An Empirical Investigation of the Influence of Qualitative Risk Factors on Canadian Auditors’ Determination of Performance Materiality*

This paper presents the results of a field experiment that tested the effects of various qualitative risk factors suggested by auditing standards and prior literature on practicing Canadian auditors’ estimates of performance materiality, a concept introduced by Canadian Auditing Standard (CAS) 320, in the audit of specific accounts in a financial statement audit. Ninety‐four practicing auditors responded to four scenarios and, based on “good” and “bad” versions of six qualitative risk factors, revised or not, as they deemed appropriate, initially established performance materiality for the audit of four different transaction streams/account balances. For all four scenarios, on average, the auditors revised, to a statistically significant degree, performance materiality, downward on the basis of “bad” information and upward on the basis of “good” information. Different combinations of transaction streams/accounts and risk factors were associated with different magnitudes of revision. However, at the level of individual participants, responses were quite varied. Some participants did not revise performance materiality and some even stated that performance materiality should not be revised based on risk‐related information. It may be that the concept of performance materiality as promulgated in CAS 320 and the relationship between overall materiality, performance materiality, and risk requires clarification to provide appropriate guidance for auditors to make performance materiality judgments.     

Effect of international working experience of individual auditors on audit quality: Evidence from China

This paper investigates the effects of auditors with international working experience on audit quality in emerging markets. Such auditors are associated with better audit quality, a pattern that is further supported by an examination based on a propensity score matching sample that controls for endogeneity. Chief financial officers with international experience are more conservative in the client company of their auditors who have international working experience. Further, reviewer partners with international working experience provide better audit quality in terms of low accruals, less below‐the‐line items, and less audit reporting aggressiveness, while engagement partners with international working experience require high audit fees. Moreover, financial reports signed by auditors with international working experience significantly increase analyst forecast accuracy and decrease analyst forecast dispersion. Our results are robust to different specifications and alternative measures. Overall, this paper highlights the importance of human capital and provides direct evidence on how auditors with international working experience use their knowledge and audit skills in emerging markets.     

An Empirical Investigation of the Interface Between Internal and External Auditors

Professional standards place specific responsibilities on auditors for the discovery of material mis-statements in reports of corporate financial performance. Certain factors have been shown to increase the likelihood of fraudulent financial reporting. One warning sign is the potentially pervasive effect of a weak internal control environment consistent with a weak internal audit group. This study investigates the impact of internal audit department quality differences on auditors ‘willingness to place reliance on the work performed by internal auditors. The study also gives consideration to auditors’ recent experiences with material errors and irregularities and examines the influence of two previously untested individual auditor differences on audit judgment decisions: (1) conflict management style and (2) perception of internal/external auditor communication barriers. The results indicate that auditors attend to internal audit department quality differences and that individual auditor differences exhibit significant influence over auditor judgments. Implications for audit practice are considered and directions for future research are suggested.     

EXTERNAL AUDITOR EVALUATION OF THE INTERNAL AUDIT FUNCTION

This study examines the relative importance of the factors used by external auditors when valuating an internal audit function. The study also examines the consistency of external auditors in making evaluations of an internal audit function. The factors used are based on Statement of Auditing Practice AUP 2 “Using the Work of an Internal Auditor” and a similar study conducted in the U.S.A. The two factors which this study finds to be the most significant are ‘technical competence’ and ‘due professional care’. The study finds a high degree of consensus across the respondents with respect to the evaluation of the internal audit function, and a high degree of insight and stability in their judgements.     

AUDITOR'S SKILL,AUDITING STANDARDS,LITIGATION, AND AUDIT QUALITY

This paper introduces a model of the market for audit services in which auditors differ in their levels of skill, which may or may not be observable and capture differences in ability. The model captures the interplay amongst auditing standards, litigation, and auditors’ levels of skill, which determines auditors’ responses to auditing standards. The paper shows that the quality of audit supplied by any auditor is increasing in the auditor's level of skill regardless of whether or not auditors’ levels of skill are observable. An increase in the quality of audit prescribed by auditing standards is shown to induce some auditors endowed with low levels of skill to decrease the quality of their audits so that the average quality of audit and economic welfare may actually decline as auditing standards are raised. Auditors’ choices of audit quality are furthermore shown to be increasing in trial awards. Incentives for trials and out-of-court settlements are shown to depend crucially on whether or not auditors’ levels of skill are observable. Only when auditors’ levels of skill are unobservable do trials obtain with some probability. When auditors’ levels of skill are unobservable, the introduction of either restrictions on costs awarded by the courts or an imperfection in the courts’ technology is shown to lead the most skilled auditors to supply audits of a quality strictly exceeding the quality prescribed by the prevailing auditing standards. When the courts err often enough, the most skilled auditors having exercised due care furthermore make offers to settle when sued.     

AN INVESTIGATION OF AUSTRALIAN AUDITORS’ USE OF THE MANAGEMENT REPRESENTATION LETTER

Auditors’ use of the management representation letter has assumed renewed significance because Australian, UK, US and International auditing guidelines recommending that auditors obtain appropriate representations from management have now been adopted as standards. Results from this exploratory survey confirmed that auditors’ use of the representation letter to obtain audit evidence was generally consistent with the professional guidance, but two anomalies were noted. First, one-third of respondent auditors did not use the letter to provide sole audit evidence. Comments from some auditors indicated doubt about the legal acceptability of such evidence. While past litigation might justify such caution, auditors should consider whether it is efficient to neglect the use of the management representation letter to provide primary audit evidence. Second, there was evidence that some auditors use management representations as sole audit evidence when other appropriate audit evidence is available. This suggests the need to inform these auditors about the danger of over-reliance on management representations. Finally, results showed that most auditors use the representation letter to inform management of their responsibilities. This informative use is consistent with professional guidance and with the corporate governance literature that recommends clarifying management’s understanding of their responsibilities and enhancing management’s sense of accountability. This informative use is most important to auditors belonging to smaller audit firms, and suggests that these firms’ clients have greater information needs.     

The Contribution of Internal Audit as a Determinant of External Audit Fees and Factors Influencing This Contribution

Despite extensive research on the determinants of external audit fees, there is little empirical evidence on the effect of internal audit contribution on the external audit fee. Using a cross-sectional regression model based on prior audit fee research, this study provides evidence that internal audit contribution is a significant determinant of the external audit fee. Further, a second model that provides evidence on the determinants of internal audit contribution is developed and tested. This second model indicates that internal audit contribution is influenced by internal audit quality and, conditional on the level of inherent risk, the availability of internal audit and the extent of coordination between internal and external auditors. These results are based on a unique data-set comprised of publicly available data matched with survey responses from internal and external auditors affiliated with 70 non-financial services Fortune 1000 firms. The sample includes all of the former "Big 6" international accounting firms and clients from twenty-nine different industries.     

The influence of corporate governance mechanisms on the quality of financial reporting and auditing: Perceptions of auditors and directors in Singapore

This study uses two hypothetical cases to examine the perceptions of auditors and directors in Singapore about corporate governance practices relating to the quality of financial reporting and auditing. In the first case, the strength of the audit committee, the existence of an internal audit function and the strength of a corporate code of conduct were manipulated. All three variables were perceived to have some influence on financial reporting and audit quality. However, some interesting differences were found between the perceptions of auditors and directors. Auditors place more weight on the internal audit function, possibly due to their familiarity with the role that internal audit can play in reducing audit risk and enhancing controls. Directors have more confidence in board enforcement of a strong code of conduct, possibly reflecting the view that this encourages staff to adhere to higher ethical standards. In the second case, audit partner rotation, outsourcing of internal audit services and whether the audit firm audited all companies within a group were manipulated. Auditors believed that their ability to resist management pressure was enhanced when they audited all companies within the group. No significant differences were found for the other variables, suggesting that neither group believes that these practices impair audit independence.     

The use of analytical procedures by external auditors in Canada

The Enron debacle and other scandals highlight the issue of whether analytical procedures (APs) or more traditional audit approaches based on substantive testing are more appropriate. This paper surveys the use of APs by Canadian external auditors and augments understanding of the impact of auditing standards on professional practice. Our results demonstrate that APs are extensively applied in practice, particularly by larger firms, and that their use dominates the final review stage of the audit regardless of firm size. While standards do not appear to be an important influence upon practice for audit firms in general, this is not the case for smaller firms. Though auditors place more reliance on APs to reduce tests of detail, there are limits to this reliance. Our results indicate that while auditors may have increased their use of APs with the expectation of efficiency gains, these may be realized at present only partially.     

Auditors' Liability, Vague Due Care, and Auditing Standards

This paper expands the set of previously considered liability rules to include a negligence liability rule with a vague specification of due care. Auditors who are negligent in conducting their audit are liable for losses that result from reliance on misstated financial statements. However, what constitutes negligence for auditors is not clearly specified in the law. Consequently, courts often resort to Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (SAS) as benchmarks for determining due care. A liability regime that consists of a vague negligence rule supports and amplifies the credibility of auditing standards. While auditing standards alleviate some of the vagueness that is inherent in the legal standard, they also form a lower bound on due care, since an audit of a quality that is lower than the quality that auditing standards require would be considered negligent. Thus, the vague specification of due care enables auditors to commit to audit quality as pronounced in auditing standards. This paper explores this link between professional standards and auditors' legal liability. It establishes that the commitment to auditing standards could not have been as credible as it is, if auditors' liability was determined based on the strict liability rule, or based on a negligence rule with a clearly specified due care, since under these two liability rules courts would not need to refer to auditing standards to establish fault. The paper also demonstrates that a legal regime where audit standards are used as a benchmark to evaluate negligence is not the same as a legal regime where due care is defined clearly. Therefore, previous studies that assumed a negligence regime with clear due care may have overstated the effort level that is induced by legal liability.     

中国上市银行内部控制审计现状分析及对策建议

作为内部控制系统的再监督机制,内部控制审计对于银行业具有重要的作用。随着《企业内部控制基本规范》及配套指引的出台,中国各上市银行加快了规范内部控制审计的步伐,但在内部控制审计的地位、独立性和权威性、方法论、信息化、行业标准化和团队建设中仍存在一些不足。有关的完善建议包括:从组织架构和管理体制上确保内部审计的地位;更加充分重视风险文化的建立;更加注重对审计方法论、技术和内容等的精细化研究;培养专家型和研究型的审计人员;开发更多的计算机审计技术;监管部门应加快出台银行业内部控制审计操作指南。     

Audit committee quality indices,reporting quality and firm value

We investigate the relation between audit committee (AC) quality indices, financial reporting, internal control quality and firm value using a US dataset for the period 2002–12. The indices are developed by linking firm value with principal component analysis (PCA) factors based on a broad set of 82 AC variables, some of which influence the quality of the AC, but are not addressed in prior literature. Significant AC factors include ‘overlapping directors’, ‘busyness’ and ‘foreign director’, and we use these factors to develop ‘high’ and ‘low’ AC quality indices. We show that low AC quality firms are more likely to manage earnings, be external auditor dependent with respect to non‐audit tax services, and switch to a lower quality auditor. Low AC quality firms are also more likely to have internal control concerns disclosed by predecessor auditors, including accounting issues, financial restatements, audit opinion concerns and deficiencies that undermine internal control effectiveness. Further, they are more likely to receive an audit report containing additional explanatory notes. Conversely, high AC quality firms are significantly less likely to have these concerns. Our findings highlight the value of using AC quality indices in delivering greater oversight of the financial reporting process.     

Human Information Processing the Consistency of Audit Risk Judgments

This research utilises the human information processing methodology to determine whether audit risk judgments are consistent with those obtained by using the audit risk model advanced by Statements on Auditing Standards (SAS) Nos. 39 and 47. The effects of two audit-risk specific factors (the level of algorithmic audit risk and the combination of components of audit risk) are examined. The results of analysis of variance (ANOVA) procedures and cue-utilisation indices reveal that some of the auditors' judgments are inconsistent with the multiplicative nature of the audit risk model. In addition, evidence suggests that auditors affiliated with regional and local firms may depart from the audit risk model when substandard tests of details procedures are performed. The differences noted in the judgments of Big Eight auditors and regional and local auditors indicate that modified versions of the audit risk model may be employed by auditors in different types of audit engagements.     

External auditors’ reliance on internal audit: the impact of sourcing arrangements and consulting activities

This study examines the impact of internal audit outsourcing and involvement in consulting on external auditors’ reliance on the work of internal audit. We test whether these factors influence reliance on internal audit work already undertaken and the use of internal auditors as assistants, distinguishing between control evaluation and substantive testing. Involvement in consulting impacts reliance on work undertaken and the use of internal auditors as assistants for control evaluation. External auditors make greater use of internal auditors as assistants for substantive testing when internal audit is provided in‐house. Overall, external auditors use internal audit more for control evaluation tasks.     

The attitude of Libyan auditors to inherent control risk assessment

Previous empirical evidence contradicts the practices of audit risk assessment recommended by the professional auditing standards. Key differences represent the presumption that auditors can readily distinguish between different categories of risk, how they assess such risks in practice, their application to the different account levels and their capacity to differentiate between what may constitute potentially high or low risks. The paper addresses these differences in the context of the Libyan auditors’ perceptions and practices. The nature and development of the audit profession in Libya makes this a good comparator for the US and UK contexts of audit behaviour. Equally importantly, the religious, political and socio-cultural context combined with Libya's role as an emergent economy is representative of many other economies in the world, thus providing a good comparator for assessing the validity and applicability of the established auditing management principles and procedures. One hundred and sixty four practicing auditors in Libya were investigated, initially by questionnaire and subsequently interview of a smaller sample of 20 auditors. The evidence reinforces prior empirical evidence that inherent and control risks are assessed interdependently, auditors are aware of the risk differentials depending on the level of account and are cognizant of factors normally associated with potentially high and low risk levels.     

Is the quality of female auditors really better? Evidence based on the Chinese A-share market

Unlike previous studies in which a single index was used to measure audit quality, this study establishes a new comprehensive index to measure audit quality via Discretionary Accrual, as estimated by Jones’ basic model (1991) and Audit Opinions. The former is used to measure the quality of financial statements, and the latter is used to measure the auditors’ independence in the mainstream international literature. We examine whether and how an auditor’s gender affects the quality of his or her audits under the framework of empathy theory and gender role socialization theory. Using a large sample of 9861 auditor-firm-year observations from Chinese A-share–listed companies from 2011 to 2015, we find that the audit quality of signed auditors shows significant gender differences: these significant gender differences differ from the findings of previous studies that female auditors could provide a higher-quality audit than male auditors; that is, in our study the audit quality of the male auditors exceeds that of the female auditors. After distinguishing the positive and negative directions of the Discretionary Accrual, we find no significant gender differences in audit quality between male and female auditors when the earnings had been adjusted upward by the client; that is, female and male auditors had the same audit risk perception. However, when the client adjusted earnings downward, which indicates a lower audit risk for the auditor, the audit quality of female auditors was significantly lower than that of the male auditors. After controlling for the age and position of the auditors, we also find that the gender differences in the auditors’ audit quality decreased significantly or even disappeared when the auditor’s age exceeded 45?years and/or their position was manager or above. These results are consistent with the empathy theory and gender role socialization theory.     

Measuring audit quality of local governments in England and Wales

The purpose of this paper is to model and test the audit quality provided to local governments in England and Wales. A key question is: are there major differences in audit quality provided? The Audit Commission, a national public body under Parliament, regulates the audits. It sets audit standards, appoints the auditors, and (although each auditor and client local government set the specific audit fee for that client) it establishes a formula to determine standard audit fees. The Audit Commission also conducts an annual review of the audit quality provided by the selected auditors, as well as a survey of client satisfaction. The majority of audits are conducted by District Auditors (public sector employees of the Audit Commission). About a quarter of local governments are audited by one of six private sector auditors (including three of the Big 4). Actual results indicate that audit quality differences are associated with the number of governmental audit clients and local government type. Generally, there were modest quality differences by auditor category.     

Internal control reporting differences among public and governmental auditors: The case of city and county Circular A-133 audits

We investigate potential differences in audit reporting outcomes between Circular A-133 audits performed by governmental auditors vs. those performed by certified public accounting (CPA) firms. Specifically, we investigate the association between auditor type and the likelihood of auditor-disclosed internal control concerns. We employ a cross-sectional sample of 13,386 single audit reports of US cities and counties during 2004–2006. In contrast to prior literature, the results indicate that in the post-Sarbanes–Oxley environment, CPA firms appear more likely to issue audit reports that identify internal control concerns than are governmental auditors in the context of Circular A-133 audits. The differences are more pronounced for larger CPA firms.     

Risk-preparedness mechanism and audit quality: Evidence from mandatory increase of professional indemnity insurance and professional risk fund

We examine the risk-preparing benefits of Chinese audit firms’ professional indemnity insurance (PII) and professional risk fund (PRF) by using the Notice on Adjusting the Application Requirement of Audit Firms for Securities Qualifications as an exogenous shock. This policy requires audit firms to raise the sum of the cumulative compensation limit of their PII and PRF from 6 million to 80 million yuan. It is found, first, that the capital market regards this policy revision as a signal to strengthen investor protection and responds positively; client firms with high audit risks have a stronger response. Second, auditors’ governance of financial information has strengthened, resulting in the significant improvement of their clients’ financial reporting quality, with a stronger effect on firms with higher earnings management risk. There is no evidence that audit firms pass the costs on to their clients. Finally, the mismatch between auditors and new client firms is alleviated. We show that in an emerging market with weak investor protection, establishing a sound risk-preparedness mechanism for audit firms and strengthening the capacity for civil compensation ex post greatly improve the adaptive degree between international auditing standards and the legal environment of China, thereby enhancing the overall service quality of the audit market.     

The influence of litigation risk and internal audit source on reliance decisions

External auditor reliance on the work of internal auditors in an integrated audit of the financial statements and internal control is an important audit planning procedure that can impact audit efficiency and effectiveness. The purpose of this study is to examine how perceived auditor litigation risk and internal audit source affect external auditors' reliance decisions in an integrated audit environment under varying levels of risk of material misstatement. In an experimental study using 89 practicing Big 4 auditors, this study finds that auditors who perceive low litigation risk from placing reliance on the work of internal auditors will rely more on outsourced internal auditors than in-house internal auditors. The results also show that auditors' reliance decisions are sensitive to the level of account risk consistent with the risk-based approach to the integrated audit encouraged by the PCAOB.