An evidential reasoning approach to Sarbanes-Oxley mandated internal control risk assessment

In response to the enactment of the Sarbanes-Oxley Act 2002 and of the release of the Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 5, this study develops a risk-based evidential reasoning approach for assessing the effectiveness of internal controls over financial reporting (ICoFR). This approach provides a structured methodology for assessing the effectiveness of ICoFR by considering relevant factors and their interrelationships. The Dempster-Shafer theory of belief functions is utilized for representing risk.First, we develop a generic ICoFR assessment model based upon a Big 4 audit firm's approach and apply it to a real-world example. Then, based on this model, we develop a quantitative representation of various levels of ICoFR effectiveness and related risk-assessment as defined by the PCAOB and contrast these representations with levels implied by Auditing Standard No. 5. In doing so, we demonstrate the potential value of formal risk assessment models in both facilitating the assessment of risks in an individual engagement and in assessing the effects of different regulations.     

Audit Labor Usage and Fees under Business Risk Auditing

The adoption of business risk audit (BRA) approaches during the 1990s by several leading audit firms has been the subject of considerable scrutiny and commentary. Under BRA, the auditor responds to the increasing complexity of auditee financial reports by acquiring a deep and comprehensive understanding of the auditee's industry, strategy, business models, and processes—tasks best accomplished by higher-ranked labor—and by employing this understanding to make audit labor allocations. Using proprietary data for 165 audits conducted in 2002, we investigate three propositions about audit labor use under BRA. First, relative to pre-BRA benchmarks for the same auditor, we expect BRA audits to use a greater proportion of higher-ranked labor. Second, we expect engagements with high assessed auditor business risk (ABR), a summary risk assessment that reflects the BRA auditor's rich understanding of the auditee, to be allocated more labor and more higher-ranked labor than pre-BRA benchmarks. Third, at all ranks of labor, we expect a positive association between assessed ABR and levels of labor use. We find empirical evidence consistent with these propositions. We also find that total labor use in our sample is only modestly lower than pre-BRA norms. Analysis of fee data from these engagements suggests that audit fees in 2002 are substantially less than would be expected under pre-BRA benchmarks. After controlling for audit labor use, both total fees and fees per hour increase with assessed ABR for first-year auditees but not for continuing auditees. Overall, our results provide evidence on the impact of the BRA audit regime and speak to the likely impact of BRA on audit effectiveness and efficiency.     

A note on perceptions of auditors’ internal control report mandated by the PCAOB: Can reformatting the report enhance perceived value added?

The auditor’s report is a critical link in communicating financial data to users. Because of substantial audit costs incurred in integrated audits, the perceived value added by the auditor’s report becomes even more important. The auditor’s report prescribed by Auditing Standard No. 2 (and the new Auditing Standard No. 5) issued by the Public Company Accounting Oversight Board (PCAOB) includes a limitations paragraph. The SAS 58 audit report format that has been in use over 15 years does not contain a limitations paragraph. The SAS 58 report likely serves as a mental frame of reference (a referent report) for users evaluating other independent auditor’s report formats relating to assurance services, including the AS2 and AS5 reports. Whether inclusion of a limitations paragraph could adversely affect the users’ evaluation of the AS2 report is the focus of this study. In light of the publicity given to fraudulent financial reporting and other prevailing economic/environmental conditions, it is reasonable for users to expect that the auditor’s report provide a high degree of assurance regarding material fraud.We extend the [Foster, B. P., McClain, G., Shastri, T. (2005). A note on Pre-Sarbanes-Oxley Act users’ and auditors’ perceptions of a limitations paragraph in the auditor’s internal control report. Research in Accounting Regulations, 18, 195-217] study, by focusing on the AS2 report using data obtained about user perceptions from a field experiment conducted with MBA students. Results suggest that users perceive that an internal control report format without the limitations paragraph will enhance the readability and reliability of the report, and reduce the level of accommodation (additional information) required for decision making. Users perceive that the auditors’ exposure/liability is likely to remain substantially the same whether or not the report format includes a limitations paragraph. Also, users perceive that incorporating fraud wording would further enhance the readability and reliability dimensions of the internal control report format without the limitations paragraph. Taken collectively, the auditor’s report format with fraud wording, but without the limitations paragraph likely maximizes economic benefit accruing to users by minimizing their information risk. Policy-making bodies may find the results and approach taken in this study useful to evaluate report formats for assurance services.     

现代风险导向审计与项目审计工时:来自中国证券市场的初步证据

2007年审计准则变更将现代风险导向审计引入了中国证券市场,旨在提高审计的效率和效果。本文为了检验2007年审计准则和现代风险导向审计在中国的应用效果,对准则变更前后审计项目投入的水平进行了比较。我们发现:(1)现代风险导向审计提高了会计师事务所的审计效率;(2)现代风险导向审计在一定程度上提高了会计师事务所对高风险客户的关注程度;(3)四大将新旧审计准则的转换成本部分转移给其客户,而非四大在市场竞争的作用下自行承担了转换成本。     

Audit market structure,fees and choice in a period of structural change: Evidence from the UK – 1998–2003

This paper presents evidence on audit market concentration and auditor fee levels in the UK market in the crucial period of structural change following the PricewaterhouseCoopers’ (PwC) merger and encompassing Andersen’s demise (1998–2003). Given the current interest in auditor choice, analysis is also undertaken at the individual audit firm level and by industry sector. There is evidence of significant upward pressure on audit fees since 2001 but only for smaller auditees. Audit fee income for top tier auditors (Big 5/4) did not change significantly while the number of auditees fell significantly, consistent with a move towards larger, less risky, clients. A decomposition analysis of the aggregate Big 5/4 concentration ratio changes over the period identifies the impact of four distinct consumer-based reasons for change: leavers; net joiners; non-par auditor switches; and (only for the audit fees measure) audit fee changes. Andersen’s demise markedly reduced the level of inequality among the top tier firms but PwC retained its position as a ‘dominant firm’. On switching to the new auditor, former Andersen clients experienced an initial audit fee rise broadly in line with inflation, with no evidence of fee premia or discounting. They also reported significantly lower NAS fees, consistent with audit firms and auditees responding to public concerns about perceptions of auditor independence. There is no general evidence of knowledge spillover effects or cross-subsidisation of the audit fee by NAS. The combined findings provide no evidence to indicate that recent structural changes have resulted in anticompetitive pricing; the key concerns remain the lack of audit firm choice and issues concerning the governance and accountability of audit firms.     

Audit fee determinants and auditor premiums: evidence from the micro-firm sub-market

Despite the growing literature on the market for audit services, to date no study has examined the determinants of audit fees for the smallest auditees in the market. This study therefore provides some new theory and evidence on the determinants of the audit fees of micro-firms operating in the UK manufacturing sector. A key finding of the study is that in the highly competitive market under consideration, independent small auditees willingly paid a premium to be audited by a mid-tier or a (then) Big Six auditor, with the latter commanding the higher premium. It is concluded that these findings are consistent with Big Six (and, to a lesser extent, mid-tier) auditors commanding a brand premium stemming from the (perceived) higher quality audit conducted by large auditors, for which small firms are willing to pay a premium in order to benefit from associated ‘reputational’ and ‘signalling’ effects. The common finding that the explanatory power of audit fee models declines as a function of firm size is also examined. The empirical analysis confirms this effect, but evidence is offered that, rather than resulting from model misspecification, it is likely that audit prices of the smallest auditees are relatively insensitive to variations in corporate size, which may result from lower incremental economies of scale and minimum pricing.     

Does information asymmetry predict audit fees?

This study investigates whether and how information asymmetry in the stock market affects the quantum of audit fees paid by auditees. It is based on a sample of 218 US publicly traded companies and adopts two well-established proxies for information asymmetry, namely bid-ask spread (BAS) and probability of informed trading (PIN). Empirical results provide evidence that, after controlling for all main audit fees determinants, information asymmetry is positively related to the quantum of audit fees paid. Overall, evidence supports the contention that less transparent companies convey higher audit risk, and therefore auditors require higher compensation.     

Determinants of audit fees in Bangladesh

This paper reports the results of an analysis of the determinants of audit fees of both financial and non-financial companies in Bangladesh. The Bangladeshi audit services market is unusual in that there is no direct involvement of international audit firms in it. The results of the regressions show that the size of the auditee has the greatest influence on audit fees. Whilst there was no international Big Six grouping, it was possible to construct a group of Bangladeshi audit firms which commanded a price premium, based on their size and whether they had a link with an international firm of auditors. Financial services companies were found to have higher audit fees relative to non-financial companies. Subsidiaries of multi-national holding companies also had higher audit fees. The surprising result was that auditees which employed at least one qualified accountant had higher audit fees.     

A survey of models for determining optimal audit strategies

The problem studied in this survey is how to optimize the allocation of audit resources over an auditee population with respect to available population statistics. The auditees are assumed to optimize their expected utility based on information about the audit strategy. This survey is limited to models where the auditee can vary the fraud amount along a continuous scale.If the auditor is not able or willing to announce the audit strategy, a Nash equilibrium can be derived in which the auditor and auditee correctly anticipate each other's strategies. If the auditor announces the audit strategy in advance, the problem is formulated as a sequential game with perfect information which is solved as an optimization problem.Early models in the literature resulted in unrealistically high degrees of fraud. Later models have incorporated a split into one group of inherently honest auditees and another group of potentially dishonest auditees. The fraction of inherently honest auditees is exogenous.In this paper, the four combinations of non-announcing/pre-announcing the strategy and all potentially dishonest/some inherently honest auditees are studied. For the case of pre-announcing the strategy with some inherently honest auditees, two new solution methods are presented.Two main conclusions are as follows. First, models with some inherently honest auditees have greater external validity. Second, when a pre-announced strategy is feasible, as it often is with tax and benefit audits, the pre-announced strategy is preferred by the auditor over the non-announced strategy.     

CFOs’ and public accountants’ perceptions of material weaknesses in internal control areas as required by Section 404 of the Sarbanes-Oxley act

One of the most controversial aspects of the Sarbanes-Oxley Act of 2002 (SOA) is related to Section 404, which requires management to assess the entity’s internal controls, and then its independent auditor to attest and report on management’s assessment. The auditing standard governing this requirement was promulgated by the Public Company Accounting Oversight Board (PCAOB). Its title is Auditing Standard (AS) No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements [Public Company Accounting Oversight Board (PCAOB) (2004). An audit of internal control over financial reporting performed in conjunction with an audit of financial statements. Auditing Standard No. 2, Washington, DC: PCAOB]. AS No. 2 requires, among other things, that management must disclose any “material weaknesses” in internal controls. However, absent any guidance other than definitions from the PCAOB, management and independent auditors are left to their own judgment to define and recognize “material weakness in internal control” or “significant deficiency” while implementing AS No. 2. The research question, then, becomes to what extent, if any, are weaknesses in internal control over financial reporting consistently assessed, recognized and agreed upon by both parties? Or does their professional judgment and point of view cause different perceptions? Most of the Section 404 research has focused on the characteristics of the material weaknesses disclosed (and the capital market or other impacts of reported material weaknesses). This study, in contrast, is behavioral in context, and examines the perceptions of CFOs and CPAs as to whether they believe an internal control material weakness exists under four independent scenarios. The results indicate that the CPAs were significantly more conservative in their assessments in two of the four cases.     

Gender-diverse boards and audit fees: What difference does gender quota legislation make?

We investigate the effect of board (audit committee) gender diversity on audit fees in the French context. We also examine whether the relationship between the proportion of female directors and audit fees is moderated by the enactment of the gender quota law in 2011. We use the system GMM estimation approach on a matched sample of French firms listed in the SBF 120 index between 2002 and 2017. Consistent with the supply-side perspective, we contend that female independent directors and female audit committee members, by improving board monitoring effectiveness, affect the auditor's assessment of audit risk, resulting in lower audit fees. Our findings also document that, by breaking the glass ceiling, the effectiveness of the gender quota law lies not in increasing the proportion of female insider directors, but in boosting the appointment of female independent directors and female audit committee members. Using the difference-in-difference approach, our results reveal that female independent directors and female audit committee members are more willing to assert their monitoring skills after the quota law, leading to lower audit fees. Moving beyond tokenism, we show that, after the quota law, the negative impact on non-audit fees is strengthened only for female independent directors.     

Regulating the Market for Audit Services: A Game Theoretic Approach

We apply game theory to model how alternative mandatory audit firm rotation regimes can affect the strategic interaction between auditee and auditor firms, and analyze potential consequences on detection risk and impairment of auditor scepticism. The major results suggest that: (1) relative to an initial state with no rotation requirement but high probability for impaired auditor scepticism, imposing either short-term or long-term mandatory audit firm rotation will remove the threat to auditor scepticism and lead to higher audit fees and lower detection risk; (2) relative to long-term mandatory audit firm rotation, imposing a short-term rotation will lead to lower audit fees and higher detection risk, resulting from greater informational frictions. We further find that imposing supplementary regulatory instruments, such as increased regulatory scrutiny of the auditee and/or auditor, can be used to lower the detection risk and increase audit quality. We discuss implications of these findings for empirical research.     

The effect of audit firm size on audit prices: A study of the Australian Market

The effect of audit firm size on prizes is a complex function of competition in the market for audit services, product differentiation, and scale economics to large firms. In this study, a competitive market is supported in Australia with product differentiation to Bif Eight accounting firms. Specially, Big Eight accounting firms have significantly higher audit prices than non-Big Eight firms. This results holds for ‘large’ and ‘small’ auditees. A test is also made of price cutting in the Australian market. Price cutting is defined as lower initial audit fees than continuing engagement fees for a comparable audit. Test results do not evidence price-cutting behavior by accounting firms. There is in fact weak evidence that initial audit fees are higher than continuing engagement fee levels. Higher initial fees suggest that accounting firms may recover at least some of the audit start-up costs immediately.     

The impact of audit penalty distributions on the detection and frequency of fraudulent reporting

We investigate how the distribution of the penalties incurred by auditors for failing to detect fraud influences their effort to detect fraud and auditees’ commission of fraud. We compare a probabilistic, skewed audit penalty to a penalty that automatically imposes the expected penalty of the probabilistic distribution (hereafter, a deterministic penalty). Our experiments show that a deterministic penalty with the same expected value of a probabilistic, skewed penalty increases audit effort to detect fraud and decreases fraudulent reporting by auditees and that these benefits hold in a game involving both auditee and auditor players.     

Public Disclosure of Audit Fees and Bargaining Power between the Client and Auditor: Evidence from China

Before the public disclosure of audit fees was mandated, it was unlikely for an audit client to have accurate information about how much other companies were charged by their auditors. Public fee disclosure decreases the cost of auditees' access to audit fee information for the auditor's portfolio of clients and is thus likely to increase the relative bargaining power of auditees over auditors when they negotiate audit fees. Using both proprietary and public audit fee data before and after public fee disclosure was mandated in China, we provide evidence consistent with the preceding conjecture. We find that public fee disclosure reinforces the magnitude of audit fee decreases for overcharged clients and weakens auditors' ability to raise audit fees for undercharged clients. These findings suggest the existence of unintended consequences of public fee disclosure regulation, the original rationale of which was a concern about audit pricing practices that could undermine auditor independence.     

The Dempster‐Shafer Theory: An Introduction and Fraud Risk Assessment Illustration

This article introduces the Dempster‐Shafer theory (DS theory) of belief functions for managing uncertainties, specifically in the auditing and information systems domains. The use of DS theory is illustrated by deriving a fraud risk assessment formula for a simplified version of a model developed by Srivastava et al. (2007). In this formulation, fraud risk is the normalised product of four risks: risk that management has incentives to commit fraud; risk that management has opportunities to commit fraud; risk that management has an attitude to rationalise committing fraud; and risk that an auditor's special procedures will fail to detect fraud. The article demonstrates how to use such a model to plan for a financial audit where management fraud risk is assessed to be high. In addition, it discusses whether audit planning is better served by an integrated audit/fraud risk assessment as now suggested in SAS 107 (AICPA 2006a, see also ASA 200 in AUASB 2007) or by the approach illustrated here where a parallel, but separate, assessment is made of audit risk and fraud risk.     

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.     

The effect of large audit firm mergers on audit pricing in the UK

This paper examines the effects on UK audit market concentration and pricing of mergers between the large audit firms and the demise of Andersen. Based on data over the period 1985–2002, it appears that mergers contributed to a rise in concentration ratios to levels that suggest concern about the potential for monopoly pricing. The high concentration ratios have not improved the level of price competition in the UK audit market. Our pooled models suggest that concentration ratios are associated with higher audit fees. The evidence suggests that the effects of mergers between big firms on brand name fee premium and on price competition vary depending on the particular circumstances. The brand name premium is strongest for the largest quartile of companies prior to the mergers. After the Big Six mergers, the premium increases for average‐sized companies but falls for the smallest and largest companies. Following the PricewaterhouseCoopers merger, the premium increases for below median‐sized clients but decreases for above‐median sized clients. For the Deloitte‐Andersen transaction, the premium falls for the smallest and largest companies but increases for those in the second quartile. Our results provide evidence that auditees are likely to pay higher fees if their auditor merges with a larger counterpart. We attribute merger‐related fee hikes to product differentiation, rather than anti‐competitive pricing.     

Auditor quality,audit fees,organizational structure,and risk taking in the US life insurance industry

Using a system of simultaneous equations, this study examines the relation among external audit monitoring, in the US life insurance industry. We find insurers with higher leverage risk and surplus risk are more likely to use Big‐4 auditors and to pay higher fees. In return, insurers hiring Big‐4 auditors and paying higher audit fees have lower leverage risk and surplus risk. Second, the results suggest that mutual life insurers have a higher leverage risk and surplus risk than stock life insurers. This evidence is in contrast to that for property–liability insurance companies. Third, we find insurers are less likely to hire Big‐4 auditors and to pay higher audit fees after implementation of the Sarbanes–Oxley Act (SOX). Finally, life insurers with Big‐4 auditors or paying higher audit fees are more likely to take lower risks after the implementation of SOX.     

Evidence of Fraud,Audit Risk and Audit Liability Regimes

We investigate the effectiveness of proportionate liability in reducing the probability of fraud and audit risk relative to joint and several liability in two strategic audit settings: one that provides conclusive evidence of fraud and one that provides inconclusive evidence of fraud. In both settings the auditor makes an audit effort choice, but in the second setting the auditor also evaluates the audit evidence. Our results show that when the auditor chooses only effort, a proportionate liability rule with large marginal liability relief decreases audit risk. However, when the auditor also evaluates the audit evidence this result no longer holds.