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Audit Quality: What are the weak links? 4 th EIASM-BOCCONI WORKSHOP ON AUDIT QUALITY 27 September 2012* by Theodore J. Mock University of California, Riverside.

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Presentation on theme: "Audit Quality: What are the weak links? 4 th EIASM-BOCCONI WORKSHOP ON AUDIT QUALITY 27 September 2012* by Theodore J. Mock University of California, Riverside."— Presentation transcript:

1 Audit Quality: What are the weak links? 4 th EIASM-BOCCONI WORKSHOP ON AUDIT QUALITY 27 September 2012* by Theodore J. Mock University of California, Riverside *Updated following Workshop. See notes for some additional explanation and comment

2 Audit Quality [ AC ]: Some preliminary questions Is there a problem? Are there weak links in the chain of activities that produces a financial statement audit? And if so what are [is]: – The weak links that sometimes break? – The weakest Link? (What is a ‘weak link’?) – The opportunities to strengthen these weak links? What does ‘practice’ and the press say? What does research say? What role can we [academics] play in strengthening the weak links?

3 Is there a Problem? Audit Quality is not what it might be! Bad Grades are rising for Auditors**: Are audits getting worse? Or are the inspectors getting pickier? … “A Review of audits finds a decline in their quality” … Audit Firm% deficient 2009% deficient 2010 D&T19%45% PwC12%39% KPMG22%23% E&Y9%21% Average15%33% 24 August 2012 ** “ the [PCAOB] Board cautions against extrapolating from the results … AIU Audit Quality summary Biggest audit firms hit by scathing regulator's verdict [22 Sept 2012 ?]

4 What is a ‘weak link’ and what are some possible examples? Lack of Professional Skepticism Lack of Independence Lack of Expertise Excessive Legal liability Dysfunctional Regulation Inadequate Formal Education, Training and Continuing Education

5 Please Complete the handout and respond to two Questions Q1: Given that there is evidence that audit quality is ‘less than ideal’, what do you believe is The Weakest Link in achieving an acceptable, if not ideal, level of audit quality?

6 Please Respond to Question # 2 Q2: Given that audit quality knowledge, and thus the academic research that produces this knowledge, is incomplete with respect to our understanding of AQ, what is the weakest link, that is the main constraint, that limits our ability as academics to develop the AQ knowledge [research] that is needed?

7 There are 6 categories and many audit variables that may affect AQ CategorySome Examples 1. Audit Firm Variables Audit Firm ‘Culture’, Human Resources, Organization Structure, Incentive Schemes, Specific Auditor Characteristics, Quality Control Process/Procedures, Audit Methodology, Audit Process [see #2], 2. Audit Process Client selection/continuance process; audit planning process [assess RMM, CR, FR, conduct ARPs, etc.]; audit program planning [determine NETS for control and substantive testing]; audit testing [evidence collection and documentation]; evidential reasoning and decision phase; reporting phase,; review and quality control 3. Audit Client Client Type [private, public, international, etc.], Organization Structure, Incentive schemes, Code of Conduct, Complexity, System of Internal Control, 4. Audit Environment Economic, political, regulatory regime, litigation, Information technology, rate of environmental change, changes in demand for assurance services [e.g. sustainability report assurance], … 5. Audit Education Student quality, faculty quality, faculty incentive structure, Program types, pedagogy, 6. Audit Research Research method, training, support, resources, incentive systems, data access

8 Other frameworks of audit variables that may affect AQ ‘Weakest Links’ Framework [2012] UK FRC AC Framework [2006] Knechel et al. Synthesis Project ‘Indicators’ Framework [2012] Audit Firm- Audit Firm Culture - Skill and Qualities of Personnel Inputs - Incentives & motivation - Professional Skepticism, Etc. Process - Judgment - Risk Assessment - Review & Quality Control, Etc. Outcomes - Adverse outcomes - Audit Reports, Etc. Audit Process- Effectiveness of Audit Process - Reliability & Usefulness of Audit Reporting Audit ClientContext - Partner compensation - Audit & Non Audit Fees - Auditor Tenure Audit EnvironmentFactors outside of control of auditors Audit Education Audit ResearchIdentifies multiple research opportunities

9 Compilation of Question #1 Weakest AQ link[s] as indicated by workshop participants [ N = 26 responses] ‘Weakest Links’ Categories Summary of factors thought to possibly lead to low AQ. Audit Firm [N = 19 responses] Incentive Issues [ n =10] Auditor characteristics: - lack of independence (5) - Competence, expertise, skills ( 3) - Lack of Professional skepticism ( 1 ) Audit Process [ 1 ]Audit Report limitations ( 1 ) Audit Client [ 1 ]Lack of evidence, unobservable F/S attributes ( 1 ) Audit Environment [ 6 ] Fee pressure ( 4 ) ; Expectation gap ( 1 ); Political ( 1 ) Audit Education [ none ] Audit Research [ none ] Other [ 1 ] Holistic/System-Complexity Issues [Quality is a result of a multitude of interacting variables ] ( 1 )

10 Weak Links: Some other possibilities identified from professional sources Lack of fundamental professional scepticism …[UK FRC Audit Inspection Unit ] Frequent Audit Deficiencies* [PCAOB Inspections] 1. Failure to test issuer assumptions [ 20% Deficiencies] 2. Failure to test valuation or other models [16.2%] 3. Insufficient audit evidence [16.2%] 4. Inappropriate reliance on controls [10.7%] Agenda Items from Regulatory Bodies: 1.Auditor’s Reporting Model [IAASB, PCAOB] 2.Audit Independence [PCAOB] 3.Failure to Supervise [PCAOB]

11 Some ‘Weak Links’ based on my audit research Mock & Turner [1977] & related studies : Research on Auditor’s Investigation and Analysis of Client’s Internal Accounting Controls: – Significant Unexplained decision or judgment variance; – ‘Questionable judgments’, – Dysfunctional Partner Review Effects, – Poor Rationale Documentation Mock & Wright [1999] and related studies: Research Asking the Question ‘Are Audits Risk Adjusted’?: – Auditor’s exhibit significant difficulty in linking their risk assessments and the nature, extent or timing of audit procedures … Srivastava and Mock [2005], Fukukawa & Mock [ 2010]: Evidential reasoning and risk assessment research: – Audit evidential reasoning decisions exhibit extreme Cognitive Complexity and analytical challenges and must reconcile Alternate audit risk concepts,. The Audit Report [Grey, Mock & Turner 2009] and the AAA Audit Section Synthesis project [ 2012]: Significant weaknesses in quality of auditor communications, a wide ‘expectation’ and ‘information’ gap exists.

12 Based on this, two strong candidates for ‘The Weakest Link’ are #1. Limitations, biases, and lack of clear guidance results in audit quality breakdowns related to basic Auditor Judgment. Thus, opportunities for enhanced AQ include: – Enhanced University-Level Education – Better audit Judgment and Decision Making Research – Improved Audit Firm Training, Decision Aids, Quality Control Review and Audit Documentation, … – Enhanced Professional-Level Quality Control [e.g. PCAOB and UK AIU inspection & enforcement] and transparency as to inspection results.

13 #2. The 2012 AAA Audit Section synthesis project on The Audit Reporting Model clearly suggests that at least perceived AC can be improved by enhanced audit communications [closing the expectation AND information gaps]. Two strong candidates for ‘The Weakest Link’ [continued]

14 What the 4 th Bocconi AQ Workshop papers imply concerning ‘weak links’ Category of Variables Variables Studied & Basic Research Findings in the 4 th AC Workshop papers [N = 18 papers] Research Method Audit Firm7 studies 5 archival 2 survey Audit ProcessNone! Audit Client3 studies 1 Archival 1 Survey 1 Experimental Audit Environment5 studies 3 Archival 1 Survey 1 Experimental Audit Education None Audit Research [ 3 ] Not directly related to AC?3 studies 3 Archival Totals: 18 studies 12 Archival 4 Survey 2 Experimental

15 What the 4 th Bocconi AQ Workshop papers imply concerning category of weak links & research methods Category of Variables Variables Studied & Basic Research Findings in the 4 th AC Workshop papers [N = 18 papers] Research Method Audit Firm - Office industry expertise [ and related efficiencies] is ‘not detrimental’…; - Both ‘insiders’ & ‘outsiders’ perceptions of AQ rate audit firm attributes higher that audit-team attributes; - [Some] Human Resource policies significantly relate to AC; - Engagement partner ‘type’ is associated to AC; - Auditor ‘social capital’ is positively associated with AC. - Effect of office-level characteristics [e.g. industry expertise] on AC depend on the client’s industry complexity; - Multi-level modeling confirms importance of audit firm [rather than office differences] 5 archival 2 survey Audit ProcessNone!

16 What the 4 th Bocconi AQ Workshop papers imply concerning category of weak links & research methods Category of Variables Variables Studied & Basic Research Findings in the 4 th AC Workshop papers [N = 18 papers] Research Method Audit Client BAQC 08: compelling evidence in favor of the explanation that family firms have superior financial reporting quality BAQC 14: … audit committee members view appropriate auditor communication and their perceived effectiveness of monitoring the external auditor to be significant determinants of perceived audit quality. BAQC 09: … when the [client] manager takes an incentive- inconsistent action on an initial proposed audit adjustment, auditors …are more likely to allow the manager to meet or beat the consensus analysts’ EPS forecast. …also find evidence [that] auditors put more trust in a [client] manager who initially takes an incentive-inconsistent action, … 1 Archival 1 Survey 1 Experimental Audit Environment[ see next slide ] 3 Archival 1 Survey 1 Experimental

17 What the 4 th Bocconi AQ Workshop papers imply concerning category of weak links & research methods Variables Studied & Basic Research Findings in the 4 th AC Workshop papers [N = 18 papers] Research Method Audit Client Audit Environment BAQC 04: RQ1: Results support predictions that the effect of office-level characteristics on audit quality depend on the complexity of the client’s industry and that the engagement office’s industry expertise is more important than office size in those industries with a high level of accounting complexity, and that the opposite is the case in industries with low complexity. BAQC 03: Main Results: audit quality, proxied by two different measures of earnings management, improves following mandatory audit firm rotation BAQC 07: RQ: How does mandatory auditor rotation affect AC? Results: we find evidence of lower quality audited earnings in the first three years following mandatory auditor rotation, relative to later years of auditor tenure. BAQC 12: RQ: What is the effect of non audit services threats on independence perceptions … Univariate results show that a high self-interest and a high familiarity threat, as well as the existence of a self-review threat, impair auditor independence in appearance.... BAQC 13: RQ: Do joint audits improve AC [? Results: Our results confirm.. 1) …, and 2) the non- significance association between joint audit and abnormal accrual. [No sig effect on AC] BAQC 15: RQ: What is the impact of the proposed regulator measures [ regulators have proposed numerous changes including the prohibition of non-audit services, mandatory external rotation, mandatory joint audits, and the auditor being appointed by an independent regulator. ] on … closing the ‘expectation gap’? Basic Results:.. none of the four proposed measures is estimated to generate an incremental net benefit. …only two of the measures, external rotation and prohibiting non-audit services, are estimated to make a significant contribution to closing the expectation gap. 3 Archival 1 Survey 1 Experimental

18 So What? Assuming this ‘exercise’ has provided each of us with a better idea as to some key weak links and critical factors which affect AQ, so what? What can we do as teachers and researchers? First, given that this is primarily a research workshop, lets consider your ideas as to research constraints & opportunities.

19 Compilation of Research Weak Links and Opportunities from Workshop participant’s replies to Q2 [ N = 26 responses] Category Number indicatingSome examples Data Constraints 12 Data Proprietary; Audit process is unobservable; Too costly to obtain; Measurement difficulties 11 AC is Not observable; Not directly measurable. Definition difficulties 3 Definition Not generally accepted; Quality Threshold not established Research Methods 1 Little opportunity to conduct experimental research. Resource Constraints 1Lack of resources to conduct research.

20 What important roles can we [academics] play in addressing the problem? 1.Enhance the education process at all levels. To do this we need better research knowledge about possible weak links in the audit decision/judgment process and how they impact AC. Thus 2.We need to provide better research on audit judgment and individual difference factors that are linked to AQ.

21 What important roles can we [academics] play in addressing the problem? 1.Provide needed research 2.Enhance the education process at all levels. How can we provide the kind of graduates that will provide QAs when we have little research knowledge about weak links in the audit decision/judgment process?

22 AQ Research: Insights & Opportunities Some Research Challenges & Weak Links 1.Objective/Scientific Methods of Synthesizing Prior Research [ See Knechel et al 2012] 2.Research skill set and related biases of academics 3.Practice Opportunities [i.e. inspections] & Impediments [i.e. confidentiality, litigation] 4.Academic Opportunities & Impediments

23 Summary Slide: Audit Quality: What are the weak links ? Although the ideal, equilibrium level of AQ is probably in determinant, there is consensus that AQ is deficient in too many cases. There is likely not ‘a single weakest link’ in AQ, however there are many variables that relate to AQ, some of these are evident in prior research, in the inspection activities of regulators, and in the replies to the ‘weakest link’ survey of Workshop participants. Key among these are variables which relate to a) Audit firm variables such as incentive schemes b)Audit judgment and individual auditor variables such as level of professional skepticism and cognitive constraints As educators, we have opportunities in both teaching and research to enhance AQ However, AQ research is constrained by lack of access to important data, lack of operational measures of AQ and in some cases resource constraints. Although not a focal topic of this presentation, it seems likely that audit education and its impact on AQ is a largely unexplored topic.


25 Selected References Biggs, S. and T. Mock. 1983 An Investigation of Auditor Decision Processes in the Evaluation of Internal Controls and Audit Scope Decisions, Journal of Accounting Research Financial Reporting Council (FRC). 2006. Promoting Audit Quality. Discussion Paper. Fukukawa, H. and T. Mock. 2011. Audit Risk Assessments Using Belief versus Probability, Auditing: A Journal of Practice & Theory. Grey, G. et al., 2012. Perceptions and Misperceptions Regarding the Unqualified Auditor’s Report by Financial Statement Preparers, Users, and Auditors, Accounting Horizons, 25 (4): 659–684 Griffith, Hammersley & Kadous 2010 Auditing Estimates …. Knechel, W. R., G. Krishnan, M. Pevzner, L. Shefchic, & U. Velury, 2012. Audit Quality Indicators: Insights from the Academic Literature. AAA Audit Section Synthesis Project. Mock, T. & J. Turner. 1981. Internal Accounting Control Evaluation and Auditor Judgment, Audit Research Monograph #3, American Institute of CPAs. Mock, T., J. Turner, G. Gray & P. Coram. 2009. The Unqualified Auditor’s Report. AICPA/IAASB Research Report Mock, T & A. Wright, 1999. Are Audit Program Plans Risk Adjusted?, Auditing: A Journal of Practice & Theory.1999 Mock, T. Et al., 2013 [forthcoming]. The Auditor's Reporting Model: Current Research Synthesis and Implications, Auditing: A Journal of Theory & Practice, Srivastava, R and, T. Mock, 2005. Why We Should Consider Belief Functions in Audit Research and Practice. The Auditor’s Report. Vol. 28, No. 2. Srivastava, R, T. Mock, A. Wright & K. Pincus. 2012. Multiple Hypothesis Evaluation in Auditing, Auditing: A Journal of Practice & Theory

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