Auditors’ decision-making under going-concern uncertainties in low litigation-risk environments: Evidence from Hong Kong

This study examines the audit opinions issued by auditors in a low litigation-risk environment at a time of high economic uncertainty – that of Hong Kong in the period immediately after the Asian financial crisis of 1997. Empirical research using United States data has shown that, contrary to professional guidance which restricts the issue of “disclaimer of opinion” only to situations where existing uncertainties prevent the auditor from forming an opinion, auditors tend to use the “disclaimer” report (in the going concern context) to signal more extreme client firm’s distress. In the high litigation-risk environment of the US, researchers have attributed this tendency to the idea that “disclaimer of opinion” reports are used by auditors to provide some protection against potential legal liability. The results of this study provide evidence that, even in the low litigation-risk environment of Hong Kong, auditors still use “disclaimer” reports to signal more extreme client firm financial distress. Thus, the maintenance of a high litigation-risk environment does not appear to be a necessary pre-requisite for high quality audits.     

Auditor changes following big eight mergers with non-big eight audit firms

This paper examines the reaction of clients of “non-Big Eight” audit firms to mergers of their auditors with “Big Eight” firms. We postulate that a non-Big Eight audit firm's clients will retain a Big Eight acquirer following a merger if they benefit from the Big Eight firm's specialized services and/or reputation. Clients that do not have these economic incentives to retain the Big Eight firm are more likely to change to another non-Big Eight audit firm following the merger. Empirical tests of the characteristics of clients that remain with a Big Eight acquirer or change to another smaller auditor following an audit merger generally support our hypotheses.     

Hypothesis revision strategies in conducting analytical procedures

A number of accounting tasks require an evaluation of competing hypotheses. For instance, a management accountant considers alternative reasons for a significant standard cost variance while an auditor must determine whether an unexpected fluctuation in a client's account balance was caused by an error, irregularity or a change in economic conditions. In spite of the prevalence of hypothesis evaluation in practice, little is known about the process. In this paper we provide evidence on two issues that could compromise effective and efficient hypothesis evaluation: (1) the revision of beliefs over competing hypotheses given diagnostic evidence; and (2) whether an eliminated hypothesis is subsequently resuscitated (i.e. reconsidered as plausible). To address these issues, 55 auditors were provided audit test results and were asked to evaluate five potential hypotheses that may have caused a material fluctuation in the gross margin ratio of a client. The findings indicate that, when presented with diagnostic evidence about a target hypothesis, auditors were prone to adjusting the likelihood of the target hypothesis but not revising the likelihoods of the competing hypotheses. This non-Bayesian revision strategy, which we label the “one-hypothesis syndrome”, appears to represent a trade-off reflecting competing forces of cognitive strain, efficiency and accountability. While our preliminary results indicate high performance (in identifying the actual cause), additional research in less controlled settings is needed to fully evaluate the effect of this trade-off on efficiency and effectiveness. Finally, contrary to anecdotal evidence from an SEC release, auditors were reluctant to eliminate hypotheses and those who did, did not regard their eliminations as permanent.     

Substance over form in auditing and the auditor's position of public trust

Auditors are placed by society in a special position of public trust. In their public role auditors are required to base their opinions on the substance rather than the form of the transactions underlying accounting numbers. An argument using the economics of trust (implicit contract theory) is constructed to show why it is required by society that auditors opine on substance. Forces exist, however, that deflect the auditor from fulfilling his or her public role into a “rule-dominated” practice in which substance is neglected. An empirical study confirms that auditors neglect substance and perceive little exposure to litigation in doing so. It is concluded that if auditors continue on their current path, their legitimacy before society will eventually erode to nothing.     

The auditor and learning from experience: Some conjectures

There has been little systematic study of the cognitive processes by which auditors learn from experience. The purpose of this paper is (1) to review selectively the learning and cognitive psychological literature pertinent to the questions of how and how well the “ordinary person” learns from experience and (2) to relate the conclusions from this literature to the case of the professional auditor. The paper also identifies some questions and methods for future behavioral research regarding the auditor and learning from experience.     

Intersections of law and accountancy: Unlimited auditor liability in the United Kingdom

In recent years, considerable pressure has grown within the British auditing industry for limitation of liability arising from negligent mis-statements in audit reports. Under British company law, auditors are forbidden from contracting with companies for their liability to be restricted. This legal provision was introduced in the Companies Act 1929 as a byproduct of legislation relating to directors' liability. The paper explores the background to this legal provision, observing that auditor liability cannot be viewed as a self-contained matter of interest only to a limited community. Attitudes to auditor liability have been shaped against a background of changes in the law of negligence, some, but by no means all, arising from cases involving auditors. Moreover, changing concepts of the position of the auditor within corporate governance structures have at different times encouraged and discouraged the assimilation of the legal treatments of auditors and directors. These concepts themselves reflect differing notions of what actually constitutes the “company”: a collectivity of shareholders or a separate entity controlled by directors. These notions emerged against a background of corporate failure and the need to allocate losses among various parties with different degrees of culpability for failure. However, legal developments do not account by themselves for changing attitudes within the auditing industry towards unlimited liability; acceptance of full responsibility for one's statements, adopted as a badge of professional status, has more recently been seen as inhibiting the commercial development of British auditing.     

Estimation risk and auditor conservatism

Estimation risk occurs when individuals form beliefs about parameters that are unknown. We examine how auditors respond to the estimation risk that arises when they form beliefs about the likelihood of client bankruptcy. We argue that auditors are likely to become more conservative when facing higher estimation risk because they are risk-averse. We find that estimation risk is of first-order importance in explaining auditor behavior. In particular, auditors are more likely to issue going-concern opinions, are more likely to resign, and charge higher audit fees when the standard errors surrounding the point estimates of bankruptcy are larger. To our knowledge, this is the first study to quantify estimation risk using the variance-covariance matrix of coefficient estimates taken from a statistical prediction model.     

Belief perseverance among accounting practitioners regarding the effect of non-audit services on auditor independence

We hypothesize, based on management control processes in large firms (Covaleski et al., 1998), that large-firm practitioners will be less likely than small-firm auditors to report beliefs that non-audit services (NAS) impair auditor independence. Based on Goldman and Barlev’s (1974) analysis of auditor-firm conflict of interests and procedural independence safeguards, we also predict that auditors will report less concern over impairment than non-auditors. We investigate also belief perseverance – whether practitioners tend to maintain prior reported beliefs after reading research on the relationship between NAS and auditor independence.     

Applicability Of The Conservatism Accounting Convention in China: Empirical Evidence

“Conservatism” is a widely accepted accounting convention in the industrialized world, but it has long been slated and prohibited in China under the orthodox ideological influences. To date, the conservatism convention has not been fully adopted or implemented in Chinese accounting although the Chinese government has made substantial efforts to reform its accounting system to bridge the gaps between the accounting practices in China and other industrialized countries in recent years. This study has, through a wide range questionnaire survey, empirically investigated the applicability of the conservatism accounting convention in China. We found that the survey respondents (consisted of business accountants, management, government officials, bank loan officers, investment analysts and auditors), in general, held no negative attitudes against the conservatism convention under the changing business environment in the country. There is clear evidence that various interested parties of business accounting would support an expanded adoption of “conservatism” in Chinese accounting. The study findings will facilitate a proper assessment of the future development of accounting standards and practices in China.     

The impact of prior working papers on auditor evidential planning judgments

There has been significant concern in auditing about the effects of relying on prior working papers in planning audit procedures (“anchoring”). This study employed an experiment with varying information sets: prior working papers, current year information and “scenario” (summarized prior year information). Practicing auditors were asked to design a substantive audit program for a case where changes in the client's environment dictated additional procedures. A consensus program from three partners was used as a bench-mark. Experimental groups were about equally adaptive to the changing environment. However, auditors provided with prior working papers demonstrated lower efficiency. The scenario group exhibited both high relative effectiveness and efficiency, while current information subjects displayed the lowest overall level of performance.     

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 unethical practices of accountants and auditors and the compromising stance of professional bodies in the corporate world: Evidence from corporate Nigeria

Investors in Nigeria have lost several billions of dollars through the collusion of accountants and external auditors with companies’ management and directors to falsify and deliberately overstate companies’ accounts. As a consequence of unethical practices by accountants and auditors, which have resulted in the distress or occasionally the closure of companies, some indigenous Nigerian Managing Directors of multinational corporations such as Lever Brothers Nigeria Plc and Cadbury Nigeria Plc have been sacked and replaced with expatriates. Some companies placed under receivership have also lost billions of dollars due to professional misconduct by their official receivers. Contrary to the claim of ‘protecting the public interest,’ accountants and auditors may be partly responsible for cases of distress and closure of companies and banking institutions in Nigeria. However, the various Statutory Provisions and Acts relating to companies and professional bodies all place the responsibility on the accountants and auditors to detect and report to the regulators cases of suspected fraud and accounting malpractice. Through detailed consideration of cases of fraud, falsifications and deliberate overstatement of companies’ accounts, this paper examines the claim that the professional bodies are capable of protecting the public interest. It utilizes archival documents to provide evidence that suggests professional misconduct by accountants, particularly the members of the Institute of Chartered Accountants of Nigeria (ICAN). The paper provides further evidence that ICAN has been reluctant to either investigate or sanction its erring members. The paper posits that the reluctance or inability of the ICAN's “Investigation and Disciplinary Machinery” to either investigate or discipline the erring accountants and auditors suggests that whether by design or default, the ICAN's “Investigation and Disciplinary Machinery” operates to shield the activities of its erring members in accountancy firms from critical scrutiny.     

The influence of auditor narcissism and moral disengagement on risk assessments of a narcissistic client CFO

Global capital markets rely heavily on independent and skeptical auditors as gatekeepers to provide assurance that corporate financial reports are free of material fraud. The rise of narcissism among the ranks of both client and audit professionals challenge this gatekeeper function. In addition, auditor moral disengagement may undermine auditor skepticism, further eroding public confidence in the integrity of financial reporting and the audit process. We conduct a quasi-experiment with 118 auditors from three international audit firms. In a simulated interview with a client CFO, we examine whether auditors underestimate risks of fraudulent financial statements due to the interactive effects of (1) client narcissism (manipulated verbally and nonverbally) and (2) auditor narcissism. We also examine the influence of auditor moral disengagement on client risk assessments. Results indicate that CFO verbal and nonverbal narcissism significantly influenced auditors’ assessment of management-related client risk. Moreover, auditor narcissism was found to interactively influence client risk inferences such that auditors higher in narcissism exhibited narcissistic tolerance (lower risk assessments) when the hypothetical CFO displayed high verbal narcissism. Auditor moral disengagement was negatively associated with client risk assessments. We discuss the implication of these findings on future audit judgment research, audit firm policy and training on maintaining auditor skepticism, and the audit oversight role of standard-setters.     

The relative effectiveness of persuasion tactics in auditor–client negotiations

In this study, we examine the effectiveness of four persuasive arguments that auditors may use to convince clients to accept their desired position in auditor–client negotiations. In addition, we investigate how the style in which the argument is communicated by the auditor impacts its effectiveness. Our results indicate that the type of persuasion tactic used by auditors significantly impacts the amount of concessions made by clients. Specifically, we find that, while threatening to qualify the audit opinion can result in significant client concessions, a tactic of simply informing the client that other companies have handled the accounting issue in a way consistent with the auditor’s preference is as effective, or more effective, than all of the other tactics examined at eliciting significant concessions as well as engendering positive affect toward the auditor. This result is consistent with findings from the persuasion literature relating to the pervasive power of social validation. We also find that clients offer more concessions, evaluate the auditor more positively, and are more satisfied with the negotiation outcome when auditors communicate their arguments using a cooperative, as opposed to a contentious, communication style. The results of this study indicate that auditors may benefit from training in persuasion tactics in order to achieve more desirable negotiation outcomes.     

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.     

AUDIT PRICING, AUDITOR CHANGES, AND THE WINNER'S CURSE

This paper presents a two-period model of the audit market. In the first period, all auditors have symmetric information and adopt identical bidding strategies. In the process of performing the audit, the incumbent auditor learns the actual costs, thereby becoming informationally advantaged in the second period. In the model presented, unlike earlier ones found in the literature, audit costs include both a component common to all potential auditors and a private component that varies across auditors. The common component of auditor costs gives rise to a ‘winner's curse’ scenario. A winner's curse is said to exist because a non-incumbent bidder who does not take into account the superior information of the incumbent would be expected to generate a loss from winning the audit engagement. The adjustment of bids by sophisticated auditors to compensate for the winner's curse is shown to play a significant role in determining the degree of low-balling (first-period price cuts) and auditor turnover. In the model, low-balling is not associated with loss of audit quality. Additionally, it is shown that it is in the interest of the client to structure audit selection in a manner that gives rise to low-balling.     

The impact of corporate governance on auditor choice: Evidence from China

As the largest and fastest growing emerging market, China is becoming more and more important to investors throughout the world. The purpose of this paper is to investigate the determinants of firms’ auditor choice in China in respect of their corporate governance mechanism. Normally firms have to take a trade-off in their auditor choice decisions, i.e., to hire high-quality auditors to signal effective audit monitoring and good corporate governance to lower their capital raising costs, or to select low-quality auditors with less effective audit monitoring in order to reap private benefits derived from weak corporate governance and less-transparent disclosure (the opaqueness gains). We develop a logit regression model to test the impact of firms’ internal corporate governance mechanism on auditor choice decisions made by IPO firms getting listed during a bear market period of 2001–2004 in China. Three variables are used to proxy for firms’ internal corporate governance mechanism, i.e., the ownership concentration, the size of the supervisory board (SB), and the duality of CEO and chairman of board of directors (BoDs). We classify all auditors in China into large auditors (Top 10) and others (non-Top 10), assuming the large auditors can provide higher quality audit services. The empirical results show that firms with larger controlling shareholders, with smaller size of SB, or in which CEO and BoDs chairman are the same person, are less likely to hire a Top 10 (high-quality) auditor. This suggests that when benefits from lowering capital raising costs are trivial, firms with weaker internal corporate governance mechanism are inclined to choose a low-quality auditor so as to capture and sustain their opaqueness gains. On the other hand, with improvement of corporate governance, firms should be more likely to appoint high-quality auditors.     

Effects of managerial overconfidence and ability on going-concern decisions and auditor turnover

I examine how the appearance of managerial overconfidence and managerial ability affect 1) auditors' decisions to issue a going concern opinion and 2) auditor dismissal rates after issuing a going concern opinion. Managerial attributes are likely to have an influence on auditors' decisions because auditors obtain and evaluate information about client management's remedy plans when there is substantial doubt about the entity's ability to continue as a going concern. While prior literature on managerial overconfidence classifies all managers who demonstrate overconfident behaviors in one group, I argue that the literature needs to take managerial ability into consideration when measuring overconfidence. I find that auditors are more likely to issue a going concern opinion to clients with seemingly overconfident managers only when the management who appears overconfident is also incompetent. I also find that auditors are more likely to be dismissed after issuance of a going concern opinion when the client company has seemingly overconfident management. Finally, I find that the association between managerial overconfidence and auditor dismissal subsequent to issuance of a going concern opinion is stronger when management is relatively more powerful than the company's audit committee.     

Precision in auditing standards: effects on auditor and director liability and the supply and demand for audit services

Theoretical research suggests that large auditors have more incentive to issue accurate reports compared to small auditors (DeAngelo, 1981; Dye, 1993). Controlling for the client characteristics of large and small auditors, this paper shows that large auditors issue reports that are more accurate and more informative signals of financial distress. These findings are consistent with the theoretical prediction of a positive relationship between auditor size and auditor accuracy.