Mining Audit Research

Learn a few tips from researchers—without going back to school.

by Cynthia Bolt-Lee

his column is the first of a series that will review accounting research journals to distill practical pointers for busy CPAs. The resulting summaries offer useful suggestions practitioners can apply immediately to day-to-day activities. This installment is devoted to auditors in the field.

“Audit Partner Tenure and Audit Quality,” by Peter Carey and Roger Simnett in the May 2006 issue of The Accounting Review, studied the relationship between audit partner rotation and audit quality. The authors examined whether the length of time an auditor worked with a client affected audit quality. They measured audit quality by whether or not a going-concern audit opinion was issued for “distressed” companies; the direction and amount of abnormal working capital accruals; and targeting earnings benchmarks. The results found that audit partners who had worked long term with a client were less likely to issue a going-concern audit opinion even when they probably should have and that they had a tendency to target earnings benchmarks. These findings support the frequent audit partner rotation requirement of Sarbanes-Oxley.

Aloke Ghosh and Doocheol Moon, authors of “Audit Tenure and the Perceptions of Audit Quality” (The Accounting Review, April 2005), also examined the length of an audit partner’s association with a client and its effect on the audit. Their analysis included the effects on the investor and determined that investors considered earnings quality and audit effectiveness to be higher the longer an auditor worked with a company. This research suggests that limiting the length of time an auditor can serve a specific client may negatively affect a company’s share price.

Jacqueline Hammersley, in her March 2006 article in The Accounting Review, “Pattern Identification and Industry-Specialist Auditors,” determined that auditors familiar with the client’s industry were more adept than nonspecialist auditors at diagnosing complex financial statement misstatements that appeared when performing financial statement analysis. This suggests auditors with specific industry expertise perform more reliable audits in that sector. Industry-specialist auditors are those who work within a specific field such as banking, insurance or manufacturing.

In his work, “Explaining Financial Difficulties Based on Previous Payment Behavior, Management Background Variables and Financial Ratios,” Peter Back (European Accounting Review, December 2005) showed it is easier to detect financial difficulties in small and midsize firms when using nonfinancial variables such as payment delays rather than using financial statement ratios, which is standard. A firm’s audit program should require both analytical procedures and nonfinancial analysis to obtain the best evidence regarding a client’s financial status. While GAAP does not require nonfinancial analysis, this research indicates that use of this audit technique enhances audit decisions.

Research published in the July 2005 issue of The Accounting Review by Mark Nelson, Steven Smith and Zoe-Vonna Palmrose, titled “The Effect of Quantitative Materiality Approach on Auditors’ Adjustment Decisions,” examined auditors’ requirement to adjust a client’s financial statements due to material misstatements detected during the audit. The two alternative approaches used in the study are the cumulative approach (which considers only misstatements added during the period) and the current-period approach (which includes misstatements existing at the end of the current period). The methods are known to calculate misstatements differently. The authors suggest the approach used should be discussed with the audit committee. Auditors should be aware of this calculation difference and consider using both methods to provide more thorough information when analyzing the need for financial statement adjustment due to material misstatements.

Note: GAAP does not prescribe how to calculate materiality. Two methods discussed in the auditing standards are the current-period approach (rollover approach) and the cumulative approach (iron curtain approach). Both methods take total misstatements and compare them to net income to determine whether an adjustment to the financial statements is necessary. The SEC is considering requiring disclosure of the materiality approach and encourages auditors, at a minimum, to disclose their approach to the audit committee. The SEC issued SAB 108 in September 2006 to address this. FASB is also considering guidance in this area.

Ed O’Donnell and Joseph Schultz studied the effects of auditor judgment when performing a strategic assessment of their client’s business model during the audit risk-assessment phase in their July 2005 article in The Accounting Review, “The Halo Effect in Business Risk Audits: Can Strategic Risk Assessment Bias Auditor Judgment About Accounting Details?” Auditors who developed a favorable strategic risk assessment were found to be more tolerant of fluctuations in financial statement account analysis. Audit teams might consider separating the risk assessment function from the performance of analytical procedures to ensure they avoid potential bias.

Ken Trotman, Arnold Wright and Sally Wright examined methods of training auditors to enhance their negotiation skills in the article “Auditor Negotiations: An Examination of the Efficacy of Intervention Methods” (The Accounting Review, January 2005). They tested three training methods on audit managers and partners to measure their effectiveness in improving negotiation results. The first was role-playing in which the auditor took the client’s perspective in a negotiation. The next method, called “passive intervention,” had the auditor discuss the client’s position without role-playing. The third method, titled a “practice intervention approach,” had the auditor simulate discussion with the client prior to actual negotiations. Results indicated role-playing was more effective than the other methods and will improve the outcome of debates between auditors and clients.

The effects of accountability pressure on auditors was examined by Todd DeZoort, Paul Harrison and Mark Taylor in their work “Accountability and Auditors’ Materiality Judgments: The Effects of Differential Pressure Strength on Conservatism, Variability and Effort” (Accounting, Organizations and Society, 2005). Their work, based on a study of 160 auditor-participants, measured auditor judgment of materiality and auditor judgment related to proposed audit adjustments when auditors were pressured to justify their decision making in these areas. Results suggested auditors required to comply with an accountability process were more conservative and consistent in judging materiality than auditors under less pressure. This research stresses the relationship between pressure and performance and demonstrates the need for appropriate workpaper documentation to support an auditor’s decision-making process.

“Accelerating the Acquisition of Knowledge Structure to Improve Performance in Internal Control Reviews,” by Faye Borthick, Mary Curtis and Ram Sriram (Accounting, Organizations and Society, July–August 2006), examined structure-training in the internal control review and how it affected the auditor’s judgment. Structure-training is defined as “focused instruction that makes the knowledge structure explicit” for an entity’s transaction flows and control objectives.

The study examined internal controls taught by control objective (less structured) as opposed to teaching by transaction flow (more structured). Individuals receiving structure-training rather than basic audit theory and objectives could perform specific audit tasks better and advance more quickly than those who did not. Results suggest that very specific and precise audit training enhanced performance and prepared auditors to advance to more challenging tasks sooner. It also indicates that structure-training of experienced hires in areas such as workpaper review helps practitioners make a more efficient transition when moving to another CPA firm.

“The Importance of Business Risk in Setting Audit Fees: Evidence from Cases of Client Misconduct,” by John Lyon and Michael Maher (Journal of Accounting Research, March 2005), examined audits prior to the Foreign Corrupt Practices Act in countries where bribery is an accepted business practice. They found that clients that disclosed such fees in their SEC filings paid higher audit fees. The authors suggest that if auditors assess high business risk for a client, they pass their “expected costs” on to the client in the form of higher audit fees. Both client and auditor should be aware of this relationship.

“Independence Threats, Litigation Risk and the Auditor’s Decision Process,” by Allen Blay (Contemporary Accounting Research, Winter 2005), examined the decision-making process of preparing a client’s audit report when the auditor is facing threats of litigation or is concerned about losing a client due to independence issues. Results suggest those facing litigation were more likely to modify their audit report. Auditors fearing the loss of a client were more likely to give an unqualified opinion.

In “Recognition vs. Disclosure, Auditor Tolerance for Misstatement and the Reliability of Stock-Compensation and Lease Information,” by Robert Libby, Mark Nelson and James Hunton (Journal of Accounting Research, June 2006), the researchers determined audit partners were more lenient about the reliability of footnotes compared to amounts in the financial statements themselves. The authors suggest there is a need for an audit standard modification to ensure that footnote disclosures receive the same scrutiny as the financial statement.

According to the summer 2006 Contemporary Accounting Research article, “Pricing of Initial Audit Engagements by Large and Small Audit Firms,” by Aloke Ghosh and Steven Lustgarten, discounts are generally given to clients during the initial audit engagement. Their research revealed that small CPA firms tended to discount their audit fees an average of 24% over the prior auditor’s fee, while the average discount on first-year audits of new clients for large firms was about 4%. Additionally, the authors showed that new engagements accounted for 34% of all clients in small firms but only 9% in large firms. The authors attributed the difference in fee reduction in the two sectors to competition and indicated that fee cutting does not reduce auditor independence.

Cynthia Bolt-Lee, CPA, is an associate professor at The Citadel School of Business Administration in Charleston, S.C., where she teaches auditing, taxation and introductory accounting. Her career includes eight years in audit and tax practice for local and international firms. Bolt-Lee’s research interests include tax ethics, accounting education, practitioner use of research and innovative instructional strategies. Her e-mail address is cynthia.bolt@citadel.edu.