Arnold M. Wright

Corporate Governance and the Audit Process

There has been growing recognition in recent years of the importance of corporate governance in ensuring sound financial reporting and deterring fraud. The audit serves as a monitoring device and is thus part of the corporate governance mosaic. The objective of this paper is to examine the impact of various corporate governance factors, such as the board of directors and the audit committee, on the audit process. Importantly, there is little professional guidance on how auditors should consider such factors when formulating an appropriate audit strategy, and there has been only one prior study on this issue (Cohen and Hanno 2000). Because there are no current specific auditing standards that relate to the effect of corporate governance on the audit process, we conducted a semi†structured interview with 36 auditors on current audit practices in considering corporate governance in the audit process. Reflecting on client experiences, auditors indicate a range of views with regard to the elements included in the rubric of “corporate governance†. Most significantly, auditors view management as the primary driver of corporate governance. The inclusion of top management in the “corporate governance mosaic†is inconsistent with agency theorys prescription of the board and other mechanisms serving as a means to independently oversee managements actions to protect stakeholders. Auditors consider corporate governance factors to be especially important in the client acceptance phase and in an international context. Further, despite the attention placed on the audit committee in the academic literature, in the business community, and by regulators in different countries (e.g., Canada, United States, Australia), several respondents indicated that their experiences with their clients suggest that audit committees are typically ineffective and lack sufficient power to be a strong governance mechanism. Implications for research and practice are presented.

An Examination of Factors Affecting the Decision to Waive Audit Adjustments

The value of audit services is determined by an auditors ability to both (1) discover misstatements in the clients accounting system and (2) report those misstatements (DeAngelo [1981a, 1981b]). Audit adjustments reflect the auditors discovery of a potential breach in the clients accounting system. The decision to waive an audit adjustment is important, since it can potentially lead to misleading financial statements. Waiving an adjustments) may also result in litigation and loss of auditor reputation. Despite its importance, we have very little empirical evidence on the decision to waive an adjustment. The purpose of this study is to initiate an understanding of the importance placed by auditors on a number of factors noted in the literature in determining whether a proposed audit adjustment is waived. The study reported here utilizes archival data gathered from actual audit engagements to examine variables that may explain the decision to waive an audit adjustment. The findings reveal that in addition to materiality, a number of factors appear to be considered, including directional impact on income, the nature of the adjustment (objective versus subjective), and size of the client. Finally, a number of adjustments exceeding materiality were waived, highlighting the need for future research to more fully understand factors affecting this important decision and to ensure that business decisions (e.g., client pressures) do not overly influence the auditor.

Form vs. Substance: The Implications for Auditing Practice and Research of Alternative Perspectives on Corporate Governance

The objective of this paper is to provide a more comprehensive view of corporate governance than that considered by the traditional agency literature predominately employed in auditing and accounting studies of governance. Specifically, we discuss three widely recognized additional theoretical perspectives: resource dependence, managerial hegemony, and institutional theory. Resource dependence is developed in the strategic management literature and focuses on the contribution of governance mechanisms as a vehicle to help a firm achieve or further its strategic objectives. In contrast with the agency and resource dependence perspectives which offer a functional view of governance, the managerial hegemony perspective views the board and its attendant committees as being under the control of management and hence could be potentially viewed as dysfunctional from a stockholder viewpoint. Finally, institutional theory, developed in the sociology of organizations and organizational behavior literatures, suggests that it is necessary to understand the substance of the interactions between different governance parties and how these parties use at times symbolic gestures and activities to maintain their form to all relevant parties. Although the value of using multiple theoretical perspectives with respect to governance has been well recognized in the economics and behavioral literatures, this is the first paper that we are aware of that examines the effect of using alternative theories of governance on accounting/auditing issues that are influenced by the governance structure of a firm. In addition, we examine how these theories provide a useful basis for reconciling conflicting findings in the existing agency-based audit-related governance literature. Finally, we provide examples of how these alternative theories provide important new insights to issues in auditing research and practice.

Are Financial Auditors Overconfident in Their Ability to Assess Risks Associated with Enterprise Resource Planning Systems

The first objective of the current study is to examine the extent to which financial auditors recognize heightened risks associated with an enterprise resource planning (ERP) system, as compared to a non‐ERP (legacy) system, in the presence of a control weakness over access privileges. The second objective is to assess the propensity of financial auditors to consult with information technology (IT) audit specialists within their firm when assessing ERP and non‐ERP system risks during the planning stage of an audit. One hundred sixty‐five auditors participated in an experiment in which we manipulated system type (ERP versus non‐ERP) and measured auditor type (IT audit specialists versus financial auditors). Both auditor types indicate significantly higher business interruption, process interdependency, and overall control risks with the ERP, as compared to the non‐ERP, system. Additionally, while IT audit specialists assess significantly higher network, database, and application security risks with the ERP...

The impact of prior working papers on auditor evidential planning judgments

Abstract 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 clients 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.

Hypothesis revision strategies in conducting analytical procedures

Abstract 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 clients 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.

Auditors’ Professional Skepticism: Neutrality versus Presumptive Doubt†

Although skepticism is widely viewed as essential to audit quality, there is a debate about what form is optimal. The two prevailing perspectives that have surfaced are ‘neutrality’ and ‘presumptive doubt’. With neutrality, auditors neither believe nor disbelieve client management. With presumptive doubt, auditors assume some level of dishonesty by management, unless evidence indicates otherwise. The purpose of this study is to examine which of these perspectives is most descriptive of auditors’ skeptical judgments and decisions, in higher and lower control environment risk settings. This issue is important, since there is a lack of empirical evidence as to which perspective is optimal in addressing client risks. An experimental study is conducted involving a sample of 96 auditors from one of the Big 4 auditing firms in the Netherlands, with experience ranging from senior to partner. One of the skepticism measures is reflective of neutrality (the Hurtt Professional Skepticism Scale - HPSS) whereas the other reflects presumptive doubt (the inverse of the Rotter Interpersonal Trust scale - RIT). The findings suggest that the presumptive doubt perspective of professional skepticism is more predictive of auditor skeptical judgments and decisions than neutrality, particularly in higher risk settings. Since auditing standards prescribe greater skepticism in higher risk settings, the findings support the appropriateness of a presumptive doubt perspective and have important implications for auditor recruitment and training, guidance in audit tools, and future research.

The effects of fee pressure and partner pressure on audit planning decisions

Abstract Significant concerns have been voiced about the negative impact of competition on audit quality. Recent research suggests that auditors may reduce budgeted hours in response to fee pressure despite an increase in client risk ( Houston, 1999 ). However, only one prior study Gramling, (1999) has considered the role of the auditors superiors, who may encourage subordinates to increase audit efficiency, particularly in cases where audit revenues have been reduced McNair, (1991) . Gramling focused on reliance on internal auditors rather than a generic program planning decision. Further, there is little empirical evidence on the program planning strategies pursued by auditors with respect to the nature of tests, and no prior evidence regarding staffing assignments in response to these pressures. In developing program plans auditors are accountable to multiple sources such as an immediate superior (e.g. a manager), the partner, the firm and, in a broader sense, to the public. Often these sources provide conflicting forces, which have been referred to by Gibbins and Newton (1994) as “complex accountability”. To investigate these issues, eighty-three auditors completed a case based on an actual audit client in which they were asked to perform program planning for the revenue cycle. Fee pressure and partner pressure were manipulated (present or absent) in a between-subjects design. There were three main findings. First, corroborating prior studies, auditors reduced total budgeted hours in response to fee pressure. Second, auditors reduced planned tests in response to partner pressure to improve audit efficiency. Third, there is evidence to suggest that in response to multiple competitive pressures auditors are more likely to reduce budgeted hours of more experienced staff. Specifically, auditors subject to both fee pressure and partner pressure may focus on reducing second year staff hours because greater efficiency gains (i.e. cost reductions) come from eliminating hours assigned to this more experienced personnel than first year staff. These results suggest that both fee pressure and partner pressure motivate auditors to improve audit efficiency. Moreover, fee pressure may be perceived by auditors, based on previous experience, as an implicit suggestion to improve audit efficiency. These findings suggest firms must be cautious in communicating audit fees to staff, and that the audit partner plays a key role in communicating ways to manage competitive pressures.

Order effects and recency: where do we go from here?

Previous studies of auditor judgments have examined whether the order in which information is received affects their judgments. In particular, these studies have considered whether there is a recency effect which occurs when the disconfirmatory/confirmatory evidence treatment results in a final judgment which is significantly higher than the confirmatory/disconfirmatory treatment. More recent studies have investigated the circumstances when recency effects exist and when they are mitigated. The results of the studies are mixed. After the addition of two further studies (Arnold et al., 2000; Monroe and Ng, 2000) in this edition of the journal, the results are still mixed. The paper outlines the possible explanations for the mixed results across studies and some issues that need to be addressed prior to collection of further empirical evidence.

The Effect of Partner Preferences on the Development of Risk-Adjusted Program Plans

Abstract Professional standards require auditors to tailor audit testing to the level of assessed risks. The purpose of this experimental study is to explore the impact of a partner preference on the extent to which program plans are risk-adjusted. Partner preferences for either efficiency or a “balanced” approach (consideration of both effectiveness and efficiency) were manipulated. Sixty-one auditors completed a case where they were asked to perform program planning for the revenue cycle. The results show that there was a significant interaction between auditors’ risk assessments and partner preferences. When there was an incentive for efficiency as prompted by the partner, even though auditors recognized higher risks compared to the prior year, they did not correspondingly alter audit program plans. In contrast, a balanced partner preference led to higher risk assessments and a greater number of tests and hours than for the efficiency condition.