audit committee members do not consistently view management’s incentives to be threats to management credibility.  The authors propose that audit committee members’ disposition to trust plays a critical role in their interpretation of management incentives and associated judgments.  Below are two objectives that the authors address in their study: 

    • Examine how dispositional trust influences audit committee members’ decisions to support the auditor when management has incentives to manage earnings.
    • Examine how dispositional trust influences audit committee members’ assessment of management credibility and likelihood of deception when management has incentives to manage earnings. 
    Design/Method/ Approach:

    The authors collected their evidence using a simulated task completed by experienced, independent, and currently-serving audit committee members.  Participants were asked to act as audit committee members and make a subjective judgment about auditor- proposed adjustments.  Participants were assigned to an environment of either higher or lower levels of management incentive to manipulate earnings based on proximity to EPS.  The research evidence is collected in the mid-2000s time period (post SOX).

    Findings:
    • The authors find that less trusting audit committee members are more likely to support the external auditor than are more trusting audit committee members when management has incentives to manage earnings.
    • The authors find that less trusting audit committee members are more likely to perceive that management is not credible and more likely to perceive that management is being deceptive than are more trusting audit committee members when management has incentives to manage earnings.
    • The authors find that less trusting audit committee members are more likely to perceive that management’s incentives to manage earnings result in potential deception by management, and less trusting audit committee members increase their support for the auditor because of concerns about management deception. 
    Category:
    Governance, Corporate Matters
    Sub-category:
    Board/Audit Committee Oversight, Audit Committee Effectiveness
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  • The Auditing Section
    Restoring Trust after Fraud: Does Corporate Governance...
    research summary posted May 7, 2012 by The Auditing Section, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.05 Board/Audit Committee Oversight in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Restoring Trust after Fraud: Does Corporate Governance Matter?
    Practical Implications:

    The results of this study suggests that the economic costs firms incur to improve their governance environment are effective in helping to restore some of the firm’s credibility after a fraudulent reporting event.  The study supports prior research that associates weak governance structures with fraudulent financial reporting.  Just as important, the results indicate that fraud firms receive some positive economic benefits from this recovery strategy, at least in terms of abnormal market returns. 

    Citation:

    Farber, D. 2005. Restoring Trust after Fraud: Does Corporate Governance Matter? The Accounting Review 80 (2): 539-561.

    Keywords:
    fraud; corporate governance; credible financial reporting; investor trust; agency costs; independent directors; audit committee
    Purpose of the Study:

    Given the fraud-related scandals of the early 2000’s, regulators recognized the impact that a high quality corporate governance environment can have on firms’ financial reporting quality and enacted several provisions to strengthen or enhance firms’ governance structures.  Academic studies support this perception and show an association between weak corporate governance structures and fraudulent financial reporting.  However, while the academic evidence supports regulators’ belief that strong corporate governance helps prevent fraudulent financial reporting, there is little evidence regarding what steps are actually taken by firms to improve their governance environments after these firms have committed acts of fraudulent financial reporting.  In addition, there is little evidence regarding the effectiveness of these acts in restoring the firm’s credibility with capital market participants.  Therefore, this paper addresses these concerns through the following two specific objectives:

    • Examine whether an association exists between the revelation of fraudulent financial reporting and subsequent steps taken to improve the firm’s corporate governance environment.  The corporate governance steps examined in this paper relate to the characteristics of the board of directors and audit committee, as well as other governance mechanisms such as a Big 4/non Big 4 auditor as the external audit provider and the CEO serving the dual role of Chairman of the Board.
    • Examine whether the firm’s improvements in corporate governance are rewarded by informed capital market participants.  The informed capital market participants examined in this study include analysts, institutional owners, and short-sellers.
    Design/Method/ Approach:

    The author examines a sample of U.S. publicly traded firms cited by the SEC in Accounting and Auditing Enforcement Releases (AAERs) for SEC Rule 10b-5 of the Exchange Act of 1934 violations during the period of 1982 - 1997.  The author further limits his sample to financial statement-related fraud violations.

    The author tests changes in corporate governance by matching fraud firms with a control firm based upon industry, stock exchange listing and comparable sales.  Using the combined sample of fraudulent and control firms, the author examines the stated objectives using changes in univariate statistics for up to three years subsequent to the fraud revelation and regression analysis methods.

    Findings:
    • In the year prior to fraud detection, the author finds that fraud firms have a weaker governance environment as measured by outside director percentage, the number of outside directors, the number of audit committee meetings, the number of financial experts on the audit committee, the quality of the external audit firm, the proportion of firms with the combined CEO/Chairman position, and the percentage of blockholder ownership.
    • Fraud firms, at the end of three years following the fraud detection, are statistically similar to the control firms on many governance characteristics, including outsider director percentage and the proportion with the combined CEO/Chairman position.  Fraud firms even appear to exceed the control firms in terms of the number of audit committee meetings, although control firms have a larger number of financial experts and are more likely audited by Big 4 auditors.
    • Although the author finds that analyst following and institutional ownership do not increase in fraud firms, increasing the board’s independence does appear associated with long-run buy-and-hold abnormal returns.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition, Board/Audit Committee Oversight
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  • The Auditing Section
    On the Constitution of Audit Committee Effectiveness
    research summary posted May 3, 2012 by The Auditing Section, tagged 13.0 Governance, 13.06 Board/Audit Committee Processes, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    On the Constitution of Audit Committee Effectiveness
    Practical Implications:

    The results of this study are important for regulators when considering corporate governance processes and governance disclosures.  This study also provides insight into the importance of small events surrounding audit committee meetings, such as members’ style of questioning and insistence on managers swiftly adopting corrective measures to solve problems highlighted in internal audit reports.  The results provide insights into the process with which audit committee attendees define their effectiveness.  The results call into question the effectiveness of recent regulatory attempts to strengthen formal disclosures.

    Citation:

    Gendron,Y., and J. Bédard. 2006. On the constitution of audit committee effectiveness. Accounting, Organizations and Society 31(3):
    211-239.

    Keywords:
    Audit committee effectiveness, social constructivist
    Purpose of the Study:

    Corporate stakeholders increasingly rely on the audit committee to constrain managers’ self-interested behavior.  Previous practitioner and academic recommendations for audit committee effectiveness have focused on the composition and responsibilities of the audit committee, as well as the expertise and independence of audit committee members.  This paper examines the meaning of audit committee effectiveness through the eyes of individuals who attend meetings: corporate managers, auditors and audit committee members.  The authors attempted to understand the process by which audit committee effectiveness is internally developed and sustained by audit committee meeting attendees.  The authors use sociological techniques to examine: 

    • how the activities of audit committees are perceived by attendees.
    • how the perceptions of audit committee effectiveness are influenced by both the symbolic and substantive layers of meaning. 
      The symbolic ceremonies and rituals of audit committee meetings include agenda items and best practices.  The substantive processes include one’s line of questioning, both during and outside of meetings, in order to become comfortable with their company’s financial reports and internal controls.   
    • how members’ backgrounds (expertise and independence) influence perceptions of audit committee effectiveness.
    Design/Method/ Approach:

    The authors collected their evidence via interviews with the CEO, CFO, internal auditor, audit partner, and audit committee members associated with 3 Canadian corporations.  Interviewees were asked to describe the process of a typical audit committee meeting, the role of the audit committee, and difficult issues faced by the committee.  The interviews were conducted primarily in 2000 and 2001 and updated for post-Enron insights in 2004. 

    Findings:
    • The authors suggest there is a heterogeneity in audit committee participants’ emotions, which varies from confidence to hopefulness to anxiety.  Attendees appeared to be comfortable with reviewing the financial statements and reviewing internal control systems and less comfortable with auditor dismissal.  This heterogeneity influences attendees’ configurations of the meaning of effectiveness, both from an intra- and between-individual perspective.
    • The authors find that audit committee members perceive extensive financial and accounting background as significant in making their audit committee effective.  Formal competencies appear to generate feelings of confidence in committee members, managers, and auditors. 
    • The ceremonial features of meetings contribute to perceptions of effectiveness among audit committee members, managers and auditors.  The “ideal” ceremonial and symbolic features include: structured and well-organized meetings, consistent and orderly agendas, and best practice suggestions from the audit firm.
    • The substantive features of meetings also contribute to perceptions of effectiveness.  Interviewees imply that demonstrations of toughness by the internal auditor and tensions and divergences between the internal auditor and corporate managers are indications of independence and effectiveness.  Committee members perceive their relevant and challenging questions as
      key to demonstrating their effectiveness and establishing their self-confidence.  Attendees expect auditors to keep them informed regarding accounting standards and governancepractices.  Thus, the effectiveness appears to be linked with the extent that the audit committee is able to require management and auditors to account for their positions on potentially sensitive topics. 
    • The meaning of audit committee effectiveness develops in large part through the interactions and ongoing reflections of attendees concerning the many small events and relatively unremarkable actions that take place within and around meetings.  Thus, regulator efforts at making corporate governance more transparent through the disclosure of input and process measures, are fundamentally limited due to the nature of activities that surround audit committee meetings. Moreover, the emotional heterogeneity that characterizes members’ effectiveness meanings are not easily translated into formal disclosures and detailed indicators of effectiveness. Because of these, the authors argue that several aspects of corporate governance may be doomed to remain in the shadows.
    Category:
    Governance, Corporate Matters
    Sub-category:
    Board/Audit Committee Processes, Audit Committee Effectiveness
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  • The Auditing Section
    Internal Audit Quality and Earnings Management
    research summary posted May 7, 2012 by The Auditing Section, 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:
    Internal Audit Quality and Earnings Management
    Practical Implications:

    This study develops an empirical measure of internal audit quality, and provides evidence supporting companies’ use and  development of an IAF as part of improvements to its overall governance environment.  Regulators and other parties interested in corporate governance may find it helpful to more explicitly consider the role of internal auditor in the evaluation of the firm. 

    Citation:

    Prawitt, D., J. Smith, D. A. Wood 2009. Internal Audit Quality and Earnings Management. The Accounting Review 84 (4): 1255-1280.

    Keywords:
    corporate governance; internal audit function; internal audit quality; earnings management; abnormal accruals; analyst forecasts
    Purpose of the Study:

    Standards promulgated by the AICPA and PCAOB recognize the impact that a high-quality internal audit function (IAF) can have on reducing control risk, and by extension, audit risk.  As such, regulators permit and encourage external auditors to rely on the work of others if that work is deemed to be performed by “competent and objective persons” (PCAOB 2007).  Similarly, the Institute of Internal Auditors (IIA) recognizes the IAF as one of the four cornerstones of corporate governance, along with the audit committee, executive management, and the external auditor.  However, while several prior studies establish a negative association between the quality of firm’s corporate governance mechanisms and management’s tendency and ability to manipulate reported financial results, there is little evidence that relies on archival data concerning the impact of a quality IAF on firms’ earnings manipulation activities.

    The purpose of this study is to examine archival data to determine whether differences in the quality of firms’ IAF impact firms’ earnings management activities.

    Design/Method/ Approach:

    The authors rely on the IIA maintained GAIN database (a proprietary database), that is composed of survey responses from chief audit executives associated with IIA member organizations.  Member organizations responding to the survey include publicly traded and private companies, educational and governmental institutions, as well as individual divisions within companies.  The study covers the fiscal years of 2000-2005. 

    The authors create an index based on six factors that SAS No. 65 suggests external auditors should consider when evaluating whether to rely on the work of the internal auditors, and therefore differentiate IAF quality.  Those factors include the IAF’s professional experience, professional certifications, training, objectivity, relevance of their work to the financial reporting function, and the IAF’s relevance to the organization based on how much resources the corporation invests in the IAF group.  To capture management’s earnings management activities, the authors rely on measures of abnormal accruals and whether the firm just misses or beats analysts’ forecasts.

    Findings:
    • Overall, the results suggest that higher quality IAFs reduce management’s ability to manipulate earnings.
    • Specifically, higher quality IAFs appear to be associated with smaller negative abnormal accruals.
    • Companies with higher quality IAFs appear more likely to just miss analysts’ earnings forecasts, a measure of less earnings management.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Governance
    Sub-category:
    Reliance on Internal Auditors, Internal auditor role and involvement in controls and reporting
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  • The Auditing Section
    Internal Audit Reporting Lines, Fraud Risk Decomposition,...
    research summary posted May 4, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Audit Reporting Lines, Fraud Risk Decomposition, and Assessments of Fraud Risk
    Practical Implications:

    The results of this study are important for audit firms to consider when determining the extent of reliance on internal auditor’s fraud risk assessments.  Internal auditor judgments may be influenced by pressures to decrease risk assessments when reporting to the audit committee.  Thus, the recent suggested improvements for improving audit practice and risk assessment processes by reporting to the audit committee may have adverse and unexpected consequences.  Additionally, internal auditor judgments may be influenced by an over-reliance on attitude cues, even when decomposing fraud risk assessments.  Thus, decomposition may amplify the problem that prompted its use.

    Citation:

    Norman, C.S., A.M. Rose, and J.M. Rose. 2010. Internal audit reporting lines, fraud risk decomposition, and assessments of fraud risk. Accounting, Organizations and Society 35: 546-557.

    Keywords:
    internal audit, fraud risk assessment, audit committee
    Purpose of the Study:

    The internal auditor function is one of the four cornerstones of corporate governance along with senior management, the board, and external auditors.  External auditors frequently rely on the work of internal auditors, including firm risk assessments per AS5, An Audit of Internal Control over Financial Reporting that is Integrated with an Audit of Financial Statements.  Internal auditors may report to management or to the audit committee.  Many investors and regulators have suggested that internal auditors should report directly to the audit committee to minimize the threats to independence and objectivity that may potentially occur when internal auditors report to management.  However, if the audit committee is given power over the internal audit function, this may create potential new threats to internal auditor independence not previously considered.  For example, many audit committees now have the authority to hire or fire the Chief Audit Executive.  This paper addresses the effects of internal audit reporting lines on the fraud risk assessment judgments of internal auditors.  Below are two objectives that the authors address in their study: 

    • Examine the extent that internal auditors may be subconsciously motivated to avoid reporting higher levels of fraud risk to the audit committee, relative to when the risks are reported to management.
    • Examine whether decomposition of fraud risk into the components of the fraud triangle (management attitude, incentives, and opportunities) improves the internal auditor’s sensitivity to opportunity and incentive cues.
    Design/Method/ Approach:

    The authors collected their evidence from highly experienced internal auditors (mean experience of 15.3 years) via survey instruments. The authors then collected additional evidence using an experiment where participants were asked to complete a simulated task. Experiment participants were experienced internal auditors with mean experience of 9.6 years.  Survey participants were asked five questions about risk assessment discussions, reporting lines, and reactions.  In the simulated task participants were asked to assess the level of fraud risk in a hypothetical firm.  Participants were assigned to either a higher or lower level of fraud risk and to a reporting line of either audit committee or management.  The research was conducted in the mid- to late-2000s time period.

    Findings:
    • The authors find that internal auditors perceive greater personal threats when reporting high levels of fraud risk to the audit committee than when reporting to management.  Internal auditors fear overreaction from the audit committee, potentially leading to increased workload and management reprisals.   
    • The perception of greater perceived threats leads internal auditors to reduce assessed levels of fraud risk when reporting to the audit committee relative to reporting to management.  This finding is contrary to expectations and reveals additional unexpected threats created by having internal audit report to the audit committee.
    • Internal auditors increase attention to management attitude when risk assessments are decomposed, without a corresponding increase to incentive or opportunity cues.  Thus, unlike external auditors, fraud decomposition does not appear to mitigate perceived problems associated with insensitivity to incentive and opportunity cues.    
    Category:
    Risk & Risk Management - Including Fraud Risk, Auditing Procedures - Nature - Timing and Extent, Governance
    Sub-category:
    Fraud Risk Assessment, Reliance on Internal Auditors, Internal auditor role and involvement in controls and reporting
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  • The Auditing Section
    Internal Audit Sourcing Arrangement and the External...
    research summary posted May 7, 2012 by The Auditing Section, tagged 07.0 Internal Control, 07.01 Scope of Testing, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Audit Sourcing Arrangement and the External Auditor’s Reliance Decision
    Practical Implications:

    The results of this study suggests that external auditors place more reliance on “outsourced” internal audit work, especially under high inherent risk conditions, than on “in-house” internal audit work due to the external auditors’ assessment of higher objectivity on the part of the “outsourced” internal auditor. The authors suggest this may have implications for external audit teams’ planning and assessment of internal audit work, in that whether or not the work is outsourced might need to be considered in the assessment. Also, audit clients might consider a need to outsource more internal audit work or try to make changes to increase the external auditors’ perception of their “in-house” internal audit team, in terms of objectivity.

    Citation:

    Glover, S. M., Prawitt, D. F., and D. A. Wood. 2008. Internal Audit Sourcing Arrangement and the External Auditor’s Reliance Decision. Contemporary Accounting Research 25 (1) 193-213.

    Keywords:
    assessment of internal audit work; internal audit outsourcing; auditor judgment
    Purpose of the Study:

    Under Section 404 of the Sarbanes-Oxley Act (SOX), client management must evaluate the effectiveness of internal controls over financial reporting (ICOFR). In order to meet new regulations, many firms outsourced internal audit functions to third-parties. Auditing standards state that external auditors are required to evaluate the objectivity, competence, and work performed by internal auditors. Since third-party internal audit teams likely have different incentive and motives, compared to in-house internal audit teams, the external auditor may have different perceptions of each team’s objectivity. This study examines whether external auditors’ reliance on the work of outsourced internal auditors differs from the reliance of “in-house” internal auditors.

    Design/Method/ Approach:

    The authors collected their evidence via experimental cases administered to auditors from one of the Big 4 accounting firms. Approximately 21 percent were staff-level; 59 percent were senior staff, the other 20 percent were manager-level or higher. Data was collected prior to 2007.  Participants were provided background information about the hypothetical company, the internal audit team, and the audit procedures performed by the internal audit team. Participants were asked to evaluate the internal audit team’s competency and objectivity, as well as the amount of reliance to place on the internal audit team’s work.

    Findings:
    • When inherent risk is low, external auditors are just as likely to rely on “outsourced” internal audit work as “in-house” internal audit work. 
    • External auditors perceive “outsourced” internal audit work to be more objective than “in-house” internal audit work. 
    • When inherent risk is high, external auditors are more likely to rely on “outsourced” internal audit work as “in-house” internal audit work. 
    • External auditors are more willing to rely on internal auditors’ work when they perceive the internal auditors to be performing objective tasks, versus subjective tasks. (This is for both “in-house” and “outsourced” internal audit teams.) This difference in reliance between objective and subjective tasks is magnified when inherent risk is high.
    • However, when the task is subjective, the auditor relies less on the internal audit team’s work when inherent risk is high.
    Category:
    Internal Control, Governance
    Sub-category:
    Scope of Testing, Internal auditor role and involvement in controls and reporting
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  • The Auditing Section
    Financial Restatements and Shareholder Ratifications of the...
    research summary posted April 23, 2012 by The Auditing Section, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 13.0 Governance, 13.05 Board/Audit Committee Oversight in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Financial Restatements and Shareholder Ratifications of the Auditor
    Practical Implications:

    The authors’ results show that restatements are viewed by investors as audit failures and restatements reflect negatively on investor perceptions of the external auditor. The study also suggests that audit committees’ decisions to change auditors are not influenced by shareholder ratification voting.  The authors state that the results support “efforts to require SEC registrants to submit auditor selection for a shareholder ratification vote.”

    Citation:

    Liu, L., K. Raghunandan, and D. Rama. 2009. Financial Restatements and Shareholder Ratifications of the Auditor. Auditing: A Journal of Practice & Theory 28 (1): 225-240.

    Keywords:
    restatements; shareholder voting; auditor ratification
    Purpose of the Study:

    The purpose of this study is to examine the impact that client restatements have on shareholder ratification votes for the external auditor.  Restatements have been widely recognized as an indicator of low audit quality and as such may influence shareholder perceptions of the external auditor.  Shareholder ratification of the external auditor is not required by state or federal laws; however, many firms maintain the practice as a measure of good governance.  This ratification vote is the only opportunity shareholders have to comment on their approval/disapproval of the audit firm and/or audit quality.  Furthermore, some investor advocate groups (e.g., CalPERS) have withheld votes against audit committee directors of firms that did not offer shareholders an opportunity to vote on auditor ratification.                                                                                                                           

    The authors expect that firms will have a higher proportion of shareholders not voting for the appointment of the auditor following a restatement.

    Design/Method/ Approach:

    The authors collect data on firms that restate 2004 or 2005 financial statements and compare shareholder ratification votes for the restating firms to shareholder ratification votes for a control sample of firms that did not restate their 2004 or 2005 financial statements.

    Findings:
    • The authors find that shareholders are more likely to vote against auditor ratification after a client restatement relative to firms that do not restate their financial statements and relative to shareholder voting prior to the restatement.
    • There were 19 of 97 restatement firms that had more than 5 percent of shareholder votes not in favor of ratifying the auditor; only 2 of these 19 firms subsequently changed auditors the following year.
    Category:
    Auditor Selection and Auditor Changes, Governance
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Board/Audit Committee Oversight
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  • The Auditing Section
    Audit Committee Financial Expertise, Litigation Risk, and...
    research summary posted April 23, 2012 by The Auditing Section, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.02 Board/Financial Experts in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Audit Committee Financial Expertise, Litigation Risk, and Corporate Governance
    Practical Implications:

    Based on the positive relation between litigation risk and the likelihood of appointing an accounting financial expert, this study suggests that firms with a demand for accounting financial experts are able to obtain accounting financial experts for their audit committees.  However, this relation is only present in the presence of good governance.  The authors suggest that this follows because either (1) only firms with good corporate governance seek to appoint accounting financial experts or (2) only firms with good corporate governance can attract accounting financial experts.

    Citation:

    Krishnan, J., and J.E. Lee. 2009. Audit Committee Financial Expertise, Litigation Risk, and Corporate Governance. Auditing: A Journal of Practice and Theory 28 (May): 241-261.

    Keywords:
    audit committee; financial expert; litigation risk; corporate governance.
    Purpose of the Study:

    Policy makers believed that financial expertise on audit committees would “enhance the effectiveness of the audit committee in carrying out is financial oversight responsibilities” (SEC 1999). While it was generally acknowledged that financial expertise on the audit committee would be beneficial, the definition of financial expertise (and what qualifies as financial expertise) was not widely debated until SOX Section 407 was proposed.  The SEC’s initial definition of audit committee financial expertise included a very narrow definition of expertise, including essentially accounting and auditing expertise only.  However, after many comment letters opposing the narrow definition, the SEC adopted a broader definition of expertise.  The broader definition allows those with experience in evaluating financial statements or actively supervising those who prepare, audit, analyze, or evaluate financial statements to be designated as financial experts. The initial narrow definition was motivated by the assumption that accounting/auditing financial experts would provide better monitoring than non-accounting financial experts. 

    Previous academic research has found that firms who appoint accounting financial experts (based upon the original narrow definition proposed by the SEC) have higher measures of financial reporting quality and that investors have reacted favorably to the appointments.  However, few firms actually appoint accounting financial experts to the audit committee; not all accounting experts are designated as audit committee financial accounting experts; and many audit committee financial experts do not have prior accounting expertise.  The authors set out to examine the determinants of appointing an accounting expert versus a non-accounting expert.

    Design/Method/ Approach:

    The authors construct a measure of litigation risk (a proxy for the demand for an accounting financial expert) and gather corporate governance quality measures for the Fortune 1000 firms as of 2004.  The authors then classify audit committee members as accounting or non-accounting financial experts by gathering biographical information on the audit ommittee members using proxy statements and 10-Ks.

    Findings:
    • Of the 3,218 audit committee members identified in the study, only 572 (17.8%) have accounting financial expertise as originally defined by the SEC.  The authors indicate this is a relatively low ratio. 
    • Well-governed firms with higher litigation risk have a greater likelihood to appoint an accounting financial expert.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition, Board/Financial Experts
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