Audit Quality:
What are the weak links?
4th EIASM-BOCCONI
WORKSHOP ON AUDIT QUALITY
27 September 2012*
by
Theodore J. Mock
University of California, Riverside
tmock@ucr.edu
*Updated following Workshop. See notes for
some additional explanation and comment
Audit Quality [ AC ]:
Some preliminary questions
• Is there a problem? Are there weak links in the
chain of activities that produces a financial
statement audit? And if so what are [is]:
– The weak links that sometimes break?
– The weakest Link? (What is a ‘weak link’?)
– The opportunities to strengthen these weak links?
• What does ‘practice’ and the press say?
• What does research say?
• What role can we [academics] play in
strengthening the weak links?
Is there a Problem?
Audit Quality is not what it might be!
24 August 2012
AIU Audit Quality summary
http://youtu.be/kHn9CdCb-g4
Biggest audit firms hit
by scathing regulator's
verdict [22 Sept 2012 ?]
Bad Grades are rising for Auditors**:
Are audits getting worse? Or are the inspectors
getting pickier? …
“A Review of audits finds a decline in their quality”
…
Audit Firm
% deficient 2009
% deficient 2010
D&T
19%
45%
PwC
12%
39%
KPMG
22%
23%
E&Y
9%
21%
Average
15%
33%
** “ the [PCAOB] Board cautions against extrapolating from the results …
What is a ‘weak link’ and what are
some possible examples?
Lack of Professional Skepticism
Lack of Independence
Excessive
Legal liability
Dysfunctional
Regulation
Lack of Expertise
Inadequate Formal Education,
Training and Continuing Education
Please Complete the handout and
respond to two Questions
Q1: Given that there is
evidence that audit quality is
‘less than ideal’, what do
you believe is The Weakest
Link in achieving an
acceptable, if not ideal, level
of audit quality?
Please Respond to
Question # 2
Q2: Given that audit quality knowledge,
and thus the academic research that
produces this knowledge, is incomplete
with respect to our understanding of AQ,
what is the weakest link, that is the main
constraint, that limits our ability as
academics to develop the AQ knowledge
[research] that is needed?
There are 6 categories and many audit variables that
may affect AQ
Category
Some Examples
1. Audit Firm Audit Firm ‘Culture’, Human Resources, Organization Structure, Incentive
Variables
Schemes, Specific Auditor Characteristics, Quality Control
Process/Procedures, Audit Methodology, Audit Process [see #2],
2. Audit
Client selection/continuance process; audit planning process [assess RMM,
Process
CR, FR, conduct ARPs, etc.]; audit program planning [determine NETS for
control and substantive testing]; audit testing [evidence collection and
documentation]; evidential reasoning and decision phase; reporting phase,;
review and quality control
3. Audit Client Client Type [private, public, international, etc.], Organization Structure,
Incentive schemes, Code of Conduct, Complexity, System of Internal Control,
4. Audit
Economic, political, regulatory regime, litigation, Information technology, rate
Environment of environmental change, changes in demand for assurance services [e.g.
sustainability report assurance], …
5. Audit
Student quality, faculty quality, faculty incentive structure, Program types,
Education pedagogy,
6. Audit
Research method, training, support, resources, incentive systems, data access
Research
Other frameworks of audit variables that may affect AQ
‘Weakest Links’
Framework [2012]
UK FRC AC Framework
[2006]
Audit Firm
- Audit Firm Culture
- Skill and Qualities of
Personnel
Audit Process
Audit Client
Audit Environment
Knechel et al. Synthesis Project
‘Indicators’ Framework [2012]
Inputs
- Incentives & motivation
- Professional Skepticism, Etc.
Process
- Effectiveness of Audit
- Judgment
Process
- Risk Assessment
- Reliability & Usefulness of - Review & Quality Control, Etc.
Audit Reporting
Outcomes
- Adverse outcomes
- Audit Reports, Etc.
Context
Factors outside of control of - Partner compensation
- Audit & Non Audit Fees
auditors
- Auditor Tenure
Audit Education
Audit Research
Identifies multiple research
opportunities
Compilation of Question #1 Weakest AQ link[s] as
indicated by workshop participants [ N = 26 responses]
‘Weakest Links’
Categories
Audit Firm
[N = 19 responses]
Audit Process [ 1 ]
Audit Client [ 1 ]
Audit Environment
[6]
Summary of factors thought to possibly lead to
low AQ.
Incentive Issues [ n =10]
Auditor characteristics:
- lack of independence (5)
- Competence, expertise, skills ( 3)
- Lack of Professional skepticism ( 1 )
Audit Report limitations ( 1 )
Lack of evidence, unobservable F/S attributes ( 1 )
Fee pressure ( 4 ) ; Expectation gap ( 1 ); Political ( 1 )
Audit Education
[ none ]
Audit Research
[ none ]
Other [ 1 ]
Holistic/System-Complexity Issues [Quality is a result of
a multitude of interacting variables ] ( 1 )
Weak Links: Some other possibilities
identified from professional sources
• Lack of fundamental professional scepticism …[UK FRC
Audit Inspection Unit ]
• Frequent Audit Deficiencies* [PCAOB Inspections]
1. Failure to test issuer assumptions [ 20% Deficiencies]
2. Failure to test valuation or other models [16.2%]
3. Insufficient audit evidence [16.2%]
4. Inappropriate reliance on controls [10.7%]
• Agenda Items from Regulatory Bodies:
1. Auditor’s Reporting Model [IAASB, PCAOB]
2. Audit Independence [PCAOB]
3. Failure to Supervise [PCAOB]
Some ‘Weak Links’ based on my audit research
• Mock & Turner [1977] & related studies : Research on Auditor’s Investigation and
Analysis of Client’s Internal Accounting Controls:
– Significant Unexplained decision or judgment variance;
– ‘Questionable judgments’,
– Dysfunctional Partner Review Effects,
– Poor Rationale Documentation
• Mock & Wright [1999] and related studies: Research Asking the Question ‘Are
Audits Risk Adjusted’?:
– Auditor’s exhibit significant difficulty in linking their risk assessments and the
nature, extent or timing of audit procedures …
• Srivastava and Mock [2005], Fukukawa & Mock [ 2010]: Evidential reasoning and
risk assessment research:
– Audit evidential reasoning decisions exhibit extreme Cognitive Complexity
and analytical challenges and must reconcile Alternate audit risk concepts,.
• The Audit Report [Grey, Mock & Turner 2009] and the AAA Audit Section
Synthesis project [ 2012]: Significant weaknesses in quality of auditor
communications, a wide ‘expectation’ and ‘information’ gap exists.
Based on this, two strong candidates for ‘The
Weakest Link’ are
#1. Limitations, biases, and lack of clear guidance results
in audit quality breakdowns related to basic Auditor
Judgment .
Thus, opportunities for enhanced AQ include:
– Enhanced University-Level Education
– Better audit Judgment and Decision Making Research
– Improved Audit Firm Training, Decision Aids, Quality
Control Review and Audit Documentation, …
– Enhanced Professional-Level Quality Control [e.g. PCAOB
and UK AIU inspection & enforcement] and transparency
as to inspection results.
Two strong candidates for ‘The Weakest Link’
[continued]
#2. The 2012 AAA Audit Section synthesis project
on The Audit Reporting Model clearly suggests
that at least perceived AC can be improved by
enhanced audit communications [closing the
expectation AND information gaps].
What the 4th Bocconi AQ Workshop papers imply
concerning ‘weak links’
Category of
Variables
Variables Studied & Basic Research Findings in the
4th AC Workshop papers [N = 18 papers]
Audit Firm
Audit Process
7 studies
None!
Audit Client
3 studies
Audit
Environment
5 studies
Audit
Education
Audit
Research
Not directly
related to AC?
Totals:
Research
Method
5 archival
2 survey
None!
1 Archival
1 Survey
1 Experimental
3 Archival
1 Survey
1 Experimental
None
None
[3]
[3]
3 Archival
3 studies
18 studies
12 Archival
4 Survey
2 Experimental
What the 4th Bocconi AQ Workshop papers imply
concerning category of weak links & research methods
Category of
Variables
Audit Firm
Audit
Process
Variables Studied & Basic Research Findings in the
4th AC Workshop papers [N = 18 papers]
- Office industry expertise [ and related efficiencies] is
‘not detrimental’…;
- Both ‘insiders’ & ‘outsiders’ perceptions of AQ rate audit
firm attributes higher that audit-team attributes;
- [Some] Human Resource policies significantly relate to
AC;
- Engagement partner ‘type’ is associated to AC;
- Auditor ‘social capital’ is positively associated with AC.
- Effect of office-level characteristics [e.g. industry
expertise] on AC depend on the client’s industry
complexity;
- Multi-level modeling confirms importance of audit firm
[rather than office differences]
None!
Research
Method
5 archival
2 survey
None!
What the 4th Bocconi AQ Workshop papers imply
concerning category of weak links & research methods
Category of
Variables
Variables Studied & Basic Research Findings in the
Research
4th AC Workshop papers [N = 18 papers]
Method
BAQC 08: compelling evidence in favor of the explanation that
1 Archival
Audit Client family firms have superior financial reporting quality
1 Survey
BAQC 14: … audit committee members view appropriate
1
auditor communication and their perceived effectiveness of
Experimental
monitoring the external auditor to be significant determinants of
perceived audit quality.
BAQC 09: … when the [client] manager takes an incentiveinconsistent action on an initial proposed audit adjustment,
auditors …are more likely to allow the manager to meet or beat
the consensus analysts’ EPS forecast. …also find evidence [that]
auditors put more trust in a [client] manager who initially takes
an incentive-inconsistent action, …
Audit
3 Archival
Environment
[ see next slide ]
1 Survey
1
Experimental
What the 4th Bocconi AQ Workshop papers imply
concerning category of weak links & research methods
Audit Client
Audit
Environment
Variables Studied & Basic Research Findings in the
4th AC Workshop papers [N = 18 papers]
Research
Method
BAQC 04: RQ1: Results support predictions that the effect of office-level characteristics on audit
quality depend on the complexity of the client’s industry and that the engagement office’s industry
expertise is more important than office size in those industries with a high level of accounting
complexity, and that the opposite is the case in industries with low complexity.
3 Archival
1 Survey
1
Experimental
BAQC 03: Main Results: audit quality, proxied by two different measures of earnings
management, improves following mandatory audit firm rotation
BAQC 07: RQ: How does mandatory auditor rotation affect AC? Results: we find evidence of
lower quality audited earnings in the first three years following mandatory auditor rotation,
relative to later years of auditor tenure.
BAQC 12: RQ: What is the effect of non audit services threats on independence perceptions …
Univariate results show that a high self-interest and a high familiarity threat, as well as the
existence of a self-review threat, impair auditor independence in appearance. ...
BAQC 13: RQ: Do joint audits improve AC [? Results: Our results confirm .. 1) …, and 2) the nonsignificance association between joint audit and abnormal accrual . [No sig effect on AC]
BAQC 15: RQ: What is the impact of the proposed regulator measures [ regulators have
proposed numerous changes including the prohibition of non-audit services, mandatory
external rotation, mandatory joint audits, and the auditor being appointed by an independent
regulator. ] on … closing the ‘expectation gap’? Basic Results: .. none of the four proposed
measures is estimated to generate an incremental net benefit. …only two of the measures,
external rotation and prohibiting non-audit services, are estimated to make a significant
contribution to closing the expectation gap.
So What?
Assuming this ‘exercise’ has provided each of us
with a better idea as to some key weak links
and critical factors which affect AQ, so what?
What can we do as teachers and researchers?
First, given that this is primarily a research
workshop, lets consider your ideas as to
research constraints & opportunities.
Compilation of Research Weak Links and
Opportunities from Workshop participant’s
replies to Q2 [ N = 26 responses]
Number
Category
indicating
Some examples
Data
12
Data Proprietary; Audit process is
Constraints
unobservable; Too costly to obtain;
Measurement
11
AC is Not observable; Not directly
difficulties
measurable.
Definition
3
Definition Not generally accepted;
difficulties
Quality Threshold not established
Research
1
Little opportunity to conduct
Methods
experimental research.
Resource
1
Lack of resources to conduct research.
Constraints
What important roles can we
[academics] play in addressing the
problem?
1. Enhance the education process at all levels. To
do this we need better research knowledge
about possible weak links in the audit
decision/judgment process and how they impact
AC. Thus
2. We need to provide better research on audit
judgment and individual difference factors that
are linked to AQ.
What important roles can we
[academics] play in addressing the
problem?
1. Provide needed research
2. Enhance the education process at all levels.
How can we provide the kind of graduates
that will provide QAs when we have little
research knowledge about weak links in the
audit decision/judgment process?
AQ Research: Insights & Opportunities
Some Research Challenges & Weak Links
1. Objective/Scientific Methods of Synthesizing Prior
Research [ See Knechel et al 2012]
2. Research skill set and related biases of academics
3. Practice Opportunities [i.e. inspections] &
Impediments [i.e. confidentiality, litigation]
4. Academic Opportunities & Impediments
Summary Slide: Audit Quality: What are the weak links?
• Although the ideal, equilibrium level of AQ is probably in determinant, there is
consensus that AQ is deficient in too many cases.
• There is likely not ‘a single weakest link’ in AQ, however there are many variables that
relate to AQ, some of these are evident in prior research, in the inspection activities of
regulators, and in the replies to the ‘weakest link’ survey of Workshop participants. Key
among these are variables which relate to
a) Audit firm variables such as incentive schemes
b) Audit judgment and individual auditor variables such as level of professional
skepticism and cognitive constraints
• As educators, we have opportunities in both teaching and research to enhance AQ
• However, AQ research is constrained by lack of access to important data, lack of
operational measures of AQ and in some cases resource constraints.
• Although not a focal topic of this presentation, it seems likely that audit education
and its impact on AQ is a largely unexplored topic.
Selected References
Biggs, S. and T. Mock. 1983 An Investigation of Auditor Decision Processes in the
Evaluation of Internal Controls and Audit Scope Decisions, Journal of Accounting
Research
Financial Reporting Council (FRC). 2006. Promoting Audit Quality. Discussion Paper.
Fukukawa, H. and T. Mock. 2011. Audit Risk Assessments Using Belief versus Probability,
Auditing: A Journal of Practice & Theory.
Grey, G. et al., 2012. Perceptions and Misperceptions Regarding the Unqualified Auditor’s
Report by Financial Statement Preparers, Users, and Auditors, Accounting Horizons,
25 (4): 659–684
Griffith, Hammersley & Kadous 2010 Auditing Estimates ….
Knechel, W. R., G. Krishnan, M. Pevzner, L. Shefchic, & U. Velury, 2012. Audit Quality
Indicators: Insights from the Academic Literature. AAA Audit Section Synthesis
Project.
Mock, T. & J. Turner. 1981. Internal Accounting Control Evaluation and Auditor
Judgment, Audit Research Monograph #3, American Institute of CPAs.
Mock, T., J. Turner, G. Gray & P. Coram. 2009. The Unqualified Auditor’s Report.
AICPA/IAASB Research Report
Mock, T & A. Wright , 1999. Are Audit Program Plans Risk Adjusted?, Auditing: A
Journal of Practice & Theory.1999
Mock, T. Et al., 2013 [forthcoming]. The Auditor's Reporting Model: Current Research
Synthesis and Implications, Auditing: A Journal of Theory & Practice,
Srivastava, R and, T. Mock, 2005. Why We Should Consider Belief Functions in Audit
Research and Practice. The Auditor’s Report. Vol. 28, No. 2.
Srivastava, R, T. Mock, A. Wright & K. Pincus. 2012. Multiple Hypothesis Evaluation in
Auditing, Auditing: A Journal of Practice & Theory