The effect of audit seniors’ decisions on working paper documentation and on partners’ decisions

Prior research reports that the memories of working paper preparers may be biased toward evidence consistent with their prior decisions, but that reviewers exposed to the same set of evidence can mitigate the bias by evaluating inconsistent evidence. This study tests whether audit seniors’ decisions bias their ability to recognize evidence to document in working papers, and whether biased documentation affects the decisions of audit partners who are exposed only to the subset of evidence that seniors recognize and document. Experiment 1 confirms that audit seniors’ prior decisions bias their memories for evidence to document in working papers, and also creates materials for experiment 2. Experiment 2 offers a new insight: when exposed only to the evidence that seniors recognize and document, partners make decisions biased in the direction of the seniors’ decisions, since not all of the inconsistent evidence is documented. Experimental procedures controlled for four alternative interpretations: justification, evidence order, recency, and primacy.     

Mandated successful efforts and auditor choice

This paper presents evidence that petroleum firms whose financial statements were adversely affected by Statement of Accounting Standards No. 19 (SFAS-19) increased the rate at which they changed auditors during the full cost/successful efforts controversy. Firms relatively unaffected by SFAS-19 experienced no such increase in auditor change rates. While some important theoretical and empirical limitationns are encountered, the evidence is generally inconsistent with the accounting irrelevancy view that SFAS-19 had no economic consequences for petroleum firms. Auditor-client disagreement on this accounting standard appears to be an important determinant of the decision to change auditors. However, there is no observed tendency for firms to switch to auditors with whom they agree on petroleum accounting.     

The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions

Financial accounting standards increasingly require fair value measurements. I experimentally examine how uncertainty affects auditors’ adjustment decisions when evaluating fair values. I manipulate two types of uncertainty, input subjectivity and outcome imprecision, and one reporting choice, supplemental disclosure. I find that auditors are most likely to require adjustments when fair values contain both more input subjectivity and more outcome imprecision, but that this likelihood diminishes when clients supplement recognized fair values with additional disclosure. Thus, consistent with moral licensing, I find that auditors tolerate greater potential misstatement in the financial statements when clients provide disclosure, suggesting that the SEC's preference for supplemental disclosure may have the unintended consequence of affecting fair values recognized in the body of the financial statements. I also provide evidence that auditors determine adjustment size by comparing recorded fair value to the nearest bound, rather than the midpoint, of the auditors’ own range estimate, consistent with strict application of auditing standards.     

Client Characteristics and the Negotiation Tactics of Auditors: Implications for Financial Reporting

Although the financial statements of an organization are considered a product of management, prior research suggests that a company's financial statements may be affected by the negotiation strategy employed by the auditor when resolving audit differences with management. However, little subsequent research discusses the potential strategies that auditors may employ during the negotiation process. Our study extends the literature by investigating, in a post–Sarbanes‐Oxley environment, whether auditors will employ a reciprocity‐based strategy for the resolution of audit differences and what client characteristics (client management's negotiating style and client retention risk) increase the extent to which it is utilized. Further, we explore the potential effect of a reciprocity‐based strategy on the quality of the financial statements. Such a strategy involves bringing inconsequential items to management and subsequently waiving these items in an effort to encourage management to be more cooperative in the posting of significant income‐decreasing adjustments. The results of experiment 1 indicate that client management's negotiating style and retention risk have an interactive effect on auditors' use of a reciprocity‐based strategy. Specifically, auditors are more likely to utilize a reciprocity‐based strategy when management's negotiating style is competitive and client retention risk is high. Experiment 2 findings suggest that the auditor's use of reciprocity during negotiation can actually result in more conservative financial statements by helping the auditor manage perceived client pressures to waive or reduce proposed adjustments.     

Quis Auditoret Ipsos Auditores? Can Auditors Be Trusted?

This article explores the extent to which the audit profession and its practices promote public trust in audits. Differences between auditors and non‐auditors as to beliefs about the role of a financial report audit have long been discussed under the term ‘expectations gap’. However, this prior debate has tended to focus on non‐auditors’ alleged misunderstanding of audit processes without a corresponding understanding on the part of the profession as to why the public might place its trust in auditors. The study explores the nature of trust in an auditing context and notes that like any profession, auditing faces practical limitations but the inability to directly observe the conduct of audits combined with professional status create an ‘over trust’ expectation in the public. Changes in audit practices and culture have also exposed the profession to criticism. The article seeks to offer one approach by which the auditing profession can restore public confidence; namely, evidence‐based practice, which has proven effective in improving the quality of practice in medicine. Adoption of a reflective evidence‐based approach to audit practice offers the promise of greater audit quality and an improvement in the profession's accountability and public confidence.     

The Impact of Consulting Services on Audit Quality: An Experimental Approach

We use experimental markets to examine whether providing consulting services to a non‐audit client impacts audit quality. Our paper directly addresses concerns raised by the Public Company Accounting Oversight Board that the largest public accounting firms’ growth in their consulting practices threatens audit quality. We conduct an experiment proposed using a registration‐based editorial process. We compare a baseline where the auditor does not provide consulting services to conditions where auditors provide consulting to audit clients or where auditors only provide consulting services to non‐audit clients. Our unique design provides evidence on whether providing consulting to non‐audit clients strengthens the salience of a client‐cooperative social norm that reduces audit quality. We do not find differences in audit quality by condition in our planned analysis, however we find greater variation in audit quality in the conditions where auditors provide consulting services compared to the baseline. In unplanned analyses, our results suggest providing consulting services increases auditor cooperation with managers, increasing audit quality when managers prefer high audit quality and decreasing audit quality when managers prefer low audit quality.     

An Investigation of Auditors’ Judgments When Companies Release Earnings Before Audit Completion

The majority of U.S. public companies release annual earnings prior to the completion of audit fieldwork. We investigate this phenomenon in a controlled experiment with audit partners and senior managers. We find that releasing earnings before completion of the audit pressures auditors to adopt the goals of management, thereby reducing the likelihood of post‐announcement audit‐adjustment recommendations. We also examine the effect of audit committee (AC) strength in improving auditors’ judgments after annual earnings are released. When ACs are actively involved in accounting issues and proactively communicating with auditors—characteristics currently lacking in most ACs—the negative effects on auditors’ judgments are completely mitigated. Our study provides evidence on potential unintended consequences of early release of earnings and the importance of investing in high‐quality ACs to mitigate adverse effects of client pressures on audit judgment and financial reporting quality.     

Media image of the CEO and the impact on auditors' perception of financial reporting reliability and client risk assessments

Regulators and legislators have recently adopted new governance reforms in an attempt to encourage more normative behavior by those in charge of organizations. It should not be surprising, therefore, that the image of the CEO projected by the media has become increasingly salient to decision makers. Still, the impact of CEO image on stakeholders' perceptions and subsequent behavior has received little attention by accounting researchers. In response to this void, we examine the relationship between two important environmental cues: CEO's image as presented in the media and earnings consistency. Our interest is the degree to which these variables influence auditors' perception of the ethics of corporate management, as well as their assessments of the risk of fraudulent financial statements. We document that auditor perceptions are influenced by positive media cues as well as negative cues. These results are inconsistent with auditors exercising professional skepticism which implies no reliance on positive cues, especially “managed media cues”. These results suggest that auditors, similar to others, are not immune to positive media cues about the CEO. This study contributes to the research literature examining factors that affect the perceived reliability of financial information by considering the effect of non-financial information—CEO image.     

An investigation of independent audit opinions and subsequent independent auditor litigation of publicly-traded failed savings and loans

Failures of savings and loans (S & Ls) have resulted in substantial independent auditor litigation; however, there is limited empirical evidence concerning audit opinions of failed S & Ls. Our study investigates the audit opinions of publicly-traded S & Ls that subsequently failed. We found that the independent auditors of failed S & Ls issued qualified (or modified) going-concern opinions or going-concern disclaimers of opinion on the last audited financial statement prior to failure in 19 of 24 cases. Results of univariate and multivariate analyses are consistent with several predictions concerning economic factors expected to influence the type of audit opinion, and our evidence suggests that auditors rendered going-concern reports to those S & Ls that were most likely to fail ex ante. Analysis of independent auditor litigation data reveals that auditor lawsuits related to these failed S & Ls were filed in seven cases. Five of these seven lawsuits implicated auditors who rendered going-concern reports. This suggests that going-concern reports in the year prior to the failure of an S & L do not prevent auditor litigation. Because it is possible that independent auditors will face situations comparable to the S & L crisis in the future, government regulators and the public accounting profession should be interested in research that enhances the understanding of the audit opinion formulation process in such settings.     

Accountability Demands and the Auditor's Evidence Search Strategy: The Influence of Reviewer Preferences and the Nature of the Response (Belief vs. Action)

This study examines differences in auditors' search behaviors associated with the preferences of audit management (reviewer preferences) and the nature of the required response (belief versus action) in the context of an accounts receivable collectibility review. I find that auditors facing reviewers who expressed concern about auditors spending time specifically looking for evidence inconsistent with explanations provided by the client (credence preference) examined fewer evidence items and followed a more client-prompted search (i.e., a search for evidence that follows directly from the client's explanation) than those facing reviewers who expressed concern about auditors' ready acceptance of client explanations without adequate justification (skepticism preference) and those facing reviewers who expressed no specific concern (unknown preference). Further, auditors in the action conditions examined fewer evidence items and spent less time per evidence item than those in the judgment conditions. Additional analyses also indicate that auditors who were held accountable to a reviewer with an unknown preference generally responded as if the reviewer maintained a skepticism preference.     

Professional Judgment and Departures from GAAP: “Judgment in Jeopardy” Revisited*/ JUGEMENT PROFESSIONNEL ET DÉROGATION AUX PCGR: LA PIERRE ANGULAIRE REVISITÉE

Prior to 2003, the CICA Handbook both required and allowed reporting entities to depart from generally accepted accounting principles if, in the professional judgment of the preparers and the auditors, compliance with GAAP would result in misleading financial statements. In 2003, the CICA Handbook was amended to remove these provisions. In this paper, the history of the amendment is discussed in light of Skinner's 1995 article “Judg‐ment in Jeopardy". I argue that while there is evidence of certain shortcomings in the exercise of professional judgment, remedies are available. Those remedies include (1) revisiting pre‐existing recommendations; (2) improving dialogue between standard‐setters, researchers, and practitioners; (3) increasing emphasis on accounting theory in professional accounting curricula; and (4) rigorously investigating and disciplining lapses in professional judgment. I suggest that we can rely on professional judgment, and that such reliance is both necessary and desirable. Admittedly, there will likely be few situations where compliance with GAAP would result in misleading financial statements and the discretion to depart from GAAP can lead to abuses that, at the very least, would hamper the comparability of financial statement information. However, the requirement to verify that the application of GAAP results in fair presentation is an important safeguard given the complexity of the financial reporting environment.     

Accounting Standards, Implementation Guidance, and Example-Based Reasoning

This paper examines interpretation of accounting standards that provide implementation guidance via affirmative or counter examples. Based on prior psychology research, we predict that practitioners engage in “example‐based reasoning” such that they are more likely to conclude that their case qualifies for the same treatment as the example. We test our predictions in two experiments in which participants judge the appropriateness of income‐statement recognition. Experiment 1 uses Masters of Business Administration (MBA) students and varies example type (affirmative, counter) and case (revenue recognition, expense recognition) in a 2 × 2 design. Experiment 1 supports our predictions. Experiment 2 uses more experienced practitioners, and varies example type (affirmative, counter, both) in a 1 × 3 design. Experiment 2 supports the use of example‐based reasoning, and indicates that practitioners in the “both” condition respond as if they had only received an affirmative example. These results have implications for understanding how guidance that accompanies accounting standards can result in aggressive or conservative application of standards.     

Non‐Audit Service Fees and Financial Reporting Quality: A Meta‐Analysis

Auditing as a corporate governance mechanism has attracted considerable research attention. Because of the information asymmetry between corporate managers and outside shareholders, auditors are hired to provide independent assurance that financial statements are prepared following generally accepted accounting principles. The credibility of such assurance depends on the independence, both in fact and in appearance, of the auditor. Over the years, however, the independence of auditors has come under increased scrutiny because of their joint provision of both audit and non‐audit services. A sizable literature on the impact of non‐audit fees on financial reporting quality has developed. The evidence from this literature, however, remains inconclusive. This paper provides a meta‐analysis of the available literature by assessing (a) the net effect of non‐audit fees on financial reporting quality, and (b) whether there is homogeneity in the financial reporting quality proxies used in the extant literature. Findings suggest that the level of client‐specific non‐audit fees is associated with reduced financial reporting quality. However, the underlying studies used to conduct this meta‐analysis are not homogenous.     

An Analysis of the Theories and Explanations Offered for the Mispricing of Accruals and Accrual Components

Numerous accounting studies claim that investors fail to rationally price accrual‐related information and that investors are functionally fixated. This study documents the importance of performing robustness tests when testing economic or behavioral explanations for apparent accounting‐related security mispricing. We find that performing robustness tests that exclude a small number of firm‐year observations (approximately 200 firm‐year observations or about 1% of the entire sample) reveals an inverted U‐shaped relation between buy‐and‐hold abnormal returns and total accruals. An inverted U‐shaped relation is inconsistent with the functional fixation (earnings fixation) hypothesis. We conduct similar robustness tests for the abnormal accrual anomaly and the net operating assets anomaly proposed by other investigators, and also find an inverted U‐shaped relation between buy‐and‐hold abnormal returns and abnormal accruals and net operating assets. These findings are inconsistent with the explanations put forth by those investigators. Such evidence leads us to conclude that the accrual‐related anomalies are unlikely to be due to investors' inability to process accounting information, as suggested by the functional fixation hypotheses tested.     

Auditor Independence: A Nonparametric Test of Differences Across the Big‐5 Public Accounting Firms

This small sample study provides additional evidence on the unsettled question of auditor independence: Does the provision of non‐audit services by an auditor compromise independence resulting in a poor quality audit? We also examine whether these findings vary across the “Big‐5” public accounting firms. Most prior studies addressing this question, using parametric approaches and various measures of audit quality, have reported conflicting results. Contrary to these studies, we use a non‐parametric approach and the probability of GAAP violation as a new measure of audit quality to address this question. Using data from a sample of Fortune 500 companies for the year 2000, we find that firms whose auditors provide substantial non‐audit services tend to have a higher propensity to violate GAAP. At the firm‐level analysis, we find that these results are more likely driven by few of the Big‐5 public accounting firms. For the remaining firms, the association between non‐audit services and quality of audit could not be established, primarily because of small sample size and lack of power in the test. Our main finding is consistent with other recent studies that provide evidence that the rendering of significant non‐audit services by auditors creates conflict of interest resulting in poor quality audits. Furthermore, our result of differences in these levels of association among the Big‐5 accounting firms represents a new finding, and suggests that there is a need for controlling them separately in research studies examining auditor independence.     

The Sheldon effect: fixed mindset does not always mean fragile confidence

ABSTRACT

More than just intelligence is needed to learn accounting. We see from prior work that the non-cognitive aspects of learning can influence the experience for accounting students. We investigate by survey both self-efficacy beliefs [Bandura, A. (1977). Self-efficacy: toward a unifying theory of behavioral change. Psychological Review, 84(2), 191–215] and mindset [Dweck, C. (2006). Mindset: The new psychology of success. Random House] relative to academic performance of accounting students in a first year university course. Analysis of the data shows that mindset is not a predictor of academic success, whereas self-efficacy beliefs have explanatory power. Dweck [2000. Self-theories: Their role in motivation, personality, and development. Psychology Press; 2006. Mindset: The new psychology of success. Random House] claims that students with a fixed mindset also will have fragile confidence. By measuring both self-efficacy beliefs and mindset together, we provide evidence that this may in fact not be the case. Students can have a fixed mindset and high confidence towards learning accounting.     

Functional fixation: Experimental evidence on the presentation of financial information through different digital formats

This study examines whether, in the presentation of financial information, digital formats address the concern over users’ functional fixation. The accounting literature indicates that the presentation of financial information either within the financial statements or in the notes to the financial statements often creates functional fixation where users of financial statements fail to adjust for differences in accounting policy. This leads users to judge what would otherwise be identical financial situations as being different due to the different accounting policies and methods adopted. It has been suggested that the use of digital formats in presenting financial reports may overcome functional fixation. Using an experimental design involving accountants in public practice, the results indicate that the use of digital formats to present financial reports does not fully overcome the issue of functional fixation in the processing of financial information. Although the participants were able to identify and extract relevant information, irrespective of whether or not the information was presented within the financial statements or in the notes to the accounts, the evidence indicates that functional fixation remained when the participants made final decisions based on available information. This suggests that functional fixation may not be caused by access to or extraction of information but by the level of perceived significance based on where the information is reported in the financial statements. In general, the results indicate that current technology may not be able to fully reduce functional fixation in the evaluation of financial information prepared in accordance with different accounting policies and methods.     

The choice between private and public capital markets: The importance of disclosure standards and auditor discipline to countries divesting state-owned enterprises

For a sample of 1866 privatizations from 37 countries, we estimate the impact of disclosure standards and legal institutions that discipline auditors on the method chosen to divest state-owned enterprises. The agency conflict between minority and controlling shareholders can impede a government from privatizing by selling its stake to diffuse investors in the public capital market with a share-issue privatization (SIP) that typically generates important spillover economic benefits, rather than an asset sale to a small group of buyers. However, prior research implies that accounting transparency plays a natural role in preventing controlling shareholders from siphoning corporate resources by helping minority investors identify any diversionary practices. After controlling for firm-level and other country-level characteristics, we find that SIPs become more likely when countries mandate strict disclosure standards, although this result is sensitive to model specification. In comparison, we provide strong, robust evidence that SIPs are more likely in jurisdictions that relax the burden of proof in civil lawsuits and criminal prosecutions against auditors, leading to more credible financial statements. From a policy perspective, our cross-country research suggests that investors value reforms that subject auditors to more severe private and public enforcement over several other legal determinants, including enhancing disclosure standards.     

Explaining qualifications in audit reports using a support vector machine methodology

The verification of whether the financial statements of a firm represent its actual position is of major importance for auditors, who should provide a qualified report if they conclude that the financial statements fail to meet this requirement. This paper implements support vector machines (SVMs) to develop models that may support auditors in this task. Linear and non‐linear models are developed and their performance is analysed using training samples of different size and out‐of‐sample/out‐of‐time data. The results show that all SVM models are capable of distinguishing between qualified and unqualified financial statements with satisfactory accuracy. The performance of the models over time is also explored. Copyright © 2005 John Wiley & Sons, Ltd.     

The ‘Cost’ of Climate Change: How Carbon Emissions Allowances are Accounted for Amongst European Union Companies

Following the withdrawal of IFRIC 3: Emissions Rights in 2005, European Union (EU) companies participating in an Emissions Trading Scheme (ETS) do not have definitive guidelines as to how to account for carbon emissions allowances. Using a content analysis methodology, this study examines the disclosed accounting policies of companies participating in the EU ETS, and reveals how, in the absence of clear guidance, they account for their carbon emissions allowances. As the accounting method adopted will impact upon a company's financial statements, these findings are of interest to accounting standards setters, investors, financial reporting preparers, auditors, and researchers.