Auditors' Responses to Workload Imbalance and the Impact on Audit Quality*

Using detailed data for fieldwork hours and audit hours by rank from audit engagements in Korea, we examine whether audits conducted under workload imbalance, proxied by busy‐season audits, impair audit quality, and how auditors adjust staff assignments for busy‐season audits. We generally find that busy‐season audits are associated with lower audit quality, and that audit firms reduce the involvement of senior auditors during busy‐season audits. In addition, the greater the involvement of senior auditors and junior auditors, the lesser the deterioration in audit quality. Finally, although there is no increase in interim audits in response to workload imbalance during busy seasons, increasing interim audits can mitigate the negative impact of busy‐season audits on audit quality. Our results are relevant to auditors and regulators, who have expressed concerns about the adverse effects of workload imbalance on audit quality.     

Experimental Evidence of the Impact of Increasing Auditors' Legal Liability on Firms' New Investments*

This laboratory market study examines the potential effect of increasing auditors' liability on firms' new investments. The experimental hypotheses are derived from Shibano's 2000 model, which predicts that an increase in auditors' liability will decrease the frequency of audit failures and may decrease firms' new investments if the liability level is “excessive”. Results from three experimental market settings (with low, medium, and high liability levels) suggest two major conclusions. First, firms' new investments increase significantly when auditors' liability level increases from low to medium, and decrease significantly as the liability level increases from medium to high. This result provides support for the argument that adequate auditor liability is necessary to motivate firms to invest in new projects. Excessive liability, however, may discourage firms from making new investments. Second, the frequency of audit failure decreases insignificantly when auditors' liability increases. These two results have an important policy implication: the benefit of imposing high liability on the auditor (i.e., an insignificant decrease in audit failure) may be more than offset by its cost (i.e., a significant decrease in new investments).     

The Influence of Nonaudit Service Revenues and Client Pressure on External Auditors' Decisions to Rely on Internal Audit*

This paper investigates how external auditor provision of significant nonaudit services and client pressure to use the work of internal audit influence external auditors' use of internal auditors' work. More specifically, we study how external audit evidence gathering choices are influenced by nonaudit fees and client pressure. Our research is motivated by an observation that the magnitude of nonaudit services provided to audit clients introduces the risk that client management may leverage its position with the external auditor and potentially affect the audit process. We address this issue by extending prior research and focusing on the importance of various explanatory variables, including nonaudit service revenues, client pressure, internal audit quality, and coordination, to the external auditor's decision to rely on the work of internal audit. We use data primarily obtained through surveys completed by internal and external auditors. The survey responses represent 74 separate audit engagements. Our findings reveal that when significant nonaudit services are not provided to a client, internal audit quality and the level of internal‐external auditor coordination positively affect auditors' internal audit reliance decisions. However, when the auditor provides significant nonaudit services to the client, internal audit quality and the extent of internal ‐ external auditor coordination do not significantly affect auditors' reliance decisions. Furthermore, when significant nonaudit services are provided, client pressure significantly increases the extent of internal audit reliance. Thus, external auditors appear to be more affected by client pressure and less concerned about internal audit quality and coordination when making internal audit reliance decisions at clients for whom significant nonaudit services are also provided.     

The Impact of Internal Auditor Compensation and Role on External Auditors' Planning Judgments and Decisions*

This paper reports the results of an experiment that investigates how external audit planning is affected when internal auditors have incentives and the opportunity to bias their evaluations. Specifically, we draw on attribution theory to examine how internal auditor eligibility for incentive compensation and participation in consulting (i.e., two factors that provide incentives to bias audit evaluations) affect external audit planning. In addition, we examine the effects of incentive compensation and a consulting role across two routine internal audit tasks — an objective tests of controls task and a subjective inventory valuation task — to evaluate whether their effects are contingent upon task subjectivity (i.e., opportunity to bias audit evaluations). Seventy‐six external auditors from four Big 5 public accounting firms participated in an experiment that manipulated internal auditor compensation (fixed salary versus incentive compensation), the type of work that the internal auditors routinely perform (primarily auditing versus primarily consulting), and audit task subjectivity (objective tests of controls versus subjective inventory valuation). Our results suggest that the nature of internal auditors' compensation and work affect audit planning recommendations differently. The opportunity to receive incentive compensation results in less reliance on internal auditors' work and greater budgeted audit hours, but only for the subjective task. Although a consulting role decreases perceived internal auditor objectivity, it has a limited effect on planning recommendations. Specifically, consulting has no effect on reliance, and leads to greater budgeted audit hours only when incentive compensation is available. We discuss potential explanations for the results as well as implications for audit research, practice, and regulation.     

Auditors' Generation of Diagnostic Hypotheses in Response to a Superior's Suggestion: Interference Effects*

Abstract. This study investigates the effects of a superior's suggestion on auditors' generation of additional hypotheses from long-term memory (LTM). It investigates whether an inherited hypothesis affects the category membership of additional hypotheses retrieved from LTM, in particular when hypotheses from few alternative categories are considered. Based on research in cognitive psychology, the authors predicted that providing auditors with a superior's suggestion would interfere with their generation of additional hypotheses from the same transaction cycle as that of the superior's suggestion. The experimental results are consistent with the expected interference effect. Auditors who inherited a superior's suggestion from a particular transaction cycle generated fewer additional hypotheses from the same transaction cycle than did auditors who were not provided with a superior's suggestion. Moreover, the effect came into play immediately when auditors inherited a hypothesis involving a typical problem: the first hypothesis generated tended to come from a different transaction cycle than that of the superior's suggestion. Résumé. Dans l'article qui suit, les auteurs se penchent sur l'incidence que peut avoir la suggestion d'un supérieur sur les hypothèses supplémentaires que formulent les vérificateurs en puisant dans la « mémoire à long terme ?. Ils cherchent à déterminer si une hypothèse transmise exerce une influence sur la catégorie à laquelle appartiennent les hypothèses supplémentaires tirés de la mémoire à long terme, en particulier lorsque les hypothèses envisagées proviennent d'un petit nombre de catégories possibles. En s'appuyant sur la recherche en psychologie cognitive, les auteurs supposent que la suggestion communiquée par un supérieur aux vérificateurs perturbera chez ces derniers la formulation d'hypothèses supplémentaires tirées du même cycle d'opérations que celui dont provient la suggestion du supérieur. Les résultats expérimentaux des chercheurs confirment cet effet perturbateur. Les vérificateurs à qui un supérieur a transmis une suggestion d'hypothèse provenant d'un cycle d'opérations donné ont formulé moins d'hypothèses supplémentaires provenant du même cycle d'opérations que les vérificateurs à qui aucune suggestion n'a été faite par un supérieur. En outre, l'effet perturbateur se manifeste immédiatement au moment où les vérificateurs se voient transmettre une hypothèse faisant intervenir un problème type: la première hypothèse formulée tend à provenir d'un cycle d'opérations différent de celui dont la suggestion du supérieur est issue.     

Context-Dependence of Auditors' Interpretations of the SFAS No. 5 Probability Expressions*

Abstract. Statement of Financial Accounting Standards (SFAS) No. 5 requires accrual of contingent losses which are deemed probable. This disclosure criterion is intended to be applied uniformly across a variety of contexts. We performed an experiment which examined whether audit managers' interpretations of the SFAS No. 5 probability expressions are influenced by one contextual feature, event base rate. Counter to the intention of the Financial Accounting Standards Board (FASB), interpretations of the expression probable were positively associated with event base rate. Résumé. Le SFAS n^o 5 exige l'imputation à l'exercice des pertes éventuelles qui sont jugées «probables». La règle ainsi établie veut que ce critère de présentation d'information soit appliqué uniformément dans des contextes très divers. Les auteurs procèdent à une expérience dans le cadre de laquelle ils examinent si la façon dont les responsables de mission interprètent la gamme de probabilités, au sens du SFAS n^o 5, est influencée par une caractéristique contextuelle, la fréquence relative de l'événement. Contrairement au résultat visé par le FASB, les interprétations du terme «probable» sont en relation positive avec la fréquence relative de l'événement.     

The Effect of Accountability and Time Budgets on Auditors' Testing Strategies*

This study investigates the joint effects of accountability and time budgets on auditors' testing strategies. The task studied, substantive analytical procedures, requires auditors to identify and test hypotheses when investigating the cause of unexpected fluctuations. Thus, auditors must determine the number of tests to conduct (i.e., extent), the number of potential hypotheses to directly test (i.e., breadth), the number of tests for each hypothesis (i.e., depth) and the number of potential error or non‐error hypotheses to test (i.e., focus). Testing strategies, which we define as choices made with respect to extent, focus, depth, and breadth of testing, have significant practical and theoretical implications. For example, reducing the breadth of testing may result in failure to test the correct hypothesis, potentially impairing audit effectiveness. In this study, auditors inherited five potential causes of an unexpected increase in the gross margin of a client. As in practice, their task was to conduct tests to investigate and identify the actual cause of the fluctuation. Auditors were randomly assigned to one of four conditions created by fully crossing accountability and time budgets. The results indicate that accountability leads to an increase in the extent and breadth of testing but does not affect the depth of testing. Further, accountability leads to an increase in the testing of errors but results in a decrease in the testing of non‐errors. The focus on breadth and error testing is consistent with the notion that accountability, to a superior with unspecified preferences, promotes more cautious behavior. The results also show that a time budget decreases the extent and depth of testing but does not affect the breadth of testing. There was no evidence that the two factors interactively affected testing strategies or performance. Finally, increased breadth of testing was the mechanism that led to better performance as measured by the identification of the actual cause of the unexpected fluctuation.     

The Effects of Industry Specialization on Auditors' Inherent Risk Assessments and Confidence Judgements*

This study experimentally examines how industry specialization affects auditors' inherent risk assessments and their confidence in those risk assessments. Two groups of participants ‐ experienced banking specialist auditors and equally experienced nonbanking auditors ‐ provided inherent risk assessments for a hypothetical banking client for two financial statement accounts. They assessed inherent risk for an industry‐specific account (loans receivable) and for a nonindustry‐specific account (property and equipment). The results indicate that nonbanking auditors assessed inherent risk significantly higher than industry specialists for all but the valuation assertion for the loans receivable account. However, the difference between the nonbanking auditors' and banking specialists' inherent risk assessments was not as great for the property and equipment account. Further, nonspecialists were less confident about the appropriateness of their inherent risk assessments compared with industry specialists. Potential implications for research and practice are discussed in light of the study's findings.     

Auditors' Use of Formal Advice from Internal Firm Subject Matter Experts: The Impact of Advice Quality and Advice Awareness on Auditors' Judgments

When subject matter experts are consulted during an audit, the quality of the expert's advice depends upon their ability to fully understand and incorporate client‐specific facts into their advice. Public Company Accounting Oversight Board (PCAOB) inspection reports suggest that auditors are neglecting to perform the required work to assess the quality of experts' recommendations. This study examines how characteristics of the audit, notably staffing decisions, can impede auditors' ability to discern advice quality. In an experiment, we examine how receiving advice of different levels of quality (lower or higher incorporation of relevant client facts) and awareness at the planning stage of the use of a subject matter expert (a priori aware or unaware) impacts auditors' effort, utilization of the advice, and judgment accuracy. We find that awareness of an expert being employed led to a social facilitation effect such that auditors who were a priori aware put forth more effort prior to receiving the expert advice and were initially in less agreement with management's aggressive revenue recognition position than auditors who were unaware. Upon receiving the expert advice, auditors who were a priori aware were more accurate than auditors who were unaware. These results should interest both audit regulators and practitioners by demonstrating how the timing and communication of consulting decisions affect auditors' assessments of advice received from subject matter experts.     

A Note on the Association between Audit Firm Size and Audit Quality*

Abstract. This study proposes that comparison of management earnings forecasts with audited, reported earnings provides an approach to the measurement of audit quality. Assuming that managers have incentives to minimize the difference between forecasted and reported income, higher-quality audit firms will tend to be associated with larger forecast errors. Therefore if, as previous literature suggests, larger auditing firms provide higher-quality audits than do smaller auditing firms, larger auditing firms will tend to be associated with larger forecast errors, all else being equal. Data from the Toronto Stock Exchange are used to examine this proposition. After controlling for client characteristics such as risk, the results indicate that larger auditing firms tend to be associated with larger forecast errors consistent with the proposition that, other things being equal, larger auditing firms provide higher-quality audits than do small auditing firms. Résumé. Les auteurs proposent une technique de mesure de la qualité de la vérification qui consiste à comparer les prévisions de la direction relatives aux bénéfices et les bénéfices déclarés qui ont été vérifiés. Si l'on suppose que les gestionnaires ont intérêt à minimiser l'écart entre les bénéfices prévus et les bénéfices déclarés, les vérificateurs de haut calibre auront tendance à être associés à des erreurs prévisionnelles plus importantes. Par conséquent, si, comme l'ont suggéré les études antérieures, les cabinets d'experts-comptables importants offrent des services de vérification de meilleure qualité que les cabinets d'experts-comptables de taille plus modeste, les cabinets d'experts-comptables importants auront tendance à être associés aux erreurs prévisionnelles plus grandes, toutes choses étant égales. Les auteurs utilisent les données de la Bourse de Toronto pour vérifier cette affirmation. Une fois contrôlées les caractéristiques du client telles que le risque, les résultats indiquent que les cabinets d'experts-comptables de grande taille tendent à être associés aux erreurs prévisionnelles plus importantes, ce qui confirme l'hypothèse voulant que, toutes choses étant égales, les cabinets d'experts-comptables de grande taille offrent des services de vérification de meilleure qualité que les cabinets d'experts-comptables de taille plus petite.     

Implications of the Joint Provision of CSR Assurance and Financial Audit for Auditors' Assessment of Going-Concern Risk

We examine whether the joint provision of corporate social responsibility (CSR) assurance services and financial audit by the same audit firm influences auditors' assessment of going-concern risk. We predict that the provision of CSR assurance and financial audit by the same audit firm creates CSR-related knowledge spillovers from the CSR assurance team to the financial audit engagement team, which helps in the auditor's assessment of going-concern risk. Using more than 28,000 firm-year observations from 55 countries, we document that, relative to audit firms that provide only the financial audit, audit firms that provide both CSR assurance and financial audit for the same client (i) issue more frequent going-concern opinions and have lower Type II going-concern errors, (ii) have clients that book larger environmental and litigation provisions, (iii) report earnings that are more persistent and value-relevant and are less likely to book income-decreasing earnings restatements, and (iv) do not charge higher audit fees or total fees. Our results are important especially because of firms' increasing exposure to CSR risks and the growing number of countries that require assurance of CSR reports.     

Auditors' usage of unaudited book values when making presampling audit value estimates*

Abstract. An important issue in audit judgment research concerns auditors' use of unaudited book values when making judgments in the presampling phase of the audit. This paper presents a rudimentary model of the auditor's belief revision process with respect to unaudited book values from an audit value estimation perspective. An experiment testing some implications of the model is also presented. The model proposes that the auditor should judge the validity of unaudited book values in the circumstances and use them accordingly when making presampling audit value estimates. The experimental results indicated that the subjects (auditors) used available unaudited book values and that the extent of usage varied over accounts. However, the results also indicated some inaccurate presampling validity judgments which led to overweighting of unaudited book values. Résumé. Une question importante qui préoccupe les chercheurs dans le domaine de la formulation de jugements en vérification a trait à l'utilisation par les vérificateurs de valeurs comptables non vérifiées dans la formulation de jugements au cours de la phase de la vérification précédant l'échantillonnage. Les auteurs présentent un modèle rudimentaire du processus de révision des convictions du vérificateur en ce qui a trait aux valeurs comptables non vérifiées dans une perspective d'estimation de la valeur de vérification. Ils font également état d'une expérience destinée à vérifier certaines des conséquences du modèle. Selon le modèle, le vérificateur devrait juger de la validité des valeurs comptables non vérifiées dans les circonstances et les utiliser en conséquence dans la formation d'estimations de la valeur de vérification avant échantillonnage. Les résultats de l'expérience révèlent que les sujets (vérificateurs) utilisent les valeurs comptables non vérifiées disponibles et que l'étendue de cette utilisation varie avec les comptes. Toutefois, les résultats révèlent aussi l'inexactitude de certains jugements relatifs à la validité antérieure à l'échantillonnage, à la suite desquels une importance trop grande a été accordée aux valeurs comptables non vérifiées.     

The Effect of Audit Quality on Earnings Management*

This study examines the relation between audit quality and earnings management. Consistent with prior research, we treat audit quality as a dichotomous variable and assume that Big Six auditors are of higher quality than non-Big Six auditors. Earnings management is captured by discretionary accruals that are estimated using a cross-sectional version of the Jones 1991 model. Prior literature suggests that auditors are more likely to object to management's accounting choices that increase earnings (as opposed to decrease earnings) and that auditors are more likely to be sued when they are associated with financial statements that overstate earnings (as compared to understate earnings). Therefore, we hypothesize that clients of non-Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accruals reported by clients of Big Six auditors. This hypothesis is supported by evidence from a sample of 10,379 Big Six and 2,179 non-Big Six firm years. Specifically, clients of non-Big Six auditors report discretionary accruals that are, on average, 1.5-2.1 percent of total assets higher than the discretionary accruals reported by clients of Big Six auditors. Also, consistent with earnings management, we find that the mean and median of the absolute value of discretionary accruals are greater for firms with non-Big Six auditors. This result also indicates that lower audit quality is associated with more “accounting flexibility”.