Audit Environment Research Articles

An Examination of Memory Conjunction Errors in Multiple Client Audit Environments

This study is the first in an auditing context to examine auditor susceptibility to memory conjunction errors, a type of systematic memory error that is related to the memory reconstruction process. Conjunction errors occur when memory traces associated with one event are incorrectly attributed to another event during memory reconstruction. Auditors may be particularly susceptible to memory conjunction errors due to their simultaneous exposure to multiple audit clients and their use of standardized audit forms and checklists to capture information. Unrecognized, such errors could adversely affect the efficiency and/or effectiveness of the financial statement audit process. We conducted an experiment that employed practicing audit professionals addressing multiple audit clients. Consistent with our hypotheses, the results indicate that memory conjunction errors in an audit environment are a complex function of (1) the consistency between the audit evidence recalled from an unrelated audit and the characteristics of the client that is the target of the memory reconstruction, (2) the consistency between this recalled audit evidence and the characteristics of the client to which the evidence is actually associated, and (3) the level of risk present in the audit environment that is the target of the memory reconstruction. While research has shown that audit risk factors can generally serve to decrease some types of auditors' memory recognition errors in single client situations (e.g., Sprinkle and Tubbs 1998), our results show that increases in audit risk can actually exacerbate memory errors involving multiple audit clients and memory conjunction errors. Finally, the findings of the study suggest that auditors are not only susceptible to memory conjunction errors, but also that such errors may play a significant role in elements of the audit-planning process related to auditors' likelihood of material error assessments.

Multiple hypothesis evaluation in auditing

In many audit tasks, auditors evaluate multiple hypotheses to diagnose the situation. Research suggests this is a complex task that individuals have difficulty performing. Further, there is little guidance in professional standards or literature dealing with the many complexities present in the audit environment. Using probability theory, this study derives the appropriate revision of likelihoods for multiple hypotheses given different realistic audit conditions. The analysis shows that the relationships among the hypotheses dramatically impact the use of audit evidence and the resulting pattern of probability revisions. We also identify testable hypotheses to guide future research and discuss practice implications regarding ways to improve the effectiveness of analytical procedures.

Decision Aids for Generating Analytical Review Alternatives: The Impact of Goal Framing and Audit-Risk Level

An auditor generating potential explanations for an unusual variance in analytical review may utilize a decision aid, which provides many explanations. However, circumstances of budgetary constraints and limited cognitive load deter an auditor from using a lengthy list of explanations in an information search. A two-way between-subjects design was created to investigate the effects of two complementary approaches to trimming down the lengthy list on the number of remaining explanations carried forward into an information search. These two approaches, which represent the same goal (reducing the list) but framed differently, are found to result in a significantly different number of remaining explanations, in both low- and high-risk audit environments. The results of the study suggest that the extent to which an auditor narrows the lengthy list of explanations is important to the implementation of decision aids in analytical review.

The determinants of audit fees—evidence from the voluntary sector

Given the growing demand for accountability in the public sector, there is a need to begin to investigate audit pricing issues in this sector. This study makes three contributions. First, it develops and estimates, for the first time, a model of audit fee determinants for the charity sector. As in previous private sector company studies, size, organisational complexity and audit firm location are the major determinants. A positive association between audit fees and fees for non-audit services is also observed. Charity sector factors of empirical significance include the nature of the charity (i.e., grant-making or fund-raising), its area of activity and the importance of trading income. Separate models for grant-making and fund-raising charities reflect the relative complexity of the audit of fund-raising charities. Second, the lower auditor concentration in the charity sector market, compared to the private sector market, permits a more powerful test of whether large firms and/or auditor expertise are rewarded with a fee premium. In the more complex audit environment of fund-raising charities, the results show that Big Six audit firms receive higher audit fees (18.5%, on average) than non-Big Six firms. Also, non-Big Six audit firms with charity expertise are rewarded with a fee premium over other non-Big Six firms. Finally, the study demonstrates that the charity audit fee rate is significantly lower than that of private sector companies; in fact it is approximately half. A change in the reporting of charity audit fees is proposed to reflect any element of ‘charitable giving’ by the audit firm.

Continuous audit: Model development and implementation within a debt covenant compliance domain

Because of technological advances and the current audit environment, there is a growing interest in the concept of continuous audit. Conceptually, a continuous audit is an assurance service where the time between the occurrence of events underlying a particular subject matter and the issuance of an auditor's opinion on the fairness of a client's representation of the subject matter is eliminated. A continuous audit is the natural evolution of the integration of technology into the auditing domain. Although the concepts of continuous auditing are now more than a decade old, only recently have technologies emerged that are both widely available and affordable, making implementation of the continuous audit feasible. The Canadian Institute of Chartered Accountants and the American Institute of Certified Public Accountants have together called on the research community to investigate the concept of continuous auditing and its implementation in various audit domains. In response to this call, we develop a conceptual model of a continuous audit, and, as proof of concept, we design and demonstrate an implementation of continuous audit within the debt covenant compliance domain. The demonstrated Web application uses digital agents and alarm triggers sent over the Internet to continuously monitor whether actual values of a client's variables are in compliance with standards for these variables set out in the debt covenant agreement.

An Experimental Assessment of Recent Professional Developments in Nonstatistical Audit Sampling Guidance

The American Institute of Certified Public Accountants has recently set forth significant revisions in its nonstatistical audit sample-size decision aid (AICPA 1999). In a controlled setting involving 149 experienced auditors, we test the effects of the new guidance on auditors' sample-size judgments, extending Kachelmeier and Messier's (1990) (KM) investigation of a previous AICPA (1983) decision aid. We find that the current decision aid results in significantly smaller sample sizes than the previous aid. Further, auditors continue to “work backward” in their choice of decision aid inputs, resulting in sample sizes that are more intuitively acceptable. An optional supplemental worksheet added to the AICPA's guidance to assist the auditor in specifying tolerable misstatement generates a marginal increase in sample sizes, but does not eliminate the working-backward phenomenon. However, the supplemental worksheet significantly reduces sample size variability. Additional findings update the conclusions in KM by showing that the excess of decision-aided sample sizes over intuitive sample sizes in their study no longer applies. A final extension addresses a limitation in KM by showing that sample-size judgments are not sensitive to the variation of population size as a separate treatment factor. Overall, this study directs focus to an improved understanding of nonstatistical sampling judgments, which are of increasing importance in the contemporary audit environment.

The Determinants of Audit Fees - Evidence from the Voluntary Sector

Given the growing demand for accountability in the public sector, there is a need to begin to investigate audit pricing issues in markets within this sector. This study makes three principal contributions. First, it develops and estimates, for the first time, a model of audit fee determinants relevant to the charity sector. The model is based on 210 of the top 500 UK charities with average incoming resources of 27 million pounds. As in previous private sector company studies, size, organisational complexity and audit firm location are the major determinants. A positive association between audit fees and fees for non-audit services is also observed. Charity sector factors of empirical significance include the fundamental nature of the charity (i.e., predominantly grant-making or fund-raising), the importance of trading as a source of charity income and the charity's activity. Separate models are developed for grant-making and fund-raising charities, the results reflecting the relative complexity of the audit of fund-raising charities. Second, the lower auditor concentration in the charity sector market, compared to the private sector market, permits a more powerful test of whether large firms and/or auditor expertise are rewarded with a fee premium. The results show that Big 6 audit firms receive higher audit fees (18.5%, on average) than non-Big 6 firms for audits of fund-raising charities. There is also evidence that non-Big 6 audit firms with expertise in the sector are rewarded with a fee premium over other non-Big 6 firms, again in the more complex audit environment of fund-raising charities. Finally, the study demonstrates that the charity audit fee rate is significantly lower than that of private sector companies; in fact it is approximately half. Further research that discriminates between alternative explanations of this differential is called for. A change in the reporting of charity audit fees is proposed to reflect any element of 'charitable giving' by the audit firm.

The Impact of Regulatory and Audit Environment on Managers' Discretionary Accounting Choices: The Case of SFAS No. 106

This paper studies the impact of a firm's regulatory and audit environment on managers' discretion in choosing from the set of actuarial choices available under Statement of Financial Accounting Standards No. 106. Data disclosed by 500 firms under SFAS No. 106 during the period 1993–96 is used for the tests. Correlation, portfolio, and fixedeffects regression analyses are conducted on this data. The results show that the magnitude of the discretionary component of the postretirement benefit obligation is negatively associated with the extent of the external regulations and auditor quality. Tests on the market response to the disclosed postretirement benefit obligation show that the market values only the nondiscretionary component of the obligation. This research provides evidence that federal regulation and independent audits serve as useful watchdogs of the public interest. Proper financial disclosures also lead to increased transparency and market efficiency in detecting and correcting for the effects of opportunistic actions of managers.

Audit committees, Cadbury Code and audit fees: an empirical analysis of UK companies

Audit committees have become more important and prevalent in recent years but there is a relative paucity of empirical research concerning their value. This paper contributes to this research by reporting an analysis of the relationship between the size of the audit fee and the existence of an audit committee. The analysis builds on previous research in this area in several ways. First, it uses more recent data than previous research which may have been influenced by transitional problems. The data in this paper were collected from financial reports for the years ending in 1994 and 1995. Second, it investigates the effect on audit fees of audit committee adherence to the Cadbury Committee Report recommendations of 1992. Finally, the analysis is set within a theoretical framework developed from agency theory. The results suggest that audit committees have been through a transitional phase comprising changes to the general audit environment and a learning phase for the establishment and operation of committees. By 1995 there is no evidence that audit committees, whether adhering to the Cadbury Code or not, have any overall effect on audit fees. The only effect found was a reduction in fees due to improved internal controls in the presence of auditee complexity. There was evidence that size was the main determinant of the presence of an audit committee.

The Role of Auditee Profitability in Pricing New Audit Engagements

This paper examines the role of auditee profitability in pricing new audit engagements. Changes in the auditing environment are noted that suggest that auditors are managing their practices differently than they did in prior years. Audit fees are examined to answer two questions: (1) whether CPA firms still discount fees for new engagements in the current audit environment; (2) whether such fee discounts are dependent upon auditee profitability. The results suggest that auditors still discount new engagements in the 1990s, but that they are less willing to offer discounts when auditees show losses in the year prior to the new audit engagement. Further, this result is stronger for companies that switch from non-Big 6 firms to Big 6 firms than it is for intra-Big 6 switches. These findings suggest that auditors are managing their exposure to audit risk by adjusting audit fees.

Effects of the preparer's justification on the reviewer's hypothesis generation and judgment in analytical procedures

The process gains arising from the review process have been the subject of much research interest, but few studies have examined how features in the audit environment can influence the review process. In this paper, we investigate how one such feature — the preparer's justification for a conclusion made — affects the nature of hypotheses generated by reviewers and their likelihood assessments. Using the context of an analytical procedures task, our results showed that exposure to a preparer's justification for a non-error cause reduced the number of alternative error hypotheses generated by the reviewer, and increased the reviewer's belief in the likelihood of a non-error cause. We also showed that three mechanisms moderated the influence of the preparer's justification on the reviewer's judgment — generation of alternative hypotheses, explaining an alternative hypothesis, and making an initial independent assessment. Implications of the results are discussed.

Success in failure? Reflections on the changing Spanish audit environment

The 1990s in Spain have witnessed a significant shift in attitudes towards the role of auditing, with promises of more transparent reporting being replaced by talk of audit expectations gaps. This paper explores the changing atmosphere, both through an analysis of one of the most notorious scandals of recent times - involving the Banco Español de Credito (‘Banesto’) - and a more general review of the way the Spanish profession has responded to such downturns in public expectations of auditing. While at first sight, the profession appears to have become more defensive and the audit environment more competitive, the multinational accounting firms do appear to have strengthened their position in the Spanish audit market. Intriguingly, despite public expressions of concern with the quality and capabilities of auditing and the imposition of large fines on audit firms for inadequate audit work, proposed ‘solutions’ for improving audit quality include the establishment of a self-regulated audit regime and reductions in auditor liability. The Spanish experience allows for some timely reflections on the significance of an audit expectations gap and highlights the importance of viewing the audit function from an international perspective.

The Effects of Fee Pressure and Client Risk on Audit Seniors' Time Budget Decisions

In the current competitive and litigious audit environment, auditors must appropriately balance cost control and effectiveness when planning audits. This study experimentally examines the joint effects of fee pressure and client risk on audit seniors' planning judgments and decisions. Consistent with predictions, seniors' budgeted audit hours and inherent risk assessments suggest that seniors are less responsive to increased risk in the presence of fee pressure. Fewer budgeted audit hours in the presence of fee pressure may improve short-term profitability but may not be in accordance with professional standards and the firm's interest if audit effectiveness is compromised. Further analyses suggest that, in the presence of increased client risk, seniors planned fewer audit procedures when fee pressure was present than when it was absent, with decreases most likely for less reliable audit procedures and low-risk audit areas. Finally, in the presence of increased client risk, seniors expected to work more hours than budgeted, regardless of the level of fee pressure.

LITIGATION RISK FOR AUDITORS AND THE RISK SOCIETY

The auditing industry has mounted a global campaign to reduce its liability. In Canada, it is attempting to change from a doctrine of joint and several liability to proportionate liability, to have the Federal government legislate a statutory cap on liability, or to have the Provincial governments approve the establishment of Limited Liability Partnerships. These initiatives are consistent with the proposals of the CPA firms in the US and the CA firms in the UK. This cross-national trend suggests that a global theory of society is needed to analyze the consequences of audit risk. This paper uses the “risk society” model proposed by Beck to understand why the audit industry focuses on reducing exposure to liability, rather than on improving the quality of audits. Beck's theory of “reflexive modernization” provides an analysis of the so-called “liability crisis” that attempts to overcome the institutional construction offered by the auditing industry. The paper recognizes that it is very difficult for observers outside of the large auditing firms to judge the real risks of audits and to develop alternative public policy options. Ideally, we should be able to evaluate litigation in a modern audit environment. However, the audit firms are not required to disclose sufficient information about their costs to determine the real impact. Meanwhile, professional groups are lobbying hard for changes that will reduce auditors risk without addressing the root causes of audit failures.

The future of auditing: the debate in the UK

Upon its creation in 1991, the UK's Auditing Practices Board (APB) debated the future of financial statement auditing, leading to a succession of APB publications in 1992, 1994 and 1996. A significant theme of these publications focused on the need for an audit environment in which auditing can be sustained as a professional judgement, in the face of pressures tending to subvert the audit into a process of compliance with rules. This paper articulates an ‘accountability model’ of the audit, developed as a consequence of APB's debate and underpinning many of the policy implications of the APB papers. This model is articulated in terms of the concepts of lateral and hierarchical accountability. The fear that judgement would be displaced from auditing has for the moment proved groundless given the recent introduction of new judgemental audit methodologies based on an assessment of business risks. Nevertheless, it is argued that the underlying accountability model and its implied imbalance between the hierarchical and lateral accountabilities of the audit engagement partner, still stands.

Fuzzy logic: application for audit risk and uncertainty

Auditors generally describe risk in terms of probabilities. Risk arises from lack of information which in turn leads to uncertainty. Since uncertainty exists when information is deficient and information can be deficient in different ways, it follows that auditors deal with different types of uncertainty. This article describes different types of uncertainty and a relatively new method of dealing with uncertainty referred to as fuzzy logic. Fuzzy logic and fuzzy set theory have contributed greatly to the development of artificial intelligence and have the potential to facilitate internal auditors’ measurement and management of risk and uncertainty in the audit environment.

Primacy Effects and the Role of Risk in Auditor Belief-Revision Processes

Numerous studies in the audit judgment literature provide evidence indicating that auditors can be susceptible to recency effects. This study extends the research by examining auditor susceptibility to primacy, an order effect, which, like recency, can lead to suboptimal audit-planning decisions (see Ashton and Ashton 1988) and yet, unlike recency, has received very little attention in the accounting literature. Specifically, the research investigates whether primacy effects in auditor belief revisions are a conditional function of the level of inherent risk present in the audit environment (high/low) and the nature of the information contained in the latter portion of the information sequence (e.g., whether the information is positive or negative with respect to the client's internal controls). The results, consistent with expectations, indicate that auditors are susceptible to primacy effects when making likelihood of error and audit-hour planning judgments in settings that are relatively low in inherent risk, and such effects are due to less integration of late positive information in low- as compared to high-risk conditions. No evidence of primacy was found for either judgment when the inherent risk associated with the audit setting was high and, auditors did not differentially revise their beliefs across inherent risk conditions for late negative information. The findings indicate that primacy is essentially the result of insufficient integration of late positive information in low inherent risk settings, suggesting that primacy may lead to overauditing and thus, an inefficient use of audit resources.

Discussion of an Experimental Investigation of Auditor-Auditee Interaction Under Ambiguity

Experimental economics studies in auditing typically test for economic forces in multiperson settings and ignore psychological considerations. Behavioral studies in auditing typically test for psychological forces in single-person settings and ignore economic forces. Zimbelman and Waller [1999] (hereafter ZW) manipulate and test for both economic and psychological forces in a multiperson setting. The authors construct an experiment that places auditors in a strategic setting that also subjects them to the psychological force of ambiguity (uncertainty regarding a probability distribution). The auditors respond both to auditees' economic incentives and to ambiguity; auditees also appear to respond to the ambiguity faced by the auditors, although evidence of this effect is weaker. These results show how psychological responses to ambiguity can percolate through a strategic setting, from the auditors (who face ambiguity directly) to the managers (who face the auditors who face ambiguity). The audit setting is a natural one in which to integrate psychological and economic theory. The typical audit environment contains significant ambiguity, and the natural response to such ambiguity (to collect more data than would be predicted by traditional expected-utility theory) has important economic ramifications. The single-person environment of most behavioral studies would fail to capture the complete effects of ambiguity on audit behavior and outcomes, because the likelihood of

An Examination of Factors Affecting Audit Practice Development*

AbstractIn this study, we examine the possibility that audit managers' judgments may be affected by practice development objectives. Given the competitive nature of public accounting, the extent to which auditors are inclined to be aggressive in the domain of practice development may be a function of their superiors' preferences. This study builds on the exploratory work of Hooks, Cheramy, and Sinich 1994 and Asare, Hackenbrack, and Knechel 1994 by examining the delicate balance that exists between a public accounting firm's need to “grow its business” and its need to maintain its objectivity and professionalism. An experiment is conducted to determine whether the auditor's willingness to tender a bid on an engagement is affected by (1) the nature of the auditor‐auditee relationship (i.e., do existing clients receive the same treatment as potential clients?), or (2) the audit partner's aggressiveness with respect to practice development, which also includes elements of ethics and competence.Seventy‐four audit managers from two Big‐Six firms participated in the study. The results indicate that the type of client (current or potential) and the type of partner (more or less aggressive with respect to practice development) significantly affected the auditors' judgments. Specifically, subjects in the “current client” condition, as well as those who are accountable to a more aggressive partner, are more likely to recommend bidding for the client. The experimental results of this study are based on a case where the client was proposing a relatively aggressive position with respect to accounting for research and development (R&D) costs. Our findings also suggest that the judgements related to bidding on the client are not independent of the auditor's willingness to accept the client's accounting treatment. These results also provide further evidence that the influence of accountability is important in the professional audit environment.

Critical factors to consider in the development of an audit client engagement decision expert support system: a Delphi study of Big Six practicing auditors

The litigious audit environment is driving accounting firms to change their audit client engagement strategies in order to remain viable and successful in a very competitive environment. Firms are realizing the need to make better, more informed decisions regarding client acceptance/continuance decisions. Expert Support Systems are suggested as a useful tool for reengineering the audit client engagement decision. Towards this goal, this study uses the Delphi method with a panel of experts from the Big Six accounting firms to determine critical factors which may cause a firm to reject potential clients. © 1997 John Wiley & Sons, Ltd.