Client Risk Factors and Audit Resource Allocation Decisions

While contemporary auditing standards such as ISA 315 provide broad categories of client risks, prior research regarding audit resource allocation decisions has been based on individual client risks. This study contributes to the literature by using factor analysis to examine how individual client risks are categorized into broad risk factors and by examining the extent to which such broad risk factors are associated with audit engagement planning decisions. These issues are important because auditing standards direct auditors to consider risk patterns and interrelationships in addition to individual risks. Finally, we consider additional individual client risks that reflect those relevant to contemporaneous audit approaches and have not been examined in prior studies. Based on archival data extracted from the working papers of 228 clients of a Japanese audit firm, we find that individual client risks empirically group together in a way that is similar to categories discussed in recent auditing standards. We also find significant relationships between audit resource allocation decisions and broad risk factors that have not been found in prior studies which use individual risk assessments in their models. Finally, we find that client risks that are emphasized in holistic audit approaches such as aggressiveness of forecasts and industry decline also have a significant impact on audit resource allocations.     

Audit Standards and Auditor Liability: A Theoretical Model

The business of auditing is heavily regulated. Auditor regulation exists through licensing, professional standards and liability. The auditor's liability for losses to financial statement users from audit failure is subject to a test of negligence. What constitutes due audit care is, however, not generally well-specified. Furthermore, reviews of litigation against auditors conclude that compliance with professional audit standards does not always act as a complete defence to allegations of negligence. The current situation can be described as one where (ex ante)—from the point of view of the auditor—uncertainty exists about the ‘legal’ standard of due audit quality (as seen by the courts in the event of litigation). This uncertainty about legal standards fundamentally affects audit behaviour in ways that are not immediately intuitive. This paper draws on insights from the economics and law literature (e.g., Kolstad et al., 1990; Shavell, 1984a, 1984b and 1987; Calfee and Craswell, 1984 and 1986) and provides an analysis of the effects of uncertainty about auditor negligence on the produced level of audit quality and on audit fees. The auditor subject to a negligence rule will produce too low or too high an audit quality level, as compared to the socially optimal level. It is shown that uncertainty about the legal standard of ‘due audit quality’ is fundamental to understanding audit quality supplied. This uncertainty is the explicator of an insurance component in audit fees. A surprising insight is that a large uncertainty about the legal standard of care can reduce rather than increase the quality of audit work supplied and increase the insurance component. Relying on insurance premiums can be more effective than direct expenditure in reducing risk. The effect of the imposition of ex ante precise audit quality standards, in combination with an uncertain negligence rule, is discussed. Since the influence of ex ante standards is indirect through its effect on ex post liability, auditing standards cannot be analysed independently of ‘legal’ standards. If the legal standard of care were clear, there would be no role for audit standards. Audit standards only affect audit behaviour if legal standards of care are unclear, and they help to clarify the legal standard. An effective combination is for ex ante standards to be set below the ex post standards of care so that they provide a lower bound on acceptable work. Under a lowest common denominator approach set too far below legal standards, audit standards would be irrelevant as far as operational decisions were concerned. As the level of standards are raised, so costs are first imposed on the lowest quality providers.     

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.     

TOWARDS A CONCEPTUAL FRAMEWORK FOR GOVERNMENT AUDITING

This article attempts to contribute to a conceptual framework for government auditing by using agency concepts in government and public finance for the examination of underlying theoretical and practical issues. Three models of government auditing are formulated: sole monitoring, dual monitoring and commercial monitoring. The main assumptions of these constructs are examined and their operations assessed in the context of international co-operation and dialogue among government auditing institutions. Problems relating to auditing accountability, audit mandate and auditor independence are identified and discussed. Despite some differences in these areas, there is a global tendency for the government auditing function to transcend the traditional parameters of financial attestation and legislative compliance in order to espouse broader notions implicit in the various gradations of comprehensive auditing.     

An Audit Framework for Expert Systems

Expert systems moved from research laboratories to widespread use in the business world during the previous decade. Current data indicate that use will continue to increase in the foreseeable future. However, auditors have not comprehensively addressed the need for and feasibility of independent audits of these systems. This paper discusses factors that will soon create a demand for independent audits of expert systems. It then identifies a framework present in current professional standards that appears to be appropriate for proceeding with the auditing of expert systems. A hypothetical case is subsequently presented to illustrate one possibility of how measurement criteria, audit procedures and an audit report developed under these professional standards might appear. Potential practice problems and research issues are identified throughout the paper.     

The Conceptual Framework as a Coherent System for the Development of Accounting Standards

The Financial Accounting Standards Board (FASB) visualized a conceptual accounting framework as a 'coherent system of interrelated objectives and fundamentals that can lead to consistent standards that prescribes the nature, function, and limits of financial accounting and financial statements' (FASB, 1976). To Australian standard setters, the primary purpose of the conceptual framework (CF) was only to be used as a 'guide' in developing and reviewing accounting standards (AASB, 1995, para. 5). The International Accounting Standards Committee (IASC) diminished the role of a conceptual framework even further by openly acknowledging that some standards are inconsistent with the guidelines offered by the framework (IASC, 1989 para. 12). Even though the Australian Accounting Standards Board (AASB) supposedly pursues a policy of harmonization of conceptual frameworks and accounting standards, there are also acknowledged inconsistencies in the conceptual frameworks of the IASC.
The aim of this article is to assess the coherence of the Australian (and IASC) conceptual framework. This analysis identifies confusion in drafting or construction of the conceptual framework, internal inconsistencies, and inconsistency with the legal framework within which business entities operate. Accordingly it is suggested that the adoption of a conceptual framework will not lead to consistent accounting standards, and inevitably the conceptual framework will lack credibility so long as it is inconsistent with legislation.     

The CF and Accounting Standards: The Persistence of Discrepancies

The conceptual framework (CF) has introduced a set of ideals and broad criteria for financial reporting focusing on servicing users' information needs. In this article, each concepts statement is considered, in turn, and its consistency with selected accounting standards examined. Particular attention is paid to accounting standards issued for the first time, or in a revised form, subsequent to the release of the concepts statements. It is found that many standards have provisions that are at odds with the CF. These inconsistencies come as no surprise. The CF is incomplete; the issue of measurement remains unresolved, leaving ambiguity in the definitions of concepts such as revenue. The CF project has remained unfinished while standard setters have given priority to other tasks, such as international harmonization, in resolving contemporary financial reporting issues.     

Social Relations and the Differential Local Impact of Global Standards: The Case of International Standards on Auditing

This article contributes to the literature exploring the contextual conditions that lead international standards to produce a differential impact with regard to inducing convergence in local practice. The article documents three types of responses by local audit firms to the implementation of International Standards on Auditing (ISAs) in Russia, namely: (1) those that claim to follow the national auditing standards modelled on ISAs and mandated by audit law; (2) those that voluntarily provide ISA audits in accordance with original ISAs; and (3) those that provide pseudo audits (‘black audits’) and ignore auditing standards. The study investigates a link between these different responses and the degree of the indigenous firms' social embeddedness in relation to the international audit firms that first introduced ISAs to Russia. The article argues that the higher the embeddedness levels the more likely the audit firms will genuinely commit to following the standards. It also shows that social embeddedness is influenced by a number of conditions, including geographical proximity between the indigenous and international audit firms, as well as commonalities in their professional characteristics, such as aspiration to intraprofessional status and target clientele. The study's findings demonstrate that the local impact of international standards is dependent not just on the characteristics of the local institutional environments in which the adopters operate but also on the social structures and relationships within which they are embedded.     

AE Briefings — Statement of Intent

This paper seeks to address the perceived failure of university teaching to foster critical understanding of audit practice and to identify a potential remedy. It contributes to the debate (Maltby, 2001, “Second thoughts about ‘Cases in Auditing’,” Accounting Education: an international journal, 10(4), 421–428) by investigating the double-faceted nature of auditing: as a sub-set of the academic discipline of accounting and as professional practice. Although case studies are helpful for students of auditing, they tend to be artificial, or at best, retrospective. This paper introduces a different type of case study for audit education using corporate failure stories from the media as an example, proposing and explaining the notion of the ‘living case’ in order to foster critical appraisal of audit practice. It contributes to the literature on audit education by describing how this different type of case can address both the technical activities and the social practice of audit through Kolb's (1984, Experiential Learning: Experience as the Source of Learning and Development, Englewood Cliffs, NJ: Prentice Hall) experiential learning theory and thus concludes that there is a place for the practical nature of auditing in academic study, in order to fully appreciate the social aspects.     

Rosie’s East End Restaurant: An experiential introduction to auditing

This short interactive case introduces several auditing concepts in the context of a familiar activity: verifying the accuracy of a restaurant bill. You will work in student teams to first determine whether the bill is accurate, and then to decide whether you are willing to pay it. During the exercise, you will keep track of the various steps and procedures you used in making your decisions. After you complete the exercise, your instructor will relate the activity to various auditing topics in the auditing process such as audit evidence, internal control, materiality, professional responsibilities and the concept of “fairly stated.” Hundreds of students have completed this exercise and report that it has helped them grasp many essential features of the auditing process, while providing a useful frame of reference for more complex aspects of the audit process.