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SUMMARY: This study examines the association between group audit risk and component auditor use. The audit risk model defines audit risk as a function of the risk of material misstatement and detection risk. We use the revelation of an internal control material weakness (ICMW) as an event that increases the risk of material misstatement. Since higher risk of material misstatement requires the lead auditor to reduce detection risk, component auditor use could change after an ICMW. We find that the likelihood of starting component auditor use significantly increases after an ICMW. We also find an increase in the number of large component auditors used after an ICMW and such increase is concentrated in more pervasive entity-level ICMWs and higher-quality component auditors. Our evidence indicates that lead auditors perceive component auditor use as decreasing group audit risk. Our findings should inform the debate on the costs and benefits of component auditor use. [ABSTRACT FROM AUTHOR] more...

SUMMARY: This study investigates whether audit clients' blockchain activities (including crypto-related activities) affect audit risk by examining the association between blockchain disclosures in 10-K filings and audit fees. Focusing on U.S. firms between 2013 and 2020, we empirically show that audit fees are higher for companies disclosing blockchain activities in 10-K filings. We further find that this positive association is more pronounced for companies disclosing current blockchain implementation than for companies with plans for blockchain activities. The results indicate that clients' blockchain activities influence audit risk as assessed by external auditors. As blockchain technology and its applications are emerging, our findings have implications that should be considered by auditors, regulators, and top management. [ABSTRACT FROM AUTHOR] more...

SUMMARY: This study draws on human capital theory to measure the quality of accounting personnel based on their education level and investigate whether the education level of the client firm's accounting personnel affects auditors' assessment of audit risk by examining audit outcomes. It shows that auditors charge higher fees and are more likely to make audit adjustments for companies whose accounting personnel have a lower level of education. The relationship between the education level of accounting personnel and audit fees (audit adjustments) is robust to an instrumental variable model, an entropy balancing approach, and a difference-in-differences analysis. Audit firms strategically assign more experienced partners to audit companies whose accounting personnel's average education levels are relatively low. Taken together, these findings suggest that the education level of clients' accounting personnel affects auditors' assessment of audit risk and audit outcomes. JEL Classifications: M40; M42; J01; J24. [ABSTRACT FROM AUTHOR] more...

SUMMARY: In this study, we examine whether increased financial flexibility afforded by the Paycheck Protection Program (PPP) affects small accounting firms' public audit client portfolio decisions. We find some evidence suggesting that accounting firms receiving PPP loans exhibit greater public audit client selectivity. Specifically, accounting firms receiving PPP loans exhibit an increased likelihood of auditor switching and engage new clients that exhibit less financial and auditor business risk but greater potential for profitability relative to departing clients. Relative to both departing and continuing clients, new clients of firms receiving PPP loans exhibit some evidence of lower audit risk. Collectively, the results provide some evidence to suggest that the increased financial flexibility afforded through the PPP loans provided smaller accounting firms an opportunity to selectively manage their public audit client portfolio. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M42; M48. [ABSTRACT FROM AUTHOR] more...

SUMMARY: Prior research finds that firms' stock liquidity is associated with more aggressive discretionary accruals and revenues, suggesting that firms face pressure to make more aggressive accounting decisions when liquidity is high. However, the literature has yet to examine whether the effects of liquidity on financial reporting quality are severe enough to impact audit risk. We address this gap and offer three main findings. First, we find a positive association between stock liquidity and the probability of restatements, suggesting that the pressures from liquidity to engage in aggressive reporting decisions are severe enough to increase audit risk. Second, we find a positive association between stock liquidity and audit fees, suggesting that auditors at least partially incorporate the audit risk from liquidity into their pricing decisions. Finally, we find that the positive association between liquidity and audit pricing is concentrated in firms with poor corporate governance mechanisms. JEL Classifications: G12; G30; M42. [ABSTRACT FROM AUTHOR] more...

SUMMARY: We examine whether consumer-generated tweets about purchases (interest) and sentiment are useful in assessing the risk of misstated revenue in the planning stage of the audit, as reflected in improvements to analytical procedures, for firms in consumer-facing industries. We obtain consumer-generated tweeting activities from 2012 to 2017 for 76 companies in 20 consumer-facing industries from a data provider. We find that, relative to a benchmark model, Twitter consumer interest, but not consumer sentiment, improves the prediction and error-detection ability of analytical procedures for most firms in consumer-facing industries. Our findings are robust to different model settings. In additional tests, we observe that the effect of Twitter consumer interest is more pronounced in smaller industries and that it remains useful in analytical procedures when compared to firms' advertising and employee headcount. Together, our results suggest that this new source of information improves auditors' assessments of the risk of misstated revenue. [ABSTRACT FROM AUTHOR] more...

SUMMARY: Tone at the top plays an important role in entities' internal control over financial reporting (ICFR) and in auditors' planning and risk assessment decisions. Using a novel measure based on employee perceptions, we find that strong tone at the top is associated with reduced audit pricing and that this relation holds even for firms that report effective ICFR. This relation is stronger when employees' tone perceptions are more consistent throughout the organization, when accounting is more complex, and when earnings manipulation risk is higher. We also find that strong tone is negatively associated with the incidence of reported material weaknesses and positively associated with positive abnormal accruals, and that the management integrity component of tone is more strongly associated with audit pricing than is the quality of management communication. Finally, we find evidence that auditors become familiar with employees' tone perceptions in the normal course of an audit. [ABSTRACT FROM AUTHOR] more...

SUMMARY: We analyze the consequences of a firm hiring a generalist CEO in terms of the audit fees paid by the firm. We find that audit fees of clients with generalist CEOs are higher than those of clients with specialist CEOs. This relation is robust to considering managerial ability, other CEO characteristics, various fixed effects, instrumental variables, and change analyses. We further show that fee differences are larger for firms with weaker monitoring and higher corporate litigation risks. Through path analysis, we find that both client business risk and misreporting risk contribute to the fee difference. Finally, we find that auditors are more likely to issue going-concern opinions to clients with generalist CEOs. Our study should be of interest to auditing standard setters who link management operating styles to audit risk. We shed light on how management operating styles associated with the CEOs' general or specialized skills affect audit pricing. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M41; M42. [ABSTRACT FROM AUTHOR] more...

SUMMARY: Audit associates routinely interact with clients to request explanations and evidence regarding financial statement account balances. Client explanations may be vague or incomplete. We examine whether auditors' assessments of the quality of client explanations and their decision to follow-up with the client are influenced by (1) communication modes that vary in media richness, and (2) a prime that is intended to stimulate skeptical behavior. Media richness refers to the amount of data inherent in the communication mode. We predict that richer communication modes, such as video, can be more distracting than less rich communication modes, such as email. More distracted auditors will assess the quality of the client's response as higher and are less likely to follow-up with the client—potentially impairing audit quality and increasing audit risk. We predict and find that a prime that focuses auditors on the verifiability of the client's response will mitigate this behavior. [ABSTRACT FROM AUTHOR] more...

SUMMARY: This study examines the impact of drought on the pricing of audit services for U.S. firms over the period 2001–2015. We employ the Palmer Drought Severity Index (PDSI) to determine drought intensity conditions at the state level on a yearly basis and regress audit fees on drought intensity after controlling for other known factors of audit fees. We document that auditors charge significantly higher audit fees for client firms headquartered in areas affected by drought. The effect of drought on audit fees is more pronounced among firms with lower accruals quality and among firms with high business operation concentration in their headquarter states. Collectively, our findings suggest that climate risk in the form of drought not only affects firm risk but also audit risk, thereby highlighting that externalities from climatic conditions are relevant to firms and auditors. [ABSTRACT FROM AUTHOR] more...

SUMMARY: We examine whether the readability of financial statement footnotes in the annual report is informative about audit engagement risk. Using various readability measures, we predict and find that firms with less readable footnotes have longer audit report lag, incur higher audit fees, and are more likely to receive a first time modified going concern opinion. We also show that readability of footnotes is associated with a higher likelihood of financial misstatements and future accounting-related litigation. Our results are robust to several measures of readability used in prior literature, as well as different specifications and design choices, revealing that financial statement footnote readability provides incremental information about audit engagement risk that affects auditor-client contracting. Data Availability: Data are obtained from public sources identified in the paper. [ABSTRACT FROM AUTHOR] more...

SUMMARY: As the scope of the audit continues to broaden (Cohen, Krishnamoorthy, and Wright 2017), research questions in management control and internal control are beginning to overlap. Even so, there is little overlap between these fields in terms of published research to date. The purpose of this paper is to take a step in bridging the gap between the management control and the internal control literatures. We survey relevant findings from the extant management control literature published between 2003 and 2016 on dysfunctional behavior and the ways in which it might be mitigated. We then use the fraud triangle as an organizing framework to consider how the management control literature might help to address audit risk factors identified in SAS 99/AU SEC 316 (AICPA 2002). The outcome of our analysis is meant to identify and classify the extant management control literature of relevance to research on internal control in a manner that researchers new to the management control literature will find accessible. We conclude with a set of future research opportunities that can help to broaden the scope of current research in internal control. [ABSTRACT FROM AUTHOR] more...

SUMMARY: Previous studies document that lenders lack incentives to monitor borrowing firms or to make concessions during bankruptcy if these lenders insure against corporate default with credit default swaps (CDS). This article investigates whether external auditors increase their audit fees for those client firms that have their debt referenced by CDS. In a comprehensive sample of U.S. companies from 2001–2015, we find that CDS-referenced companies incur larger audit fees compared to companies without CDS. The economic magnitude of the audit fee increase ranges from 5.4 percent to 11 percent, depending on the econometric specification employed. Deteriorating corporate conditions or other observable characteristics do not explain the positive association between CDS trading and audit fees, or the increase in audit fees following CDS initiations. The findings suggest that auditors increase their professional skepticism and monitoring efforts of CDS-referenced clients; they might also expect higher liability losses. JEL Classifications: G10; G30; G33; G34. [ABSTRACT FROM AUTHOR] more...

SUMMARY: Continuous auditing increases the coverage and frequency of analysis of a firm's activities, and has been touted as a powerful fraud deterrence and detection technique, but we identify and examine a potential unintended consequence. When continuous auditing is accompanied by more timely notifications to auditees of exceptions to control rules, information is revealed about the system's capability to flag exceptions to control rules. Therefore, if a system has weak fraud-detection capability, early notification that the system did not detect a fraudulent transaction could actually increase an auditee's propensity to commit fraud. We examine whether the benefit of early notification depends on the fraud-detection capability of the organization's monitoring system (i.e., whether it is a strong or weak monitoring system). We use an experimental economics approach to address our research question. Consistent with expectations, we find that early and frequent notification of audit results is not always beneficial in deterring fraud, and that its benefit depends on whether the fraud-detection capability of the monitoring system is strong or weak. We do not find evidence of the predicted benefit of continuous notification reducing the incidence of fraud when the system is strong, but we do find an increase in participants' inclination to commit fraud when the system is weak. We discuss the implications of these findings for research and practice. [ABSTRACT FROM AUTHOR] more...

SUMMARY: Using data from the Chinese market where related party transactions (RPTs) are particularly prevalent, we examine how the independent auditor responds to the potentially heightened risk of RPTs and the efficacy of the auditor's response. First, we find that the auditor is more likely to issue a modified audit opinion that specifically discusses RPTs (RPTMAO) to firms reporting higher related sales or related lending, but not to firms reporting higher RPTs of other categories (i.e., related purchases, related borrowing, and related assets/equity transactions). These findings suggest that the auditor alerts investors to the possibility of earnings management and/or expropriation risk from related sales or related lending through audit opinions. The positive relation between related sales and RPTMAO is driven by related sales with nonmarket-based or undisclosed pricing policy and related sales above the industry average. Second, RPTMAO has robust predictive power for future RPT-related restatements, and the predictive power is greater than that of modified opinions that do not specifically discuss RPTs, suggesting that the auditor is effective at communicating the risk associated with RPTs through opinion modifications, especially RPTMAOs. JEL Classifications: M49 Data Availability: Data used in this study are available from public sources. [ABSTRACT FROM AUTHOR] more...

This study examines whether auditors regard market pressure on client management as contributing to audit risk. The literature suggests that when management jobs are threatened by negative market reaction to poor mergers and acquisitions investment, managers are more likely to misstate financial statements in the postinvestment period due to pressure on their job security (Bens, Goodman, and Neamtiu 2012). We find that firms under such investment-related pressure experience larger increases in audit fees and audit lags in the postinvestment period. Our findings suggest that auditors perceive market pressure on client management as a risk factor, as recommended by Statement on Auditing Standards (SAS) No. 99. [ABSTRACT FROM AUTHOR] more...

This paper considers the potential impact of internal audit incentive-based compensation (IBC) linked to company performance on the external auditor's assessment of internal audit objectivity. We posit that external auditors will view IBC as a potential threat to internal audit objectivity, thus reducing the extent of reliance on the work of internal auditors and increasing the assessment of control risk. The increase in risk and external auditor effort should result in higher audit fees. We hypothesize that the form of incentive-based compensation, namely stockbased versus cash bonuses, moderates the association between IBC and external audit fee. Finally, we consider whether underlying financial reporting risk mitigates the external auditor's potential sensitivity to IBC. We find a positive association between external audit fees and internal audit compensation based upon company performance. The association is acute to IBC paid in stock or stock options as opposed to cash bonuses. We also find evidence consistent with the IBC associations being mitigated by the company's financial reporting risks. [ABSTRACT FROM AUTHOR] more...

We report the results of an experiment that examines how the salience of post-audit reviews (PARs; i.e., U.S. Public Company Accounting Oversight Board [PCAOB] inspections and public accounting firms' internal quality reviews [IQRs]) affects auditors' perceptions of inspection risk (i.e., the risk that an auditor or audit firm will suffer harm as a result of a PAR), as well as audit effort and fees. Using large-firm, high-level auditors as participants, we find that PAR salience (i.e., anticipation of a PAR) yields higher perceived overall engagement risk assessments, even after controlling for traditional audit risk factors, consistent with auditors viewing inspection risk as incremental to these risk factors. Further, we find that auditors respond to PAR salience by increasing both audit effort and fees-- with higher perceived engagement risk and greater audit effort for PCAOB inspections than IQRs. Finally, we observe that increases in audit fees are fully explained by effort. [ABSTRACT FROM AUTHOR] more...

We examine the relationship between aggressive income-increasing real earnings management (REM) and current and future audit fees. Managers pursue REM activities to influence reported earnings and, as a consequence, alter cash flows and sacrifice firm value. We posit that the implications of REM are considered in auditors' assessments of engagement risk related to the client's economic condition and result in higher audit fees. We find that, with the exception of abnormal reductions in SG&A, aggressive income-increasing REM is positively associated with both current and future audit fees. Additional analyses provide evidence consistent with increased effort combined with increased risk contributing to the current pricing effect, with increased business risk primarily driving the future pricing effect. We, therefore, provide evidence that aggressive income-increasing REM activities have a significant influence on auditor pricing behavior, consistent with the audit framework associating engagement risk with audit fees. [ABSTRACT FROM AUTHOR] more...

To reduce redundancies and increase efficiency in the evaluation of internal controls (PCAOB 2007, 402-403), professional standards encourage coordination between external auditors and their clients' internal audit function (IAF). Recent surveys of internal auditors find that a component of this coordination is external auditors' involvement in developing the IAF's audit plans. Nevertheless, it is not known how such involvement affects external auditors' reliance on the internal control test work of the IAF, either before or after a negative audit discovery. Based on an experiment with 107 experienced auditors, we find that external auditors involved in the development of the IAF's audit plan perceive the IAF as more objective and that both objectivity and involvement contribute to these auditors' placing more reliance on the IAF as compared to external auditors with no involvement. This initial reliance results in the involved auditors' proposing reductions to the audit budget and re-performing less of the IAF's work. Consistent with an anchoring bias, we find that involvement leads to external auditors' continuing to place greater reliance on the IAF's work, even after they become aware of a negative audit discovery that should not have occurred had the client's controls been effective. [ABSTRACT FROM AUTHOR] more...

This paper examines the impact of the development of Business Risk Auditing (BRA) on international audit standard setting and the implications regarding the potential for innovation in auditing practice. BRA was an audit methodology development promoted by the large international audit firms in the late 1990s as a significant innovation but, ultimately, it did not have the degree of impact on practice initially promised. Our analysis demonstrates that professional and regulatory priorities at the time interacted in ways that led to the most innovative elements of BRA not being advanced for inclusion in formal standards. Intriguingly this outcome was clear well before the critical attention given to auditing following Enron, which was the explanation offered for the fate of BRA in previous studies. We conclude that the capacity for innovative ideas to have a substantive influence on audit practice is highly dependent on interactions between a shifting mix of professional and regulatory interests and preferences. The BRA case illustrates how lasting innovation requires a willingness and commitment both to develop the scope of the audit and to accept variations in aspects of its execution. This will not happen if standardization per se is seen as an essential validation of successful innovation. [ABSTRACT FROM AUTHOR] more...

Existing theories posit two contradictory predictions on the relation between product market competition and audit fees. On the one hand, product market competition can mitigate agency problems between shareholders and managers and increase the accuracy of financial reporting, thus decreasing auditors' assessments of audit risk. Hence, auditors tend to charge lower fees to firms in a more competitive industry. On the other hand, product market competition can increase auditors' assessments of business risk. Therefore, audit fees are expected to increase with industry competitiveness. This study empirically tests the relation between product market competition and audit fees and finds that auditors charge more to firms in a more competitive industry. [ABSTRACT FROM AUTHOR] more...

This paper examines the materiality guidance for eight of the largest U.S. public accounting firms. Knowledge of how materiality guidance is integrated into a firm's methodology is important for accounting and auditing researchers as well as for practitioners, regulators, and educators. Our results show a high level of consistency across the firms in terms of the quantitative benchmarks (e.g., income before taxes, total assets or revenues, and total equity) used to determine overall materiality, the related percentages applied to those benchmarks, the percentages applied to overall materiality for determining tolerable misstatement, and what constitutes a clearly trivial misstatement. We also find that the firms' guidance for evaluating detected misstatements, including qualitative factors and firm guidance for group audits, is consistent across firms. However, there are differences in how the firms consider the possibility of undetected misstatements when evaluating detected misstatements. The results of this study provide important insights into implementation of standards and valuable information for future research and education. [ABSTRACT FROM AUTHOR] more...

This paper analyzes whether audit adjustments vary systematically with inherent and control risk factors. The analysis is based on proprietary data from a large recent sample of audit adjustments detected in the financial statement audits conducted by a Big 4 audit firm in Germany. We extend the scope of prior studies by incorporating client-specific planning materiality in our design, enabling us to analyze the relative magnitude of adjustments. Our findings show that audit adjustments vary systematically, as proposed by the audit risk model. Specifically, the integrity and competence of the client's management, economic position, entity-level control strength, and internal control system are associated with the number and relative magnitude of audit adjustments. The results also suggest that inherent and control risk factors are particularly strongly associated with income-affecting adjustments. [ABSTRACT FROM AUTHOR] more...

We examine the impact of PCAOB Auditing Standard No. 5 (AS5) and the economic recession on risk characteristics and degree of auditor/client misalignment in the publicly traded client portfolios of Big 4 firms. AS5 and the economic recession both likely resulted in an increase in audit firm personnel capacity as well as a decline in current and future revenue prospects, leading to concerns that the Big 4 firms may pursue clients that present greater risk to the portfolio. We find that the overall portfolio in 2009 presents greater financial risk, attributable to the impact of the recession on continuing clients. A net decrease in audit and auditor business risks is also attributable to continuing clients over this period, as increases for new clients are offset by reductions due to departing clients. Overall, the results, which should be of interest to regulators, indicate that Big 4 firms continued to balance their portfolio with risk in mind. [ABSTRACT FROM AUTHOR] more...

This study examines Big N auditors' client risk management strategy in response to the risk of upward (i.e., income-increasing) earnings management in the post-SOX era. Specifically, we empirically study the relation between clients' signed discretionary accruals and subsequent audit pricing and auditor resignation decisions. We find that audit fees and resignations are positively associated with the risk of upward earnings management. We document a pecking order of auditor responses and find that auditors are more likely to respond in the order of charging higher abnormal audit fees if the trade-off between upward earnings management risk and return is within an acceptable level, and then resign if the risk is more severe and exceeds the auditors' tolerance level. Our results are robust to alternative accruals measures, controlling for clients' internal control quality and corporate governance characteristics. [ABSTRACT FROM AUTHOR] more...

Accounting firms have steadily increased the use of outsourcing and offshoring of professional services including independent audit procedures. While firms suggest that the work is of higher quality and similar litigation risk, questions remain as to whether public perceptions may be more negative. This paper examines liability associated with an audit failure when work is performed by another office of the same firm or outsourced to a separate firm, and whether the work is performed domestically or in another country. Results indicate main effects for outsourcing on compensatory damages and an interaction between outsourcing and offshoring on punitive damages. Surprisingly, jurors assess higher than expected litigation awards for a failure by another domestic office of the firm for punitive damages. This result suggests that the close proximity in terms of both geography and organizational distance of the domestic office of the firm leads jurors to find the audit failure less understandable. Post hoc analyses indicate that potential jurors perceive that work completed by another domestic office of the firm has the highest expected quality and lowest risk, while work that is outsourced offshore is expected to be lowest quality and highest risk-consistent with proximity theory. [ABSTRACT FROM AUTHOR] more...

We examine how auditors' consideration of material items is affected by each item's directional impact on income. Prior research indicates that auditors face greater litigation risk for non-detection of fraudulent income-increasing items compared to income-decreasing items. Therefore, we expect that auditors will spend greater cognitive effort evaluating material income-increasing (as opposed to income-decreasing) items, resulting in superior memories for such items. However, in an effort to direct auditors' attention to both increasing and decreasing material items, we manipulate whether or not auditors were asked to form expectations about the future effects of material items. Our results indicate that auditors' memories for income-increasing items are significantly greater than that for income-decreasing items when auditors are not asked to form expectations about the future effects of the items. However, this difference is not observed when auditors are asked to form expectations about future effects of each item. Furthermore, our results indicate that auditors are less likely to refer back to the work papers to verify the accuracy of income-decreasing items compared to income-increasing items. This suggests that auditors are not inclined to compensate for their poor memory of income-decreasing items by referring to working papers. However, it also suggests that auditors compensate for the greater risk associated with income-increasing items by requiring greater verification of such items. [ABSTRACT FROM AUTHOR] more...

This research finds that local government-controlled companies are able to obtain more favorable audit opinions from local auditors when they face the need for new equity financing or the threat of exchange delisting. We capture this ability by comparing the observed opinions that companies receive from local auditors with those that we predict they would receive if they used a Big 4 auditor. Our empirical results highlight the importance of understanding political and economic institutions when analyzing the reporting behavior of managers and auditors in a transition economy, and suggest that regulators should be aware of the unintended consequences of basing capital market resource allocation decisions on reported accounting earnings, which can be subject to significant managerial discretion. [ABSTRACT FROM AUTHOR] more...

Internal control reporting continues to be of significant interest to regulators and legislators, as evidenced by the internal control-related requirements of the Dodd-Frank Act (2010) and the JOBS Act (2012) to exempt smaller firms from the requirements of Section 404. We extend prior research on the association between internal control weaknesses and audit report lag by (1) using data from 2008 and 2009, (2) comparing accelerated and nonaccelerated filers, and (3) examining the impact of remediation of previously disclosed internal control problems. We find that (1) in 2008, the increase in audit report lag in the presence of material weaknesses in internal control is lower for non-accelerated filers as compared to accelerated filers, and (2)while the effect of amaterial internal control weakness on audit report lag is significantly lower in 2009 than in 2008 for accelerated filers, there is no such change for non-accelerated filers. We also find that for firms remediating previously disclosed internal control problems, there is a significant decline in audit report lag; yet, the remediating firms continue to have higher reporting lags than firms that had clean Section 404 opinions in both years. We also find that, at least with respect to the effect of internal control problems on audit report lag, the "small accelerated filers" (defined as those with market capitalization less than $250 million) are treated by the auditors as being (1) substantively similar to other accelerated filers, and (2) quite distinct from non-accelerated filers. [ABSTRACT FROM AUTHOR] more...

Events leading up to the implementation of the Sarbanes-Oxley Act of 2002 (SOX) increased the public's focus on corporate governance and increased regulatory scrutiny of corporate governance mechanisms. These events also contributed to a massive restructuring in the audit market that resulted in the transfer of a large number of clients from Big N to non-Big N audit firms. We extend prior research examining the determinants of auditor-client realignments by investigating the effect of corporate governance on downward (i.e., from Big N to non-Big N auditors) switching activity. We develop a corporate governance index comprised of governance characteristics that we expect auditors to find more desirable in their clients (specifically, board and audit committee independence, diligence, and expertise). The results suggest that Big N auditors consider client corporate governance mechanisms when making client portfolio decisions. Specifically, downward auditor-client realignments are more likely for clients that score lower on our corporate governance index. However, the influence of audit committee-related corporate governance components on downward auditor-client realignments decreased post-SOX. The reduced effect of audit committee-related corporate governance components is consistent with what would be expected if the audit committee-related rules imposed by SOX reduced the variation in audit committee quality across clients. [ABSTRACT FROM AUTHOR] more...

We use simulation to investigate the joint effects of materiality, evidence extent, evidence nature, and misstatement type on achieved audit risk, i.e., the risk of undetected material financial statement misstatement due to error or fraud. Our primary results are fourfold. First, contrary to conventional audit wisdom, we show that elevating the extent of testing decreases achieved audit risk only under certain conditions and may well increase it. Second, reducing materiality (attempting to perform a more precise audit) can either enhance or jeopardize audit effectiveness. Third, learning about the quality of the internal controls over financial reporting not only can help the auditor to perform an integrated audit, but also helps the auditor to reach better judgments about the extent to which and how evidence from the auditee organization's management and/ or information systems may be distorted as a result of misstatement, reducing the risk that the auditor would be misled by such evidence. Fourth, when financial statements are biased intentionally due to fraud, it is especially important for the external auditor to supplement more traditional audit tests with tests that produce evidence that is less likely to be biased by management. Auditors who do not understand these four results run a heightened risk of compromising audit effectiveness. [ABSTRACT FROM AUTHOR] more...

Important audit judgments concerning client selection, audit program planning, and risk assessment all may be impacted by the approach taken to assess risk and to interpret audit evidence. This experimental study examines whether auditors' risk assessments are influenced by the risk assessment approach and by assertion framing. Risk assessment approach was manipulated by eliciting belief-based versus probability-based risk assessments. Assertion framing was manipulated by stating the financial statement assertions to be examined in a positive versus negative form. Four measures of risk of material misstatement are compared, including one based on the Cobb and Shenoy (2003a, 2003b, 2006) transformation of beliefs into "probabilities." Both risk assessment approach and assertion framing effects on the auditors' risk assessments are observed. Given these significant differences, the risk measure(s) the auditor chooses to focus on and the way assertions are framed are shown to be important audit choices in that such choices may impact both audit effectiveness and efficiency. [ABSTRACT FROM AUTHOR] more...

This study investigates whether the association between financial reporting risk and audit fees changed during 2000-2003: a time period marked by momentous and historic events for auditors. We find a positive statistically and economically significant relationship between financial reporting risk and audit fees paid to Big 4 auditors. More importantly, we predict and find that the relation between financial reporting risk and audit fees strengthened significantly in 2002 and 2003, consistent with a shift in the way auditors priced risk, likely in response to the events surrounding the Sarbanes-Oxley Act of 2002. Finally, we provide evidence that a commercially developed, comprehensive risk measure effectively proxies for an element of risk beyond what has traditionally been captured by various risk measures in audit fee models: namely, the risk that financial statements have been intentionally misstated. We believe this risk measure will be of interest to future researchers. [ABSTRACT FROM AUTHOR] more...

In an experiment involving a dyadic negotiation between a computer-simulated client and practicing auditors, we examine the effects of engagement risk and auditor negotiation experience on the process and outcomes of client-auditor negotiations. We find that auditors with lower negotiation experience who encounter a high risk client use a more concessionary negotiation strategy, achieve a negotiated outcome that is more aggressive (consistent with the client's aggressive preference), and are less confident that the outcome they negotiate is acceptable under GAAP compared with the negotiation process and outcome results of auditors with higher negotiation experience. In contrast, auditors with higher negotiation experience use a less concessionary strategy, achieve an outcome that is more conservative regardless of risk context, and are more confident that the outcome they negotiate is acceptable under GAAP. This study illustrates the important roles that engagement risk, task-specific negotiation experience, and pressure from the client regarding an aggressive financial reporting preference play in the process and outcomes of client-auditor negotiation. [ABSTRACT FROM AUTHOR] more...

The market for audit services has been affected in recent years by significant changes like the demise of Andersen and the implementation of the Sarbanes- Oxley Act of 2002. One impact of these market changes has been an increase in the frequency of auditor switches, and in particular, the frequency of clients switching from Big 4 auditors to smaller audit firms. We examine whether this switching activity has resulted in changes in the risk characteristics of publicly traded clients of Second Tier audit firms. This analysis is important as regulators are concerned about audit market concentration and would like to see the Second Tier audit firms expand their share of the publicly traded client market. Results indicate that Second Tier firms are accepting clients with potentially increased audit and client business risk characteristics relative to their existing client base, but they also appear to be ''shedding'' clients that have increased audit and client business risk characteristics relative to their existing client base. Some of the differences in risk characteristics for those departing clients are more pronounced in the period after 2000, when we expect the most significant changes in the audit market occurred. Second Tier auditors are increasingly exposed to more business risk as they accept larger clients coming from Big 4 predecessor auditors, which may increase their exposure to litigation. [ABSTRACT FROM AUTHOR] more...

Auditors are required to use analytical procedures to identify the existence of unusual transactions, events, and trends. Benford's Law gives the expected patterns of the digits in numerical data, and has been advocated as a test for the authenticity and reliability of transaction level accounting data. This paper describes a new second-order test that calculates the digit frequencies of the differences between the ordered (ranked) values in a data set. These digit frequencies approximate the frequencies of Benford's Law for most data sets. The second-order test is applied to four sets of transactional data. The second-order test detected errors in data downloads, rounded data, data generated by statistical procedures, and the inaccurate ordering of data. The test can be applied to any data set and nonconformity usually signals an unusual issue related to data integrity that might not have been easily detectable using traditional analytical procedures. [ABSTRACT FROM AUTHOR] more...

Recent debates on audit committee financial expertise have focused on ''accounting'' and ''nonaccounting'' financial experts. A significant proportion of firms do not appoint accounting financial experts (i.e., persons with specialized accounting/ auditing experience) to their audit committees. We examine the determinants of firms' choice of the ''audit committee financial experts'' for a sample of Fortune 1000 firms. We test the relation between the demand for accounting financial experts (AFEs), potential litigation risk, and corporate governance. We find that firms with higher litigation risk are more likely to have AFEs on their audit committee. However, the association between litigation risk and the likelihood of appointing accounting financial experts occurs for firms with relatively strong governance but not for those with weak governance. Thus, our findings indicate that (1) companies with demand for accounting financial experts–measured by potential litigation risk–seem to be able to secure accounting financial experts, but (2) such benefits only accrue in the presence of otherwise strong corporate governance. [ABSTRACT FROM AUTHOR] more...

In order to plan and perform an effective audit, auditing standards and existing research call for auditors to consider relations between accounts (American Institute of Certified Public Accountants [AICPA] 2006; Leitch and Chen 2003; Vandervelde 2006) and how various pieces of evidence fit together to arrive at audit conclusions (Bell et al. 2005). In this study, we illustrate the importance of these broad concepts and their effect on audit effectiveness. Using expectation models and multivariate normal theory, we show that consideration of relations between accounts and the concurrent (joint) analysis of accounts can lead to fewer Type II errors than individual analysis of accounts in isolation. We further show that this reduction of Type II errors is affected by the complexity and uncertainty of both the endogenous business process and exogenous business environment. Even when simply using prior-period account balances in a martingale expectation model for related accounts considered concurrently, we find fewer Type II errors result when simpler and less complex business process and business environment are present. Such a reduction in the number of Type II errors leads to increased audit effectiveness and reduced audit risk. Accordingly, our results suggest that auditors in the planning as well as in the evidence accumulation and evaluation stages should consider related accounts and consider them jointly in their assessment. [ABSTRACT FROM AUTHOR] more...

This study examines whether profit-sharing arrangements within accounting firms are associated with the riskiness of their client portfolios. Our results use unique data about the profit-sharing arrangements of the Big 8 firms during the period 1985 to 1994. We investigate whether there is a correlation between profit-sharing and risky clients. Firms consist of the financially integrated firms, i.e., those that share their profits across a large pool of partners across the country and the financially independent firms that share their profits in a small pool on a local office basis. The large-pool firms provide more incentive for partners to cooperate to audit high-risk clients than the small-pool firms. Our results show that the large-pool firms are associated with riskier client portfolios; this is indicated by a higher proportion of fees from clients that later suffer from bankruptcies. In contrast, a smaller proportion of the clients of the small-pool firms go bankrupt. Tests using financial distress as alternative measures of client risk confirm this result. [ABSTRACT FROM AUTHOR] more...

This paper explores broad trends in regulation of the auditing profession from 1981-2005, the first 25 years of Auditing: A Journal of Practice & Theory. It begins with a sketch of the 1980 regulatory environment, three constants over the next 25 years, and three external developments or "shocks" that dramatically affected audit regulation activity. The initial conditions, constants, and shocks are then related to audit regulation beginning with the audit risk model in the 1980s as the basis for self-regulated auditing standards, continuing with a vision of unregulated, non-mandated value-adding assurance services in the 1990s, and finally, the 2002 statutory adoption of independent regulation of registered accounting firms and a government-sanctioned corporate governance role for auditors. I close with some implications of the 2005 audit regulation environment for future auditing scholars and practitioners. [ABSTRACT FROM AUTHOR] more...

This article presents information several papers related to auditing. The first paper is "Client Retention and Engagement-Level Pricing." It is a study which contributes to the debate on the motives for auditor changes by examining the relationship between client retention and one of the many factors that potentially influence client retention, engagement-level pricing. Another paper is "Nonlitigation Risk and Pricing Audit Services," which demonstrates that audit fees reflect risks and activities that extend beyond the provision of the audit. more...

In this study we expand the audit fee model introduced by Simunic (1980) and extended by Houston et al. (1999) by adding a third factor, nonlitigation risk, which refers to general business risks and/or opportunities that extend beyond litigation risk or the conduct of the audit (e.g., opportunities for future audit and nonaudit revenues, potential damage to the auditor's reputation from involvement with a client). In an experiment, we ask audit partners and managers to assess various risks and develop an audit plan after reviewing one of four risk-increasing audit scenarios — the discovery of an error, the discovery of a GAAP inconsistency, a client buyout where the audited financial statements are used in the determination of the exchange price, and the loss of a major client customer. We find that, in the error and buyout cases, audit fee increases are explained only by the planned increase in audit investment; in the GAAP inconsistency case, the audit fee increase is explained in part by the planned increase in audit investment, but to a greater extent by residual litigation risk; in the loss of customer case, the audit fee increase is explained by the planned audit investment, residual litigation risk, and nonlitigation risk. These results suggest that business risk is comprised of at least three factors (acceptable audit risk, residual litigation risk, and nonlitigation risk), and that auditors are compensated to act as auditors, provide insurance for investor losses, and bear risks associated with factors that extend beyond the conduct of the audit. We also discuss how nonlitigation risk can clarify the results of previous research and be used in future research. [ABSTRACT FROM AUTHOR] more...

This study is the first in an auditing context to examine auditor susceptibility to memory conjunction errors, a type of systematic memory error that is related to the memory reconstruction process. Conjunction errors occur when memory traces associated with one event are incorrectly attributed to another event during memory reconstruction. Auditors may be particularly susceptible to memory conjunction errors due to their simultaneous exposure to multiple audit clients and their use of standardized audit forms and checklists to capture information. Unrecognized, such errors could adversely affect the efficiency and/or effectiveness of the financial statement audit process. We conducted an experiment that employed practicing audit professionals addressing multiple audit clients. Consistent with our hypotheses, the results indicate that memory conjunction errors in an audit environment are a complex function of (1) the consistency between the audit evidence recalled from an unrelated audit and the characteristics of the client that is the target of the memory reconstruction, (2) the consistency between this recalled audit evidence and the characteristics of the client to which the evidence is actually associated, and (3) the level of risk present in the audit environment that is the target of the memory reconstruction. While research has shown that audit risk factors can generally serve to decrease some types of auditors' memory recognition errors in single client situations (e.g., Sprinkle and Tubbs 1998), our results show that increases in audit risk can actually exacerbate memory errors involving multiple audit clients and memory conjunction errors. Finally, the findings of the study suggest that auditors are not only susceptible to memory conjunction errors, but also that such errors may play a significant role in elements of the audit-planning process related to auditors' likelihood of material error assessments. [ABSTRACT FROM AUTHOR] more...

The article examines the effect of risk factors on risk and control risk assessments of auditors. It shows that pervasive and specific inherent risk (IR) and control risk (CR) factors were significant in both auditors' IR and CR assessments. It also found a significant positive correlation between auditors' JR and CR assessments for the case used in this study. There exist a significant positive correlation between auditors' JR and CR assessments for the case used in this study. It analyzes background information on the audit risk model and develops the hypotheses followed by a section that describes the methodology used to gather and analyze the data. Two hypotheses concerning the significance of inherent and control risk factors on auditors' inherent risk (IR) and control risk (CR) assessments were tested by having 124 senior auditors and managers provide risk assessments on eight cases. The results show that the pervasive and specific risk factors included in the experiment were significant to both the auditors' IR and CR assessments. more...

The article presents a study of risk assessments as inputs for using the audit risk model by auditors. The consideration of audit risk is a major focus for balancing the trade-offs between efficiency and effectiveness in audits. It examines whether component audit risks are assessed independently or are assessed interdependently and conditionally. An experimental approach is made in which experienced auditors assessed the three components of the audit risk model that they regularly use as inputs to their sampling plans in practice. Conditional dependencies were tested using sequential linear models in which earlier risk components were added as independent variables to explain later risk components. Results showed that the upstream risk assessments were statistically significant, substantially increasing the explanatory power of the models in accounting for variation in the downstream risk assessments. Assessed control risk had a significant effect on the subsequently assessed analytical procedures risk. These experimental findings support practitioners' claims that their use of the audit risk model does not systematically underestimate the risk of material misstatement. more...