On Controlling for Misstatement Risk

SUMMARY Ex ante misstatement risk confounds most settings relying on misstatements as a measure of audit quality, but researchers continue to debate how to effectively control for this construct. In this study, we consider a recent approach that involves controlling for prior period misstatements (“Lagged Misstatements”). Using a controlled simulation and a basic archival analysis, we show that a lagged misstatement control can significantly bias coefficient estimates. We demonstrate this bias using audit fees as a variable of interest but also show the same issue manifests for other measures that respond to the restatement of misstated financial statements (i.e., internal control material weaknesses and auditor changes). We conclude by discussing alternative approaches for controlling for ex ante misstatement risk and providing guidance for future research. Data Availability: All data used are publicly available from sources cited in the text. JEL Classifications: M40; M41; M42.

The debate concerning the recent regulation in the USA mandating accounting firms to disclose engagement partners' identity is ongoing. We examine the impact of the Public Company Accounting Oversight Board's (PCAOB's) requirement of disclosing engagement partners' names on Form AP on the quality of audit engagements. Using two measures of audit quality (abnormal accruals and the probability of detecting material weaknesses in internal control), we find that disclosing engagement partners' names is associated with a lower level of abnormal accruals and a higher probability of accounting firms detecting material weaknesses in internal control. Our study extends the contemporary research on the disclosure of engagement partners' identification by providing additional evidence to the literature on this issue in the U.S. setting. Our study also provides evidence supporting the PCAOB's perception that this disclosure leads to higher audit quality.

This study investigates the ability of several commonly used measures of audit quality derived from publicly available data to predict an accurate measure of audit process quality derived from audit deficiencies of individual engagements identified during the PCAOB inspections process (Part I Findings). Using a unique dataset of inspected engagements, I find that several measures of audit quality used in prior literature are predictive of audit deficiencies, consistent with these measures conveying audit quality. However, I do not find any association between going concern opinions and Part I Findings, consistent with opposite forces that may influence the auditor actions related to issuance of a going concern opinion. I also find that the collective predictive power of publicly available measures of audit quality on Part I Findings is reasonably low, perhaps because many output-based measures are a joint function of financial reporting and audit process quality, and input-based measures are difficult to estimate to begin with. Overall, these results provide some guidance to researchers about which measures of audit quality to use and suggest that some results in prior literature may need to be interpreted with caution.

This study examines the factors influencing material weaknesses in internal control over financial reporting among the companies in the property industry in Malaysia. Specifically, this study examines six factors namely firm age, firm size, financial health, financial reporting complexity, rapid growth and corporate governance. Using content analysis on the annual reports of 80 property companies, this study shows that only firm size has a significant influence on the material weaknesses in internal control over financial reporting. Other factors however, show no significant influence on the material weaknesses in internal control over financial reporting. The result in this study indicates that small companies tend to have material weaknesses in internal control due to them having limited resources in building effective internal control. These companies generally could not afford to spend on expertise such as internal auditor or consultant to assist in improving and strengthening internal control. The findings of this study shed some lights to the regulators and practitioners on the factors influencing material weaknesses in the internal control over financial reporting. Of consequence, this would reduce information asymmetry between the insiders and outsiders of a company and thus, increasing the quality of financial reporting.

Purpose Prior research finds that auditors often fail to disclose existing material weaknesses in internal controls before they lead to material misstatements. This study aims to investigate whether auditors are aware of such control issues and how they respond by examining subsequent audit-related outcomes of firms with undisclosed control problems (UCPs). Design/methodology/approach Using a prediction model developed by prior research, the study first identifies firms likely to have UCPs. The study then empirically analyzes how these identified UCPs influence changes in audit fees, audit reporting lags and the likelihood of auditor changes in the subsequent year. The study analysis is based on a large sample of accelerated filers from 2007 to 2019. Findings The study finds that firms with UCPs are likely to experience higher audit fees and longer reporting lags in the following year, indicating auditors’ awareness of these problems and their proactive responses. However, these increases are smaller than those for firms with formally disclosed material weaknesses, suggesting that auditors perceive UCPs as less severe. In addition, firms with UCPs exhibit a higher likelihood of subsequent auditor dismissal and replacement with higher-quality auditors, which implies that audit committees may be dissatisfied with auditors’ decisions not to publicly report these control deficiencies. Originality/value This study contributes new empirical evidence regarding auditor and audit committee reactions to internal control deficiencies that remain undisclosed, addressing a critical yet largely overlooked issue in the auditing literature. This study offers unique insights into auditors’ internal risk assessments, materiality judgments and audit committees’ oversight roles, providing practical implications for regulators, auditors and audit committees in enhancing financial reporting transparency and audit quality.

This study examines the relation between internal control material weakness (ICMW) under Section 404 of the Sarbanes-Oxley Act (SOX) and real earnings management. Our measures of real earnings management are abnormal cash flow from operations (ABCFOs), abnormal discretionary expenses (ABDISEXP), and abnormal production cost (ABPROD). We use a sample of 1,824 manufacturing firms over the period 2004–2011 to run regressions of ABCFO, ABDISEXP, and ABPROD on ICMW and other independent variables. We find that ICMW is negatively associated with ABCFOs. Another result that emerges from this study is a positive relation between ICMW and ABPROD. Our results imply that manufacturing firms with materially weak internal controls predominantly use overproduction and excessive price discounts to manage operational activities to achieve earnings targets. As SOX Section 404 is designed to reduce the instances of firms having ICMW, our finding that ICMW firms engage in real earnings management suggests that the use of real earnings management could be reduced as SOX Section 404 succeeds in reducing ICMW.

We find that firms reporting internal control material weakness (ICW) under Section 404 of Sarbanes-Oxley Act have 13% lower valuation than non-ICW firms based on Tobin’s q. This valuation difference is mainly driven by stock underperformance of more than 13% during the year before ICW disclosure. Those ICW firms that remedy the internal control weakness in the year after disclosure have much better stock performance compared to those ICW firms who fail to remedy ICW during the same period. We further show a better stock performance in the year before disclosure if a SOX 404 ICW firm has prior SOX 302 ICW disclosure more than one year earlier. All these results are consistent with the hypothesis that the equity market has reflected the negative information associated with SOX 404 ICW reports before the actual disclosures are made. Additional analysis suggests that the market cannot independently reflect the ICW information. More likely, the activities related to the preparation of ICW disclosure generate new information that is reflected in the stock prices.

We examine whether measures of audit quality are able to measure the quality of audit in banks. We make use of a unique setting where the Reserve Bank of India (RBI) provided an accurate measure of asset quality in banks. We first attempt to establish that the RBI revealed asset quality is a better estimate than that disclosed by the banks. Using the difference between the RBI-revealed and the bank-reported figures as an external validation of audit,we are unable to find evidence that any of the generally accepted measures of audit quality do measure the quality of audit. We then examine whether the sensitivity of the bank’s asset quality to its borrowers’ health increases when the more accurate RBI-revealed figures are used and find that they do. Using the actual sensitivity of the bank’s true health to borrower health, we construct a novel measure of audit quality.

This paper investigates how increases in client audit risk influence the use of component auditors. Auditors respond to increases in audit risk by making adjustments to the audit engagement such as increasing fees and/or increasing effort. As more audit resources are demanded by clients with increased audit risk, one way for the lead auditor to free up resources is to allocate more work to component auditors. Using a difference-in-difference research design, with the revelation of an internal control material weakness (ICMW) as an event for increased audit risk, we find that component auditor use increases after the revelation of an ICMW, and increases even more when the ICMW is severe. We also find that the increase in component auditor use after an ICMW is positively associated with the likelihood of ICMW remediation. Thus, we identify a situation where component auditor use enhances audit quality and provides a benefit to the company (i.e., increased likelihood of ICMW remediation). Our study should be of interest to regulators, given the criticism by the PCAOB regarding firms’ use of component auditors and the evidence in prior literature on how component auditor use influences audit quality.

SUMMARY We present a comprehensive review of the 130 international archival auditing and assurance research articles that were published in eight leading accounting and auditing journals for 1995–2014. In order to support evidence-based international standard setting and regulation, and to identify what has been learned to date, we map this research to the International Auditing and Assurance Standards Board's (IAASB) Framework for Audit Quality. For the areas that have been well researched, we provide a summary of the findings and outline how they can inform standard setters and regulators. We also observe a significant evolution in international archival research over the 20 years of our study, as evidenced by the measures of audit quality, data sources used, and approaches used to address endogeneity concerns. Finally, we identify some challenges in undertaking international archival auditing and assurance research and identify opportunities for future research. Our review is of interest to researchers, practitioners, and standard setters/regulators involved in international auditing and assurance activities.

PurposeThe purpose of this paper is to examine the association between pervasiveness, severity, and remediation of internal control material weakness (ICMW) reported by the SEC registrants pursuant to SOX Section 404 and audit fees.Design/methodology/approachThe paper employs multivariate regression models for a sample of 854 firms that disclosed ICMW for the first time in 2004, 2005, or 2006, to investigate the empirical relationship of pervasiveness and severity of ICMW and its subsequent remediation with audit fees.FindingsThe analyses demonstrate that audit fees are significantly positively related to the severity (and pervasiveness) of ICMW in the years of ICMW disclosures and are significantly negatively related to the remediation of internal control weaknesses in the years when ICMW remediation took place. The test results further demonstrate that the remediation of systematic control weaknesses has a greater effect on reduction of audit fees compared to the remediation of nonsystematic (transaction/account related) control weaknesses, though the remediation of both systematic and nonsystematic control weaknesses is accompanied by audit fee declines.Research limitations/implicationsThe study produces evidence on pricing audit services by incumbent auditors in response to the severity of internal material control weaknesses and their remediation in subsequent fiscal periods. Its results shed light on certain new aspects of audit fee determinants in the post‐SOX period by virtue of their implications that the pervasiveness and severity of internal control problems induce auditors to make an upward fee adjustment while their remediation has a moderating effect on pricing audit services.Originality/valueThe study's finding is a useful addition to the existing fee literature and is relevant for the post‐SOX world which experienced a structural change in financial accounting and auditing environment.

We examine whether short sellers are interested in, and capable of, identifying firms with an upcoming revelation of internal control material weaknesses (ICMW). We show that short sellers accumulate positions in firms that are about to disclose ICMW under Section 404 of the Sarbanes–Oxley Act for the first time when internal control problems are severe. We find that the short-interest buildup is mainly due to the use of private rather than public information, which suggests that their trades contain incremental prediction power of the upcoming internal control failure. Furthermore, the ability of short sellers to predict ICMW is more pronounced in firms operating in poor information environment. Finally, we find no evidence that trades by short sellers prior to the ICMW disclosure create a cascade of selling that leads to an overreaction of ICMW. Overall, we present evidence that corporate governance information in the form of ICMW is part of the short sellers’ information set, and we establish a path through which ICMW impacts equity investors.

This paper aims to determine if significant associations exist between audit quality and earnings management in less developed economies, providing their various shortcomings and differences. Five different measures of audit quality (auditor size, auditor industry specialization, auditor opinion, auditor change and timeliness of auditor report) were examined based on a sample of 337 non-financial Saudi listed firms from 2006 to 2009. The absolute value of discretionary accruals is used as a proxy for earnings management by using a cross-sectional variation of the Kothari model. The results of this research indicate that only auditor opinion indicates earnings management practice. The results support the argument that auditors are powerless in front of managerial opportunistic activities. Issues that may impair audit quality in Saudi Arabia are discussed.

Prior research finds that internal control material weakness (ICMW) reduces the reliability of financial reporting numbers, imposes costs on firms and affects firm performance. Given these effects, we examine two research questions: Does the disclosure of ICMW hamper a firm's ability to hire high‐ability CEOs? Consequentially, does it also impact CEO contracting in terms of the compensation offered to newly hired CEOs? We provide three key findings. First, we find firms that disclose ICMW are more likely to appoint CEOs with lower managerial ability relative to firms that do not disclose ICMW. Second, we find ICMW firms offer lower compensation to new CEOs, suggesting that the pay offered is commensurate with the ability of the CEO recruited. However, the negative relation between ICMW and compensation is attenuated for individual CEOs with relatively higher abilities. Further analyses reveal that some high‐ability CEOs do take positions at ICMW firms, but these ICMW firms pay a premium to hire them, which contributes to greater dispersion and disparity in pay among the top‐five executives. Overall, our results point to ICMW imposing labor market consequences in terms of firm recruitment of high‐ability CEOs.

Prior research has linked audit quality with large audit firms. Consequently, a dichotomous variable, Big N/non-Big N has traditionally proxied for audit quality. Applying a different measure of audit quality than audit fee, this study investigates whether a single dummy variable for Big N is an appropriate proxy for audit quality in explaining differences in the existence of clients’ internal audit (IA) function. Results indicate that the existence of clients’ IA function is not consistent among Big 4 firms. This has important research implications for the universal use of a Big N dummy variable as a measure for audit quality.