02 Auditing

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    Mitigating the Effect of Rationalizations on Ethical Accounting Decisions
    ( 2018-09-01) Lowe, D. Jordan ; Reckers, Philip ; Sauciuc, Ashley
    In order to carry out unethical acts, individuals engage in a rationalization process to “morally disengage” from the consequences of their actions. Rationalizations provide the mechanism through which individuals are able to “morally disengage.” The purpose of our research is to examine three experimenter-devised interventions to moderate the influence of rationalizations in the process of making ethics-related decisions. Our first two interventions attempt to mitigate one’s ability to rationalize by highlighting the false premises of readily available rationalizations; whereas, our third intervention attempts to bolster the importance of one’s own self-regulation by providing a cautionary explanation of how individuals are inappropriately motivated to rationalize bad behavior. We predict that these interventions should enhance one’s ethical intentions through a reduction in rationalization. Furthermore, we anticipate that the success of our proposed interventions may vary with the degree of auditor professional commitment to the accounting profession. To test our hypotheses, we conducted an experiment with 88 auditors from four public accounting firms. Our results indicate that for auditors with a low professional commitment, two of the rationalization interventions were effective in lowering auditors’ willingness to accede to his superior’s unethical request than participants in the control group, while the third was not. As expected, the rationalization interventions were not effective for auditors with a high professional commitment level as these individuals are found less likely to rationalize. Implications of our research and suggestions for future research are also discussed. Ratioanizaion
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    Coaching Today’s Auditors: When Do Workpaper Reviewers Professionally Develop Their Preparers?
    ( 2018-08-31) Schaefer, Tammie ; Brazel, Joseph ; Andiola, Lindsay ; Downey, Denise
    Audit workpaper review is a quality control mechanism intended to detect preparer errors in the short-term and professionally develop preparers in the long-term. Currently, it is unclear as to what factors drive reviewers to professionally develop (or not develop) their preparers. Furthermore, whether error detection and professional development complement or compete during supervisory review is not known. As audit teams become more global, new contextual factors are introduced into the audit environment that may influence a supervisor’s review quality. In this study, we investigate how the preparer’s office location (local vs. international) and the likelihood of preparer recurrence affect the reviewer’s propensity to focus on the professional development of the preparer. We find that reviewers identify more with preparers from their local (vs. international) office and, as a result, focus more on professionally developing local preparers. We also observe that, regardless of office affiliation, reviewers are more apt to coach preparers who are likely (vs. unlikely) to recur the next year because they anticipate reaping future personal benefits from recurring preparers. Finally, we find that reviewers who focus more on developing preparers are also more likely to detect errors in preparer audit documentation.
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    Regulation, Auditor Litigation and Settlements
    ( 2018-08-31) Moorthy, Lakshmana Krishna ; Sarath, Bharat
    This paper aims to understand the determinants of lawsuits against auditors in securities class action litigation and the settlement pattern by auditors when the suit is not dismissed. The issues we consider are: (i) when are auditors named as defendants (ii) when do auditors choose to settle and (iii) what proportion of the settlement do auditors pay in relation to the settlement by all the other parties; and (iv) differences in settlement strategies among the big-n firms. This paper also examines how the lawsuit and settlement patterns have changed following the enactment of major regulation such as the Private Securities Litigation Reform Act (PSLRA), Sarbanes Oxley Act (SOX). Following prior literature, we first establish that auditors are more likely both to be named and to settle in cases involving restatement of earnings, accusations of violation of GAAP or accounting improprieties. We then show that the likelihood of suit and settlement increase in a measure that we construct measuring the complexity of litigation. We then examine differences in settlement patterns across periods preceding and after the passage of PSLRA and SOX. We find that auditors are named less often in the post PSLRA period (relative to the pre-PSLRA period), settle with the same frequency in both periods but pay less proportional damages. The same set of comparisons show that auditors are just as likely to be sued post-SOX as pre-SOX, but settle with lower frequency and pay the same proportion of damages. Overall this study documents the beneficial role of both PSLRA and SOX on reducing the litigation burden on auditors. With regard to settlement strategies, we document the varying strategies employed by the Big-n firms that settle at different rates, vary in their aggressiveness and time to settle signaling the willingness to fight or cooperate in the settlement.
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    Workload Leverage and the Effect on Audit Quality
    ( 2018-08-31) Westfall, Tiffany ; Harris, Kathleen ; Williams, Devin
    Practitioners and regulators suggests audit quality is negatively associated with auditor workloads (PCAOB 2015). We examine the association between office-level workload leverage and an office’s audit quality from 2004-2015 for all accelerated filers. The increase in workloads during busy season can instigate cognitive fatigue (Cohen 1980) if not appropriately mitigated by adequately preparing audit professional’s expectations (Glass and Singer 1972). Our findings indicate that increased busy-season workloads are associated with lower audit quality for accelerated clients of Non-Big 4 audit firms, whereas Big 4 auditors with higher workload leverage provide lower audit quality for non-accelerated filers. These results provide support for cognitive fatigue for all audit firm sizes; however, different sized audit firms experience cognitive fatigue at different points during busy season. Our findings contribute to the literature examining workload leverage and auditor burnout by providing empirical evidence of office workload influencing the audit process differently for different office sizes.
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    Auditor Competition and Cost of Bank Loans
    ( 2018-08-31) Geng, Heng ; Zhang, Cheng ; Zhou, Frank
    This paper examines the effect of auditor competition on the cost of bank loans of client firms. Exploiting the demise of Arthur Andersen that differently reduces the local audit market competition of metropolitan statistical areas (MSAs), we find a decrease in clients' cost of bank loans in areas with a larger decrease in competition. The competition effect on cost of bank loans is more pronounced when external monitoring is lower and when auditors compete more fiercely with price. Our finding is explained by a model in which clients shop for audit opinions and a more competitive audit market forces auditors to compromise audit quality to maintain client relationship and market share.
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    Sounds Good To Me: How Communication Mode and Framing Affect Audit Quality
    ( 2018-08-31) Durkin, Mary ; Jollineau, Jane ; Lyon, Sarah
    In the audit process, audit associates seek explanations from clients, follow-up to corroborate or refute these explanations, and document their findings. Throughout these interactions with the client, auditors must focus on the task at hand and maintain their professional skepticism. This paper examines whether (i) communication mode (face-to-face or email) and (ii) the frame of the client’s response (as explanation or fact) affect the ability of auditors to appropriately assess the quality of client communications and follow-up when necessary. We use professional auditors and conduct a 2x2 between-participants experiment. We find that auditors receiving a face-to-face response from the client that is framed as an ‘explanation’ assess the response as higher quality than auditors in the other three conditions. As a result, these auditors are less likely to follow-up with additional questions, likely impairing audit quality and increasing audit risk. We attribute the decrease in auditor performance to distractions causing the auditors to accept the client’s story at face value rather than applying appropriate skepticism. Our recommendations are that auditor associates (a) use email communication where feasible and (b) prime themselves to listen for ‘facts’ and ask the client to respond with ‘facts’ when face-to-face meetings are unavoidable or otherwise desirable.
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    How do auditors perceive and respond to client firms’ technological peer pressure? Evidence from going-concern opinions
    ( 2018-08-30) Xu, Xiaolu ; Yang, Leo ; Zhang, Joseph
    We examine how the technological aspect of competition (or technological peer pressure) affects the likelihood that auditors issue going-concern opinions. We find that a client firm’s technological peer pressure increases the likelihood that the firm receives a going-concern opinion. This finding is consistent with the notion that the perceived auditor business risk increases with client technological peer pressure so that auditors are more likely to issue going-concern opinions to such clients. Further evidence shows that this positive effect is more pronounced for client firms with greater innovation originality, that are financially constrained, and for auditors facing higher litigation risk. We also find that technological peer pressure reduces the probability of both Type I and Type II misclassifications when auditors exert more effort. Additional analyses show that client firms’ technological peer pressure positively affects the likelihood of using auditors specialized in auditing R&D. Taken together, our study implies that auditors exert more effort to increase audit quality in response to the higher auditor business risk induced by clients’ technological peer pressure, instead of simply being conservative.
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    The use and characteristics of component auditors: Implications from U.S. Form AP filings
    ( 2018-08-28) Burke, Jenna ; Hoitash, Rani ; Hoitash, Udi
    This paper investigates the common, yet previously opaque, practice of using non-U.S. audit firms (commonly referred to as component auditors) to conduct portions of audit work for U.S. public companies. Since the U.S. lead auditor ultimately accepts full responsibility for the resulting audit opinion, regulators have expressed concern for the transparency and quality of audits using component auditors. Employing data disclosed in the newly-mandated PCAOB Form AP, we find that this practice is most common amongst large clients with complex international operations. Consistent with regulator concern, we find that the percentage of audit hours conducted by component auditors is associated with lower audit quality (i.e., material weakness disclosures and restatements), longer audit delay, and higher audit fees. Interestingly, we find that not all component auditors are created equal, and that work performed by component auditors that are less competent (based on number of CPAs employed and experience leading U.S. audits and in the client’s industry) and facing greater coordination and communication challenges (based on the country’s rule of law, English language proficiency, and time zone differences from the lead auditor) drive the association with adverse audit outcomes. Overall, these findings suggest that the use of component auditors is not uniformly detrimental and that Form AP disclosures can help interested parties better assess the potential for adverse audit outcomes.
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    Measuring Audit Quality
    ( 2018-08-27) Zheng, Xin ; Rajgopal, Shiva ; Srinivasan, Suraj
    This study first provides detailed descriptive analyses on 45 specific audit deficiency allegations based on GAAS as detailed in 141 AAERs and 153 securities class action lawsuits over the violation years 1978-2016, and then uses these allegations to validate existing popular proxies of audit quality. Of all the audit quality proxies, we find that restatements consistently predict all the top six most cited audit violations. The ratio of audit fees to total fees and the presence of city specialist auditor predict five of the most cited violations. Overall, our results suggest that the predictive power of audit quality proxies depends on (i) the settings that researchers are interested in; and (ii) the specific audit violations hypothesized to matter in the investigated setting. For example, for future studies related to auditor independence, we recommend the use of restatements and audit fees to total fees ratio as proxies of audit quality.
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    Auditors and the Deterrence of Operational Opportunism: The Importance of Communication to the Board and Consistency with Peer Behavior
    ( 2018-08-23) Buchanan, Jessica ; Commerford, Benjamin ; Wang, Elaine
    Research indicates that managers are willing to make opportunistic operating decisions to meet short-term targets. In this study, we investigate when and how auditor actions can help deter this opportunistic behavior, commonly known as real earnings management (REM). Informed by Perceptual Deterrence Theory, we conduct three experiments with corporate managers as participants. In Experiment 1 we predict and find that REM can be deterred when managers expect auditors to increase scrutiny (i.e., increased inquiry and testing) and discuss their observations with the board. However, this effect occurs only when managers’ operational decisions are inconsistent (as opposed to consistent) with peer behavior. Experiment 2 results suggest that, when communication to the board is not expected, increased auditor scrutiny alone is not likely to deter REM. Experiment 3 findings suggest that when paired, increased auditor scrutiny and communication to the board can be an effective deterrent for both REM and accounting-based earnings management (AEM). However, without communication to the board, auditor scrutiny alone deters AEM, but also appears to induce more REM. Our findings highlight the importance of communication between auditors and the board, but also the limitations of auditor scrutiny as a deterrent to manager opportunism. We provide evidence that, under certain conditions, the benefits of auditor scrutiny can extend beyond the traditional domain of financial statement assurance and improve the quality of managers’ operating decisions.