Audit Strategies and Multiple Fraud Opportunities of Misreporting and Defalcation*

We examine how an auditor assesses the risk of fraud and formulates an audit plan when the auditee has the opportunity to commit various types of fraud. Unlike previous studies, the audi‐tee can misappropriate assets (defalcation), misreport financial information (fraudulent financial reporting), or misreport financial information in combination with defalcation. Our results identify four possible equilibria whose characteristics depend on the auditee's relative rewards and penalties from the various types of fraud, the cost of audit effort, and expectations about the auditee‐firm's performance. When the cost of audit effort is sufficiently small, fraud risk assessment depends on the auditee's rewards and penalties associated with each type of fraud, but not on the auditor's beliefs about firm performance. The auditor develops an audit plan that focuses on the type of fraud the auditee is most motivated to commit, and in turn, the audit plan deters all other types of fraud.     

Accounting Comparability,Audit Effort,and Audit Outcomes

Accounting comparability among peer firms in the same industry reflects the similarity and the relatedness of firms’ operating environments and financial reporting. From the perspectives of “inherent audit risk” and “external information efficiency,” comparability is helpful for auditors in assessing client audit risk and lowers the costs of information acquisition, processing, and testing. I posit that the availability of information about comparable clients helps improve audit efficiency and accuracy. Empirical results show that comparability is negatively related to audit effort (surrogated by audit fees and audit delay). Moreover, comparability is negatively associated with the likelihood of audit opinion errors. These findings are robust to different specifications of regression models, particularly for the “endogeneity” issues due to the possible reverse causality that auditor style might influence client firms’ comparability. In sum, the study shows that accounting comparability enhances the utility of accounting information for external audits.     

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.     

Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions

This study examines the persistence and economic consequences of variations in reporting style across audit partners in individual engagements. Our results show that both aggressive and conservative audit reporting, measured by the pattern of prior Type 2 and Type 1 audit reporting error rates in auditor‐specific clienteles, persist over time and extend to other clients of the same partner. Analyses of abnormal accruals and persistence of client firms’ accrual estimates corroborate this finding, and hold both for private and publicly listed companies. Further, our results also show that the market penalizes client firms susceptible to aggressive audit partner reporting decisions. In particular, we find that our proxies for aggressive audit reporting are related to higher interest rates, worse credit ratings and less favorable forecasts of insolvency for private client companies, and a lower Tobin's Q for publicly listed client companies. Collectively, these results imply that audit partner aggressive or conservative reporting is a systematic audit partner attribute and not randomly distributed across engagements.     

Do Investors Care about the Auditor's Economic Dependence on the Client?*

In this study, we investigate whether investor perceptions of the financial reporting credibility of Big 5 audits are related to the auditor's economic dependence on the client as measured by nonaudit as well as total (audit and nonaudit) fees paid to the incumbent auditor. We use the client‐specific ex ante cost of equity capital as a proxy for investor perceptions of financial reporting credibility and examine auditor fees both as a proportion of the revenues of the audit firm and as a proportion of the revenues of the audit firm's practice office through which the audit was conducted. Our findings suggest that both nonaudit and total fees are perceived negatively by investors' that is, the higher the fees paid to the auditor, the greater the implied threat to auditor independence, and the lower the financial reporting credibility of a Big 5 audit. Furthermore, our findings appear to be largely unrelated to corporate governance: investors do not perceive the auditor as compensating for weak governance. Separately, recent anecdotal evidence suggests that declining revenues from nonaudit services' as a result of recent regulatory restrictions” are being offset by substantial increases in audit fees. Other things being equal, rising audit fees imply higher profit margins for audit services, indicating that the audit function may no longer be a loss leader. Thus, to the extent that investors perceive total fees negatively, recent regulatory initiatives to limit nonaudit fees may not have adequately addressed the perceived, if not the actual, threat to auditor independence posed by fees.     

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.     

An Empirical Investigation of Audit Fees,Nonaudit Fees,and Audit Committees*

This study examines the association between audit committee characteristics and the ratio of nonaudit service (NAS) fees to audit fees, using data gathered under the Securities and Exchange Commission's (SEC's) fee disclosure rules. Issues related to NAS fees have been of concern to practitioners, regulators, and academics for a number of years. Prior research suggests that audit committees possessing certain characteristics are important participants in the process of managing the client‐auditor relationship. We hypothesize that audit committees that are independent and active financial monitors have incentives to limit NAS fees (relative to audit fees) paid to incumbent auditors, in an effort to enhance auditor independence in either appearance or fact. Our analysis using a sample of 538 firms indicates that audit committees comprised solely of independent directors meeting at least four times annually are significantly and negatively associated with the NAS fee ratio. This evidence is consistent with audit committee members perceiving a high level of NAS fees in a negative light and taking actions to decrease the NAS fee ratio.     

Enterprise Risk Management and the Financial Reporting Process: The Experiences of Audit Committee Members,CFOs, and External Auditors

The recent financial crisis has brought to the forefront the need for companies to effectively manage their risks. In this regard, one approach that has gained prominence is enterprise risk management (ERM). Importantly, little is known about the link between ERM and the financial reporting process. This link is critical, because it is imperative that financial reporting adequately depicts the financial status (e.g., valuations, estimates) and associated risks of a company as revealed by ERM. Additionally, from an auditing perspective, ERM affects the risks of misstatement, which should impact audit planning. Accordingly, the objective of this study is to examine the experiences of audit partners, CFOs, and audit committee (AC) members (“the governance triad”) on the link between ERM and the financial reporting process. To determine whether members of the governance triad focus on monitoring, strategy, or both, we also examine their definition of and experiences with ERM with respect to agency and/or resource dependence theory. To address these issues, we conduct semistructured interviews of experienced individuals that form the governance triads from 11 public companies. There are three major findings from our study. First, importantly, all three types of participants see a strong link between ERM and the financial reporting process. Second, despite recognition of the broad nature of ERM, the predominant experiences of the actual roles played by triad members center on agency theory, while resource dependence may be relatively underemphasized by all triad members. Finally, CFOs and AC members indicate that auditors may be especially underutilizing ERM in the audit process, suggesting an “expectations gap.”     

Post-Enron Implicit Audit Reporting Standards: Sifting through the Evidence

Summary The accounting scandals and the demise of Andersen have increased auditors’ ex ante business risk. As a result, stock markets revised downward the value of the external audit (Callen and Morel (2002); Chaney and Philipich (2002); Krishnamurthy et al. (2002); Asthana et al. (2003)). One commonsensical reaction on behalf of auditors should have been to apply the existing rules more carefully and, thus, issue more non-clean opinions on the financial statements they have audited. This is exactly what we see. Closer scrutiny reveals that the higher incidence of non-clean audit opinions is not due to the (substantial) changes in the audit client list or their balance sheets. This study mirrors earlier results where auditors relaxed their standards following a drop in business risk (Geiger and Raghunandan, (2001), (2002); Francis and Krishnan, (2002)).Authors are listed just by alphabetical order. We gratefully acknowledge useful comments from participants at the 2004 American Accounting Association Midyear Auditing Section conference, and outstanding suggestions from an anonymous referee for De Economist. Any remaining errors are ours.     

The Interrelation between Audit Quality and Managerial Reporting Choices and Its Effects on Financial Reporting Quality

Two distinct lines of research have been dedicated to empirically testing how financial reporting quality (measured as the earnings response coefficient or ERC) is associated with management's choice of reporting bias and with audit quality. However, researchers have yet to consider how ERCs are affected by either the auditor's reaction to changes in the manager's reporting bias or the manager's reaction to changes in audit quality. Our study provides theoretical guidance on these interrelations and how changes in the manager's or the auditor's incentives affect both reporting bias and audit quality. Specifically, when the manager's cost (benefit) of reporting bias increases (decreases), we find that expected bias decreases, inducing the auditor to react by reducing audit quality. Because we also find that the association between expected audit quality and ERCs is always positive, changes in managerial incentives for biased reporting lead to a positive association between ERCs and expected reporting bias. When the cost of auditing decreases or the cost of auditor liability increases, we find that expected audit quality increases, inducing the manager to react by decreasing reporting bias. In this case, changes in the costs of audit quality lead to a negative association between ERCs and expected reporting bias. Finally, we demonstrate the impact of our theoretical findings by focusing on the empirical observations documented in the extant literature on managerial ownership and accounting expertise on the audit committee. In light of our framework, we provide new interpretations of these empirical observations and new predictions for future research.     

Audit Firm Tenure,Bank Complexity,and Financial Reporting Quality

Theory from organizations and economics research posits that in an inter‐organizational relationship, both parties invest in relationship‐specific knowledge, which in turn facilitates the effectiveness of the relationship while strengthening the attachment between the parties. In complex settings where there are more opportunities for knowledge creation, the investments will be larger and the attachment stronger. Because banks are complex institutions that present unique challenges to auditors, we suggest that effective audits critically depend on the accumulation of significant investments in client‐specific expertise through a long association with the client. We find a positive association between audit firm tenure and financial reporting quality, and this association is particularly strong in banks that are more complex. Also, contrary to recent research we find that benefits of audit firm tenure for complex banks accrue even for long tenure and are not limited to medium tenure. Our findings largely support the notion that a long relationship with the client reflects the underlying demand for expertise, which is critical for high‐quality audits of complex organizations. Imposing short‐term limits on audit firms would adversely affect the investments in client‐specific expertise especially in the cases where this expertise is needed the most. Our findings do not support calls for mandatory audit firm rotation for large complex institutions.     

An Experimental Investigation of Approaches to Audit Decision Making: An Evaluation Using Systems‐Mediated Mental Models*

The objective of this research is to articulate a decision‐making foundation for the systems audit approach. Under this audit approach, the auditor first gains an understanding of the auditee's economic environment, strategy, and business processes and then forms expectations about its performance and financial reporting. Proponents of this audit approach argue that decision making is enhanced because the knowledge of the system allows the auditor to focus on the most important risks. However, there has not been an explicit framework to explain how systems knowledge can enhance decision making. To provide such a framework, we combine mental model theory with general systems theory to produce a hypothesis we refer to as a systems‐mediated mental model hypothesis. We test this hypothesis using experimental economics methods. We find that (1) subjects make systematic errors under the setting without an organizing framework provided by the systems information, and (2) the presence of an organizing framework results in lower reporting errors. Importantly, the organizing framework significantly enhances decision making in the settings where the environment changed. Establishing a decision‐making foundation for systems audits can provide an important building block that, in part, can contribute to the development of a more effective and efficient audit technology ‐ an important objective now when audits are facing a credibility crisis.     

Debt Covenant Restriction,Financial Misreporting,and Auditor Monitoring*

Theory suggests that financial report-based debt covenants engender incentives for the manager to relax covenant constraints through accounting choices in order to avoid costly covenant violations. Prior studies directly testing this hypothesis in the context of financial misreporting fail to find consistent evidence. Using a more refined measure of debt covenant restriction, we find that debt covenant restriction is positively associated with the probability of financial statement misstatements. This positive association is driven by performance covenants rather than capital covenants and is more consistent with the manager striving to avoid a “false-positive” violation than to delay the violation. Our results also imply that managers resort to both income-increasing and non–income-increasing misreporting to relieve covenant constraints and rely more on the latter when faced with greater earnings management constraints. Additionally, the auditor charges higher audit fees to firms with more binding covenants even outside the violation state, and audit fees increase with constraints relative to both performance and capital covenants, reflecting greater financial reporting risk and bankruptcy risk, respectively. Within capital covenants, we find some evidence of even higher audit fees for tighter intangible-inclusive versus intangible-exclusive capital covenants. Lastly, our evidence suggests that the positive association between covenant constraints and misreporting is attenuated when the auditor has more experience with debt covenants, has greater bargaining power over the client, or faces greater litigation risk.     

Auditor Fees and Fraud Firms

The issue of whether auditor fees affect auditor independence has been extensively debated by regulators, investors, investment professionals, auditors, and researchers. The revised Securities and Exchange Commission (SEC) requirements that resulted from the implementation of the Sarbanes‐Oxley Act (2002) limit nonaudit services (NAS) and mandate NAS fee disclosure. The SEC's requirements are based on the argument that auditor independence could be impaired—and hence audit quality may be reduced—when auditors become economically dependent on their clients or audit their own work. Economic bonding leads to reduced independence, which can lead to reduced audit quality. We study a sample of firms sanctioned by the SEC for fraudulent financial reporting in Accounting and Auditing Enforcement Releases (SEC‐sanctioned fraud firms) and examine whether there is a relationship between auditor fee variables and the likelihood of being sanctioned by the SEC for fraud. We use SEC sanction as a measure of audit quality that has not previously been used in the auditor fee literature and is more precise than some of the other proxies used for flawed financial/auditor reporting. We find, in univariate tests, that fraud firms paid significantly higher (total, audit, and NAS) fees. However, in multivariate tests, when controlling for other fraud determinants and endogeneity among the fraud, NAS, and audit fee variables, we find that while NAS fees and total fees are positively and significantly related to the likelihood of being sanctioned by the SEC for fraud, audit fees are not. These findings suggest that higher NAS fees may cause economic bonding, thereby leading to reduced audit quality. Our findings of significantly higher NAS fees and total fees in fraud firms hold after controlling for latent size effects and other rigorous testing. These results contribute to the literature that examines the SEC's concerns regarding NAS and can be used by policy makers for additional consideration.     

Auditors' Fee Premiums and Low‐Quality Internal Controls*

We examine the relation between low‐quality internal controls and audit fee premiums. Using a novel data set of audit hours and audit fees we find, consistent with the audit risk model, that auditors increase their effort (hours) owing to low internal control quality. We find that auditors also charge a significant fee premium to clients with internal control weaknesses. This premium is observed for severe internal control weaknesses and companies with low‐quality alternative governance mechanisms. The results are robust to multiple methods to address endogeneity, including company fixed effects, difference‐in‐differences design, and a propensity score‐matched sample. Taken as a whole, low internal control quality leads to fee premiums, which are a deadweight loss to client companies.     

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.     

Impact of Auditor Report Changes on Financial Reporting Quality and Audit Costs: Evidence from the United Kingdom

While substantial revisions to auditor reporting requirements are being implemented internationally, the impact of these reforms on financial reporting quality is unknown. We exploit the United Kingdom's recent auditor reporting changes and find that the United Kingdom's new reporting regime is associated with an improvement in financial reporting quality as proxied by significant decreases in absolute abnormal accruals and the propensity to just meet or beat analyst forecasts, and a significant increase in earnings response coefficients. As for audit costs, we do not find a significant change in audit fees or audit delay surrounding the implementation of the new reporting regime. Taken together, the results of this study suggest that new auditor reporting requirements are associated with a significant improvement in financial reporting quality without detecting a significant increase in audit costs.     

Resource Allocation Decisions in Audit Engagements*

Abstract. We examine the empirical relationship between auditors' resource allocations and selected engagement characteristics. Our measure of resources is hours of grades of labor (partner, manager, etc.) “charged” to audit activities (planning, internal control evaluation, etc.). Engagement characteristics examined are client size, industry affiliation, client complexity, risk, auditor provision of management advisory services to the auditee, and degree of control reliance. The data were obtained from publicly available sources and a survey developed and administered by an international public accounting firm. We find the cross-sectional variation in the labor charged to various audit activities can be explained by engagement characteristics found to be important in prior studies on audit fees, total labor inputs, and the mix of labor inputs. Measures of client size, industry, complexity, risk, and services provided are associated with changes in the allocation of labor among audit activities. We find no substitution of internal control review/testing for substantive testing on reliance audits. Task assignments vary by rank. Measures of client size, complexity, risk, and services provided are associated with activity-specific changes in the labor mix.     

Auditor Reporting and Regulatory Sanctions in the Broker‐Dealer Industry: From Self‐Regulation to PCAOB Oversight

The financial security of the investing public relies on high‐quality service by broker‐dealers (BDs), investors' gateway to the financial markets. The SEC has long required auditors to attest to BDs' internal controls and compliance with regulations (including those privately owned). Following the unraveling of the Madoff Ponzi scheme in 2008, the SEC required auditors of all BDs to register with the PCAOB, and Congressional initiatives signaled imminent transition from private (AICPA) to public (PCAOB) oversight. We investigate whether audit quality increased following this transition by measuring whether auditors report material internal control and compliance problems for BD clients where a deficiency presumably existed (i.e., BDs sanctioned by the Financial Industry Regulatory Authority for transgressions against stakeholders). Overall, we do not find increased reporting quality following the regulatory shift but do observe variation by auditor group and BD ownership. While reporting quality for global network firms (GNFs) increases slightly, lower reporting quality observed prior to the regulatory shift for specialist audit firms (having large BD portfolios but small overall size) is exacerbated afterward. This finding complements results of PCAOB inspections and other research identifying audit quality problems among small, industry‐specialized firms in non‐public client settings. Focusing on deficiencies likely more difficult to detect, we find lower reporting quality for private relative to publicly affiliated BDs prior to PCAOB oversight, and lower reporting quality for very small audit firms relative to GNFs following the regulatory shift.