Summary #9

External Auditors’ Reliance on Internal Auditors’ Work

How fees influence planning decisions.

BY AUDREY A. GRAMLING

his study investigated whether clients’ fee pressures on audit engagements affected audit managers’ decisions on how much to rely on work performed by a client’s internal auditors. It also examined whether fee pressure from the client could be mitigated when an audit partner placed a strong emphasis on quality audit work and professional skepticism.

Audit managers were asked to modify a preliminary time budget for a case scenario. They were told that the preliminary budget was appropriate unless the manager was willing to rely on work already completed by the client’s internal auditors. The internal auditors’ competence was described as questionable. The case said the audit client had expressed a preference—either for lower audit fees or for quality audit work. The partner was also described as having expressed a preference—either for efficiency and profitability or for audit quality and professional skepticism.

The results showed that when the client wanted lower audit fees, managers decreased audit hours by 16%, while managers whose hypothetical client emphasized the need for quality audit work cut the hours by only 10%, even though the client did not request lower fees. In both cases, in order to reduce planned audit hours, the auditors relied on the work of internal auditors whose skills were questionable. While this does not provide direct evidence that auditor independence or audit effectiveness was impaired, practitioners might want to consider the appropriateness of reducing planned audit work when a client requests a fee reduction. Further, of interest is that even when the client did not express a preference for lower audit fees, managers still reduced planned hours, despite the questionable quality of the internal auditors’ work.

Even without explicit client fee pressure, competition among firms for clients might cause managers to rely on a client’s internal auditors’ work in order to cut audit hours. Reducing hours is a way of lowering fees, which might make managers’ firms more competitive in the market, even if reducing audit hours compromises audit independence and effectiveness. Finally, the results showed that the partners’ stated preferences did not mitigate the effects of client fee pressure on managers’ planning decisions.

For the full text of the research paper, see Auditing: A Journal of Practice & Theory, vol. 18, Supplement, 1999.

AUDREY A. GRAMLING, CPA, PhD, CIA, is assistant professor of accounting, School of Business, at Georgia State University, Atlanta, Georgia. Her e-mail address is agrambling@gsu.edu.

Summary #10

The Auditor’s Objectivity Vis--vis Material Misstatements

Can standards yield undesirable results?

BY J. EFRIM BORITZ AND PING ZHANG

ndependence and objectivity are hallmarks of the auditing profession. However, auditors are subject to economic incentives to please clients that could lead them away from perfect independence and objectivity and potentially result in undesirable conduct, even if they comply with professional standards.

Auditors face two potential risks—failing to detect a material misstatement (a “type II” error) and incorrectly concluding that there is a material misstatement (a “type I” error). Under current standards, the auditor is required to achieve a low level of risk of a type II error, but there is no similar prescription for a type I error. In the study, researchers developed an economic model based on the basic assumptions that even though auditors aim to please clients, they also strive to maintain the costs of an audit as planned and to comply with standards. The study stated that the type II error related to an overstatement of company value, while the type I error related to an understatement.

The analysis showed that if the auditor concluded there was a misstatement (type I error) but the client knew or believed that there was none, then the client would encourage the auditor to do more work so that it was possible to render an unqualified opinion. Simply put, no client wants its company’s value understated. As a result, the auditor worked to eliminate the understatement. However, in order to stay within the budget as planned, the auditor let the overstatement drift as high as possible based on the level considered tolerable by professional standards for a type II error. While this finding appeared counter intuitive, the model confirmed it.

Normally, risks of misstatements below materiality might not be of concern. However, the model showed that for investment portfolios of companies in similar industries these misstatements were not averaged out, as investors might expect. Further, the misstatements persisted even when investors diversified portfolios. This is because the misstatements were all likely to be in favor of the client—overstating the company’s value—making the overall misstatement in the portfolios potentially very large. The researchers suggested that by prescribing the relationship between type I and type II errors in auditing standards, the misstatement can be adjusted. They also advocated specifying the level for type I error rates to encourage auditors to avoid the pitfalls revealed in the research.

For the full text of the research paper, see Auditing: A Journal of Practice & Theory, vol. 18, Supplement, 1999.

J. EFRIM BORITZ, PhD, FCA, CISA, is the Ernst & Young Professor of Accounting and Director of the Center for Information System Assurance, School of Accountancy, University of Waterloo, Ontario, Canada. His e-mail address is jeboritz@uwaterloo.ca. PING ZHANG, PhD, is associate professor, Rotman School of Management, University of Toronto, Canada.