Under-Researched Areas of Audit Quality: Inputs, Firms, and Institutions

Francis (2011) lists three under-researched units of analysis that affect audit quality: inputs, firms, and institutions. This dissertation analyzes how each of these units of analysis contributes to audit quality. Study 1 examines audit inputs, specifically, characteristics of the individual auditor that affect professional skepticism. Study 2 examines how firm staffing decisions affect audit quality. Study 3 examines how the Public Company Accounting Oversight Board ( PCAOB ), as a regulatory institution, promotes audit quality through their risk-based inspection program. The first study reports the results of two experiments that examine professional skepticism as a function of moral agency. Consistent with the theory of moral disengagement (through moral agency), the results suggest that common audit firm human resource practices used to promote audit quality (i.e. hiring creative individuals, and advertising public accounting\u27s role as protecting the capital markets) may unintentionally decrease professional skepticism through increasing moral disengagement. Results of Experiment 1 demonstrate creative auditors are more skeptical. However, they are also more prone to engage in less skeptical behavior as they fabricate more creative moral justifications (a specific method of moral disengagement) when working under time pressure. Further, Experiment 2 suggests that moral disengagement is increased when firms frame their public interest responsibilities as protecting the \u27capital markets.\u27 The use of this label unintentionally dehumanizes the individuals that make up the public, and as a result, it decreases professional skepticism. Alternatively, altering the frame of the public interest responsibilities to protecting individuals (such as more familiar individual investors) increases humanization and increases professional skepticism. The second study examines how firms affect audit quality. Audit regulators view audit firm staffing as key input affecting audit quality and have suggested that it has value as a potential indicator of audit quality. Further, regulators (such as the IAASB) have called for audit firms to avoid cutting staff (including in periods of economic contraction), as reductions in staff could have a negative impact on audit quality. However, little empirical evidence exists to support how firm-level staffing maps into engagement-level audit quality. This study evaluates the extent to which firm-level staffing affects audit quality. Audit firm employment is obtained from the 1991-2014 rankings of the top 100 U.S. public accounting firms and analyzed across multiple measures of audit quality. In multivariate tests, firm staffing (such as number of partners) and firm leverage (as measured by total partners divided by total professional staff) are associated with audit quality. This analysis provides support for claims made by regulators, about the value of potential labor related audit quality indicators proposed by the PCAOB. Further, decreases in partners or staff (from year to year) are negatively associated with audit quality supporting regulatory claims that audit firm staff cuts have a detrimental impact on audit quality. The third study examines the relationship between the PCAOB, as an institution, and audit quality. The PCAOB uses a risk-based selection process to identify engagements for inspection and states that their inspection findings are an indicator of audit quality. However, critics argue that the risk-based selection program produces reports that are not representative of the overall audit quality for the firm. This study creates a selection model, investigates the extent to which inspection findings are representative of overall firm audit quality, and examines the extent to which the inspection process may improve audit quality. Inspection reports of annually inspected firms from 2004 to 2012 are analyzed in combination with the financials of their issuer clients. Results suggest that inspection report findings can be generalized to the audit quality of those deficient accounts for the issuer client base exhibiting the highest levels of selection risk. Specifically, when audit firms have increased levels of revenue related to inspection deficiencies, their high selection risk clients have higher average discretionary revenues for the year inspected. Further, the analysis suggests that the PCAOB risk-based inspection process is effective in improving audit quality of deficient accounts for clients exhibiting the highest levels of selection risk in the subsequent year. The results indicate a negative association between prior levels of revenue specific inspection deficiencies and future levels of discretionary revenues for high selection risk clients

Auditor Skepticism and Client Ill Will

Professional skepticism is considered an essential component of audit quality. Consequently, research has focused on ways to increase skepticism by identifying factors that either limit or encourage its practice. However, research has yet to explore potential negative consequences of professional skepticism. We conduct two experiments to investigate if high levels of skepticism create ill will in audit clients, and how ill will affects the auditor-client relationship and audit quality. In the first experiment, we find that high skepticism creates ill will in the client, which increases the likelihood the client recommends switching auditors and decreases the amount of evidence provided to the auditor. We find that auditors can ingratiate themselves with the client as an intervention to decrease the development of ill will and mitigate its adverse effects. In our second experiment, we examine if client pressure to persuade the auditor of their accounting position mitigates the relationship between high skepticism and ill will. We find an interaction such that if the evidence does not support the accounting treatment the client recommends, a high level of auditor skepticism does not cause clients to experience as much ill will toward the auditor. We contribute to the literature by investigating a new empirical construct, client ill will, and developing a more nuanced perspective of the interactions between auditors and their clients

Rating Scales In Accounting Research: The Impact Of Scale Points And Labels

Rating scales are one of the most widely used tools in behavioral research. Decisions regarding scale design can have a potentially profound effect on research findings. Despite this importance, an analysis of extant literature in top accounting journals reveals a wide variety of rating scale compositions. The purpose of this paper is to experimentally investigate the impact of scale characteristics on participants’ responses. Two experiments are conducted that manipulate the number of scale points and the corresponding labels to study their influence on the statistical properties of the resultant data. Results suggest that scale design impacts the statistical characteristics of response data and emphasize the importance of labeling all scale points. A scale with all points labeled effectively minimizes response bias, maximizes variance, maximizes power, and minimizes error. This analysis also suggests variance may be maximized when the scale length is set at 7 points. Although researchers commonly believe using additional scale points will maximize variance, results indicate increasing scale points beyond 7 does not increase variance. Taken together, a fully labeled 7-point scale may provide the greatest benefits to researchers. The importance of scale labels provides a significant contribution to accounting research as only 5 percent of the accounting studies reviewed have reported scales with all points labeled

Fraud Risk Awareness And The Likelihood Of Audit Enforcement Action

Prior research indicates that issuing a going concern opinion to financially stressed clients generally reduces the risk of litigation against the auditor following a bankruptcy (Kaplan and Williams 2013; Carcello and Palmrose 1994). However, we propose that a going concern report may indicate prior knowledge of financial distress, an important fraud risk factor, and this may have repercussions for the auditor if a fraud is subsequently uncovered. Consistent with counterfactual reasoning theory, experimental research suggests that a documented awareness of fraud risk actually increases the likelihood of litigation against the auditor following a fraud (Reffett 2010). This concern has been echoed by the professional community (AICPA 2004; Golden, Skalak, and Clayton 2006) and may be exacerbated by the current outcome-based regulatory environment (Peecher, Solomon, and Trotman 2013). To examine this issue we review Auditing and Accounting Enforcement Releases (AAERs) issued by the Securities and Exchange Commission (SEC) for alleged financial reporting frauds between 1995 and 2012. Results suggest that going concern report modifications accompanying the last set of fraudulently stated financials are associated with a greater likelihood of enforcement action against the auditor. This finding is consistent with counterfactual reasoning theory and suggests that, from a regulatory perspective, auditors may be penalized for documenting their awareness of fraud risk when financial statements are later determined to be fraudulent

A Live Simulation-Based Investigation: Interactions With Clients And Their Effect On Audit Judgment And Professional Skepticism

Threats to professional skepticism are embedded in the social relationships and interactions between auditors and management. These can affect auditor skepticism and the extent of audit procedures performed. In this study, we conduct an experiment using live simulation to create a realistic audit setting to investigate the effect of these interactions on professional skepticism. Each participant (n ¼ 49) completed a measure of trait skepticism and conducted an audit interview with a professional actor trained to play the role of a client controller. Findings indicate that, in general, participants who interview a friendly controller (rather than an intimidating controller) are less likely to determine questionable cash disbursements to be control exceptions and less likely to recommend more intensive follow-up. However, consistent with social psychology research on construct accessibility, planned contrasts indicate that participants who score low on trait skepticism are least likely to identify control exceptions and recommend more intensive follow-up when interviewing a friendly controller. This study advances research on professional skepticism by examining the impact that type of social interaction (friendly, intimidating) has on professional skepticism using a methodology (live simulation) that allows us to simulate a realistic audit environment. Use of this methodology increases external validity and generalizability of our findings. As a result, this study corroborates concerns that the social relationships/interactions between management and the auditor can be a threat to professional skepticism, and allows us to understand better how, when, and where these threats occur