Mind the Gap: Why Do Experts Have Differences of Opinion Regarding the Sufficiency of Audit Evidence Supporting Complex Fair Value Measurements?

Reported deficiencies continue to persist in audits of fair value measurements and other complex accounting estimates (hereafter, “FVMs”), despite improvements in auditor performance observed by regulators. The persistence of reported deficiencies in audits of FVMs suggests that factors underlying this trend may be more complicated and multidimensional than previously suggested by regulators and academic research, which has focused largely on auditors' unsatisfactory performance as the principal source of reported deficiencies. Drawing from the judgment and decision‐making expertise literature, we gather field‐based data from audit experts to identify additional factors that are likely to be contributing to differences of opinion between audit and inspection experts and the persistence of reported deficiencies in audits of FVMs. We find evidence that audit experts interpret standards and evaluate audit evidence differently than inspectors, and thus perceive there to be a gap between what auditors and inspectors regard as sufficient appropriate audit evidence to support audits of FVMs (hereafter, “FVM gap”). Moreover, results highlight several areas in audits of FVMs where differences of opinion exist between auditor and inspector experts regarding what constitutes a reported deficiency. Within the contexts we examine, our results identify additional factors, beyond deficient auditor performance, that may contribute to the FVM gap. We also report audit partners' recommendations for ways to reduce the FVM gap and suggest avenues for future research. Gaining a more complete understanding of sources contributing to reported deficiencies will help regulators, standard setters, audit firms, and academics to identify ways to reduce the FVM gap and reported deficiencies in audits of FVMs.     

Learning by Doing and Audit Quality*

In this study, we present a nonstrategic, dynamic Bayesian model in which auditors' learning on the job and their choice of professional services jointly affect audit quality. While performing audits over time, auditors accumulate client‐specific knowledge so that their posterior beliefs about clients are updated and become more precise (that is, precision is our surrogate for audit quality) — what we call the learning effect. In addition, auditors can enrich their knowledge accumulation by performing nonaudit services (NAS) that, in fact, may influence clients' managerial decisions — what we call the business advisory effect. This advisory effect permits auditors to anticipate and to learn about changes in clients' business models, which in turn improves their advisory capacity. These dual “learning” and “advisory” effects are interdependent and mutually reinforcing. The advisory effect of NAS may increase or reduce auditors' engagement risk. We show that large professional fees can induce auditors to provide NAS that increase engagement risk and diminish audit quality. However, when NAS reduce engagement risk and increase audit quality, auditors may provide NAS without charging clients. The feature that distinguishes our study — the interdependence between the learning and advisory effects — provides new insight into the trade‐off between audit fees and audit quality. Consequently, our analysis helps explain why the scope of the audit has evolved over time and why the boundaries between audit and NAS are constantly shifting. A recent example of such a shift is that the Sarbanes‐Oxley Act adds control attestation to audits for public companies traded in U.S. markets.     

Auditors’ Joint Engagements and Audit Quality: Evidence from Italian Private Companies

This study examines the effect of auditors’ collaboration in joint audit engagements on knowledge transfer, auditor expertise, and audit outcomes. I employ a unique sample of Italian private companies whose financial statements are jointly audited by three individual auditors and use measures from the network literature to capture the intensity of interactions between these auditors. I find a positive association between several audit quality proxies and auditors’ collaboration in multiple joint engagements. My results suggest that auditors develop knowledge and contacts through collaboration which potentially leads to higher audit quality. Overall, my findings suggest that joint engagements facilitate knowledge transfer and increase auditor expertise.     

Using Cultural Mindsets to Reduce Cross-National Auditor Judgment Differences

In a globalized audit environment, regulators and researchers have expressed concerns about inconsistent audit quality across nations, with a particular emphasis on Chinese audit quality. Prior research suggests Chinese audit quality may be lower than U.S. audit quality due to a weaker institutional environment (e.g., lower litigation and inspection risk) or cultural value differences (e.g., greater deference to authority). In this study, we propose that lower Chinese audit quality could also be due to Chinese auditors' different cognitive processing styles (i.e., cultural mindsets). We find U.S. auditors are more likely to engage in an analytic mindset approach, focusing on a subset of disconfirming information, whereas Chinese auditors are more likely to take a holistic mindset approach, focusing on a balanced set of confirming and disconfirming information. As a result, Chinese auditors make less skeptical judgments compared to U.S. auditors. We then propose an intervention in which we explicitly instruct auditors to consider using both a holistic and an analytic mindset approach when evaluating evidence. We find this intervention minimizes differences between Chinese and U.S. auditors' judgments by shifting Chinese auditors' attention more towards disconfirming evidence, improving their professional skepticism, while not causing U.S. auditors to become less skeptical. Our study contributes to the auditing literature by identifying cultural mindset differences as a causal mechanism underlying lower professional skepticism levels among Chinese auditors compared to U.S. auditors and providing standard setters and firms with a potential solution that can be adapted to improve Chinese auditors' professional skepticism and reduce cross-national auditor judgment differences.     

Learning the “Craft” of Auditing: A Dynamic View of Auditors' On‐the‐Job Learning

We investigate how auditors learn the technical aspects of their professional role while performing client engagements, and how that learning process has been shaped by changes in societal, economic, and regulatory forces. Prior studies explicitly recognize that auditors need social skills and demeanor consistent with professional norms as well as requisite knowledge, but those studies generally focus on the processes through which new auditors are molded toward consistency with social norms. In contrast, we focus on forces affecting the transfer of technical knowledge from supervisor (guide) to subordinate (learner) in the everyday work setting. Our evidence derives from semi‐structured interviews with 30 relatively new and more experienced audit partners at one Big 4 firm, thus spanning multiple “generations” of experience. Results confirm that auditors primarily acquire technical knowledge on the job, through the interactions among individual engagement team members. However, partners express concern about changes in the practice environment that may limit effectiveness of on‐the‐job learning, including characteristics of personnel, the approach to formal training at induction, supervisors' reluctance to provide candid feedback, regulatory and economic pressures, and the increased distraction, and reduced interpersonal contact associated with the use of information technology. At the end of the day, our findings raise implications for practice regarding the difficulty of developing effective learning conditions for auditors in the face of these challenges.     

Public Company Audits and City‐Specific Labor Characteristics

Prior research emphasizes the centrality of audit offices in understanding auditing practices, and documents significant interoffice variation in audit outcomes based on industry expertise and office size. Our study examines how two city‐specific labor characteristics also affect audit offices and local audit markets: the city's average educational attainment, and the number of accountants in a city, which proxy for a city's human capital. Our argument draws on the urban economics literature and predicts that the level of human capital in a city is positively associated with an audit office's ability to conduct high‐quality audits. As expected, there is a positive association between audit quality (quality of audited earnings and accuracy of going‐concern reports) and average education level in the city in which the lead engagement office is located. This association is generally significant for both Big 4 and non‐Big 4 offices, but is relatively stronger for non‐Big 4 firms that are more tied to local labor markets. A company is also more likely to choose a non‐Big 4 auditor in cities with higher educational levels and relatively more accountants, and there is evidence of higher non‐Big 4 audit fees as a city's education level increases. Collectively, these results suggest that local labor characteristics affect audit offices, audit quality, and the ability of non‐Big 4 auditors to compete with Big 4 auditors in the audits of public companies.     

When Is the Averaging Effect Present in Auditor Judgments?

Auditing standards task auditors with collecting sufficient appropriate evidence to form audit judgments. Yet, cognitive psychology documents a robust finding in which people evaluate a bundle of relevant, directionally consistent evidence as though averaging the strength of the components. In consequence, a bundle of evidence may be viewed as weaker evidence than the bundle's strongest evidence item alone. We experimentally examine whether this averaging effect occurs in an audit context, and we test a potential moderator. In three independent mini-cases, we ask auditor participants to make judgments about going concern, internal controls, and fraud risk. We present auditors with unfavorable audit evidence relevant to each judgment, manipulating whether we present a single strong evidence item or bundle it with a weaker evidence item. We also manipulate the auditor's initial impression of the client's state. We find that experienced auditors succumb to the averaging effect, making more strongly unfavorable judgments in response to the single evidence item than the bundle, and that this bias is reduced when the observed evidence is inconsistent with the auditor's initial impression. We interpret our results as consistent with the dual-processing theory of cognition.     

Does Audit Committee Accounting Expertise Help to Promote Audit Quality? Evidence from Auditor Reporting of Internal Control Weaknesses

In this study, we examine whether audit committee accounting expertise helps to promote audit quality by motivating auditors to conduct diligent internal control audits and make appropriate internal control assessments because audit committee accounting expertise safeguards auditors from dismissal following adverse internal control opinions. Among clients with existing and likely internal control material weaknesses (as proxied by future restatements of audited financial statements), we find a greater likelihood of adverse internal control audit opinions when the audit committee has greater accounting expertise (measured by the proportion of accounting experts on the audit committee). Among all clients, we find a lower likelihood of subsequent auditor dismissal following an adverse internal control audit opinion when the audit committee has greater accounting expertise. In further analyses, we find that this lower likelihood of subsequent auditor dismissal occurs when at least two audit committee members possess accounting expertise. We also find some evidence that CFO influence (but not CEO influence) over the audit committee negates the increased likelihood of adverse internal control opinions when internal control material weaknesses likely exist, as well as the decreased likelihood of auditor dismissal following adverse internal control opinions. These findings have important implications for regulators and corporate nominating committees interested in promoting audit committee effectiveness.     

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.     

Independence Threats,Litigation Risk,and the Auditor's Decision Process*

This study examines the effect of independence threats and litigation risk on auditors' evaluation of information and subsequent reporting choices. Using a Web‐based experiment, I tracked auditors' information gathering and evaluation leading to a going‐concern reporting decision. Specifically, 48 audit managers assessed client survival likelihood, gathered additional information, and suggested audit report choices. I found that auditors facing high independence threats (fear of losing the client) evaluated information as more indicative of a surviving client and were more likely to suggest an unmodified audit report, consistent with client preferences. In contrast, auditors facing high litigation risk evaluated information as more indicative of a failing client and were more likely to suggest a modified audit report. In addition, the association between risk and report choice was fully mediated by final information evaluation. This suggests that it is unlikely that different reporting choices resulted from a conscious choice bias, but rather that motivated reasoning during evidence evaluation plays a key role in the effect of risk in auditor decision making.     

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.     

Is Audit Committee Equity Compensation Related to Audit Fees?*

Section 301 of the Sarbanes‐Oxley Act (SOX) implicitly assumes that audit committees can independently determine audit fees. Critics of section 301 have questioned this assumption in particular, and the efficacy of section 301 more generally. In response, the SEC issued a concept release in 2015 calling for public disclosure of the process that audit committees follow for determining auditor compensation. Motivated by these calls and the widespread use of stocks and options to compensate firms' independent directors, we examine the relation between equity compensation granted to audit committee members and audit fees. Using a sample of 3,685 firm‐year observations during 2007–2015, we find a negative relation between audit committee equity compensation and audit fees, consistent with larger equity pay inducing audit committee members to compromise independence by paying lower audit fees. These findings are robust to controlling for endogeneity, firm size, alternative measures of equity compensation, alternative samples, and an alternative treatment of extreme values. We further show that larger equity compensation is associated with lower earnings quality. We also find that the negative effect of equity compensation on audit fees is stronger when city‐level audit market competition is high. However, this negative relation disappears when (i) firms face high litigation risk, (ii) auditors have stronger bargaining power, (iii) the audit committee includes a high proportion of accounting experts, and (iv) auditors are industry experts. Our results are relevant for regulators and investors.     

When the Client Is a Former Auditor: Auditees' Expert Knowledge and Social Capital as Threats to Staff Auditors' Operational Independence

Auditees can play an active role in influencing staff auditors' professional judgment and skepticism. Yet, although it constitutes one of the main threats to auditor independence, very little is known about the means and extent of auditees' power during the audit engagement. To address this knowledge gap, our study focuses on a specific category of auditees, namely, auditees who have worked as auditors in large accounting firms. We interviewed 36 of these auditees and triangulated our findings with 11 interviews conducted with auditors. At the theoretical level, we conceptualize auditees' influence over auditors as intentional and active through the notion of “social power.” Overall, our analysis shows that the efficacy of auditees' power during the engagement materializes through the mobilization of two main power resources developed during their time at the firms: (i) expert knowledge of auditing techniques and (ii) social capital. On the one hand, relying on their cognitive authority, auditees' employ three different power strategies to constrain staff auditors' operational independence: stage-setting, teaching, and questioning. On the other hand, auditees' social capital can support the use of two additional strategies: attracting and monitoring. Our triangulation analysis confirms our findings and suggests that auditors may be aware of the threats to independence that auditee expertise and social capital pose. By focusing on auditees' agentic capabilities—that is, individuals' capabilities to consciously exert influence over the course of events—we reinterpret the pressures exerted by clients on auditors as the product of strategic actions and discuss substantive consequences for independence risk.     

The Disposition of Audit‐Detected Misstatements: An Examination of Risk and Reward Factors and Aggregation Effects*

While professional standards indicate that auditors have the responsibility to both detect and report material errors, empirical evidence shows that auditors waive approximately 50 percent of material errors (Wright and Wright 1997). Unlike prior research that has examined factors that may affect auditors' decisions to waive single material misstatements, the current study examines auditors' propensity to waive proposed adjusting journal entries (henceforth PAJEs) that exceed materiality, either individually or in aggregate, under several different aggregation contexts. These contexts are represented in the form of different cases that vary in terms of the materiality and income direction of the individual and aggregate PAJEs. The current paper posits that auditors will be more likely to waive PAJEs in excess of materiality (i.e., make a “non‐GAAS” decision) when there is potential reward for doing so or when there is little litigation risk from doing so. The case decisions of 155 audit partners and managers indicate that they are not affected by potential reward (Client's Relative Fees), but are affected by potential risk (the Client's Financial Health, the PAJE's Subjectivity, and the PAJEs' Aggregate Directional Effect on Income). However, these factors are not equally influential across all aggregation contexts. Additionally, auditors are more likely to make non‐GAAS decisions when they are evaluating immaterial PAJEs that aggregate to a material level than when they are evaluating a single material PAJE.     

竞赛机制设计研究回顾与展望

竞赛是社会、政治和经济中的典型现象,在激励和资源配置方面发挥了非常重要的作用,竞赛机 制设计已成为竞赛研究的理论热点问题。本文介绍了竞赛理论基础知识,主要从竞赛奖励、竞赛结构及 竞赛成功函数三个方面,综述了有关竞赛机制设计研究。在回顾以往研究的基础上,探讨了竞赛机制设 计研究未来的可能发展方向。     

Audits of Complex Estimates as Verification of Management Numbers: How Institutional Pressures Shape Practice

Auditors and regulators have invested heavily in improving audits of estimates in recent years, but problems in this area persist. We examine the causes of these problems and why they persist. To do so, we interview 24 very experienced auditors about how they audit complex accounting estimates such as fair values and impairments and what problems they experience in the process. We find that auditors overwhelmingly choose to audit the details of management's estimate rather than use other allowable approaches. The steps auditors describe and the language they use to describe those steps indicate that they follow a process of verifying individual elements of management's assertions on a piecemeal basis, resulting in overreliance on management's process, rather than engaging in a critical analysis of the overall estimate. The problems that auditors identify are consistent with this view, and include failures to notice inconsistencies among the estimate and other internal data or external conditions and overreliance on specialists to identify, evaluate, and challenge critical assumptions. We interpret these processes and problems using institutional theory and identify two root causes: standards' and firm policies' emphasis on verifying management's model, and audit firms' division of knowledge between auditors and specialists. Institutional theory proposes these conventions arise from firms extending use of procedures that are legitimate in one area (i.e., auditing accounts without significant uncertainty) to a new area (i.e., auditing complex estimates), even though they are likely less effective in the new area. These conventions are reinforced by regulators' method of inspection and by firms' reluctance to change methods without a prompt to change to a clearly better method. We argue that these institutionalized conventions thwart auditors' good‐faith attempts to engage in skeptical analysis of estimates. Thus, audit quality problems are likely to persist.     

Do Auditors Accurately Predict Litigation and Reputation Consequences of Inaccurate Accounting Estimates?

To effectively manage audit risk, auditors must correctly predict the potential litigation and reputation consequences associated with inaccurate accounting estimates. Accurate predictions are critical because underestimation of negative consequences leads to excess legal exposure and overestimation leads to overauditing. Our paper examines whether auditors correctly anticipate these litigation and reputation outcomes. We provide manager‐ and partner‐level auditors with case facts from an auditor negligence lawsuit and ask them to predict the proportion of juries that will return verdicts against their firm. We then compare auditors' predictions to the actual verdicts we observe when we provide the same set of case facts to mock jurors who deliberate as part of juries. We find that auditors overestimate the likelihood of negligence verdicts, especially when audit quality is relatively high. Our supplemental measures help explain the reasons for this overestimation: auditors tend to underestimate jurors' perceptions of audit quality and willingness to attribute inaccurate estimates to situational factors. Finally, we examine auditors' predictions about how a news article about the litigation will affect their reputation with the general public. Similar to our litigation results, we find that auditors tend to overestimate the article's negative impact on auditor reputation. Collectively, our findings suggest that auditors overestimate litigation and reputation consequences resulting from inaccurate accounting estimates. This overestimation is consequential as it leads to inefficient allocation of audit resources.     

Can Audit Committee Expertise Increase External Auditors' Litigation Risk? The Moderating Effect of Audit Committee Independence

This study examines whether the perceived independence and financial expertise of audit committee members affect external auditors' exposure to legal liability. We use an experiment in which potential jurors make judgments about auditor independence and legal liability for a case involving an audit failure. We find that perceptions of audit committee independence from management are positively associated with judgments of auditor independence and negatively associated with auditor liability. However, financial expertise of audit committee members can be a double-edged sword. Our experiment finds that judgments of auditor liability are higher when the audit committee is perceived to have higher financial expertise but lower independence from management. In assessing litigation risk of current and prospective clients, auditors may want to carefully consider the independence of audit committee members from management, particularly when audit committee members have financial expertise. In the event of an audit failure, the financial expertise of nonindependent audit committee members can negatively affect jurors' perceptions of auditor independence and liability.     

Do Mutual Fund Investors Care About Auditor Quality?

We study the influence of perceived auditor quality on investment decisions by bond mutual fund investors. Audits of bond mutual funds require significant auditor expertise. Fund managers estimate daily the fair market values of holdings that are often opaque and illiquid. Managers can use their discretion to manipulate their fund's performance results. While it is known that investment flows into funds that report good past performance, little evidence exists about whether investors' confidence in the reliability of fund financial reports is influenced by auditor quality. Using hand‐collected data from SEC filings, we find that the positive association between reported performance and investment flows is stronger for funds with auditors who are industry specialists and are longer‐tenured, as well as for funds that pay higher audit fees. We do not find that auditor office size strengthens the association. We also find that the presence of industry‐specialist auditors, long‐tenured auditors, and higher audit fees lead to additional disclosure in the form of emphasis‐of‐matter. This study contributes to the streams of research investigating perceived audit quality, fund investment decisions, and auditing for financial services.     

Revising Audit Plans to Address Fraud Risk: A Case of “Do as I Advise,Not as I Do”?*

Prior research documents that auditors fail to revise audit plans to effectively address identified fraud cues. While auditors may understand what evidence would address such cues, we propose that auditors fail to apply this understanding because they use implemental mindsets when making decisions for themselves (i.e., deciding). However, we also propose that auditors use deliberative mindsets when advising. To test our predictions, we assign auditors to a decider or an advisor role in a realistic case that contains seeded fraud cues and asks them to consider revising last year's plan. We also manipulate whether the case prompts auditors to revise the plan unconventionally. Results indicate decider-condition auditors use implemental mindsets: Prompted deciders follow the unconventional plan without regard to underlying fraud risk and unprompted deciders stick with the same-as-last-year plan. Advisor-condition auditors use more deliberative mindsets: In the prompt and no prompt conditions, they identify plans that are strongly linked to their own fraud risk assessments and that better align with experts' recommended plan for effectively addressing the seeded fraud cues. Supplemental analyses suggest deciding and advising auditors both follow the experts' plan when they believe in its potential effectiveness but, after controlling for the influence of perceived effectiveness, deciding auditors follow it to a greater extent simply because they believe the PCAOB wants it. By contrast, advising auditors do not exhibit signs of excessive PCAOB influence. Our findings provide evidence that seeking informal advice (or thinking like an advisor) helps auditors to effectively revise audit plans in response to identified fraud risk—it helps when a prompt is present or not, suggesting it complements rather than merely substitutes for interventions meant to improve auditors' judgment and decision making.