Showing papers in "International Journal of Auditing in 2004"

Benchmarking Audit Committee Effectiveness in Financial Reporting

Abstract: This paper examines the effectiveness of UK audit committees in their primary responsibility of overseeing financial reporting. A logit regression approach is used to benchmark corporate financial reporting quality against financial reporting standards in the period from 1991 to 2000. Using a sample of companies that have been subject to adverse rulings by the Financial Reporting Review Panel (FRRP), we test the impact of board and audit committee characteristics on the probability of compliance with financial reporting standards. Our results show that independent boards promote audit committee effectiveness in financial reporting and suggest that director share ownership and multiple directorships could undermine audit committee effectiveness in financial reporting. We also suggest that director financial literacy and an ‘active’ audit committee may contribute to audit committee effectiveness.

An Empirical Study of Audit ‘Expectation Gap’ in The People's Republic of China

Abstract: The audit ‘expectation gap’ is a crucial issue associated with the independent auditing function and has significant implications on the development of auditing standards and practices. Through a questionnaire survey, this study investigated the rise of ‘expectation gap’ and related auditing issues under business and auditing environment in the People's Republic of China. The results reveal that the role and benefits of public accounting (independent auditing) had been positively recognized by Chinese audit beneficiaries and auditors, and there were increasing demands for expanding the applicability of public accounting. This study obtained substantial evidence on the emergence of audit ‘expectation gap’ in China, with respect to audit objectives, auditor's obligation to detect and report fraud, auditor independence, and third party liability of auditors. The causes and practical implications of the ‘expectation gap’ are therefore analyzed contextual to the present practices of public accounting in changing Chinese social and economic conditions. This study should cast light on understanding of the institutional setting and recent development of independent audits in China.

A Grounded Theory Model of Auditor‐Client Negotiations

Abstract: The central research question addressed in this paper is ‘How do companies and their auditors resolve important audit issues?’ In-depth interviews are conducted with the audit partners and finance directors of a varied group of six major UK listed companies who had recently experienced audit interactions involving 22 significant accounting issues. A grounded theory model is developed of the negotiation process and the factors that influence the nature of the outcome of interactions. This model identifies, as principal analytical categories, a range of general relationship factors and specific accounting issue factors that influence aspects of the negotiation process. These aspects include the parties involved, the strategies adopted, the quality of the financial reporting outcome and the ease with which it is achieved. A secondary outcome of the research is that distinct categories of audit engagement partner are identified, termed the crusader, the safe pair of hands, the accommodator and the truster.

Does Agency Theory Provide a General Framework for Audit Pricing

Abstract: This paper examines whether agency theory provides a general framework for audit pricing. It is hypothesized that audit fees are determined by agency theory and a set of other factors identified in the previous literature. To empirically test the hypothesis, audit pricing is analyzed in seven countries representing different kinds of accounting and economic environments. The results of the study confirm that a negative relationship exists between audit fees and manager ownership and that a positive relationship exists between audit fees and free cash flow in several countries. This implies that agency theory can be used, at least to some extent, to explain audit fees internationally. Moreover, agency theory explains audit fees similarly across countries while the control variables have different impact on audit fees.

Audit fees and market segmentation - further evidence on how client size matters within the context of audit fee models

Abstract: The purpose of this paper is to examine the audit fee premium to the Big 6 brand in the small and large client segments of the market for audit services. We use a sample of Australian fee data for the five-year period 1995 to 1999. We find evidence of price premiums to Big 6 auditors in the small client segment. We do not find evidence of fee premiums in the large client segment. We also present evidence that audit fees are not linearly related to client size as is typically assumed in audit fee models.

The Reform of the UK's Auditor Independence Framework after the Enron Collapse: An Example of Evidence-based Policy Making

Abstract: 2University of Glasgow Following the collapse of Enron, the UK government set up a high level group of regulators and ministers to co-ordinate a review of the UK regulatory framework, including the key area of auditor independence. The Accountancy Foundation Review Board (Review Board), which was at the time responsible for the independent oversight of the UK accountancy professional bodies, took the leading role in the auditor independence review. A programme of research was set up by the Review Board and studies were provided by other bodies. The results of the research were compiled into a paper which underpinned the Review Board’s recommendations for change. This was fed into the government review process. In this paper, the research is summarised and the Review Board’s evidence-based recommendations are presented and compared with the government’s final position. Few differences are found. Insights are provided into the nature of the regulatory reform process and the quality of the evidence which underpinned it.

Voluntary Audit Committee Formation and Practices among Belgian Listed Companies

Abstract: In this paper we investigate some factors that are associated with voluntary audit committee formation in a non-Anglo-Saxon environment (and where audit committee formation is voluntary, even for listed companies). For those companies that voluntarily instaled an audit committee we also present evidence on their working practices. We use data from Belgian listed companies for that purpose. Consistent with previous Anglo-Saxon research, we find that voluntary audit committee formation is positively correlated with the proportion of independent directors on the board of directors and external audit-firm size. Contrary to prior studies, we do not find that agency costs and board size are associated with voluntary audit committee formation. As to working practices, we find that a substantial amount of Belgian-listed companies do not comply with the recommendations of the Brussels Stock Exchange regarding audit committees, as about 50% of these companies has no audit committee. Those companies that do have an audit committee perform quite well according to the Belgian recommendations, but not according to recently formulated (tougher) US requirements, as they typically do not include a financial expert nor disclose the audit committee charter.

Auditor Detected Misstatements and the Effect of Information Technology

Abstract: This paper presents information on the causes and detection of misstatements by auditors and the relationship of those misstatements with information technology (IT). The last major study of misstatements and IT used data that were gathered in 1988. In the intervening period, there have been significant changes in IT, possibly altering the error generation and detection process. Two research questions related to detected misstatements and the effect of IT are examined. The six largest public accounting firms in Norway provided data from 58 engagements. We find that (1) the major causes of misstatements were missing, poorly designed, and improperly applied controls; inadequate methods used to select, train and supervise accounting personnel; and an excessive workload for accounting personnel, (2) missing and poorly designed controls, and excessive workload for accounting personnel were more likely to be causes of misstatements in computerized business processes than those that were not computerized, and (3) the increased use of tests of details over attention directing procedures on audits appears to result from auditors deciding that it is more effective or efficient to conduct such tests than rely upon IT controls. These findings have important implications for both audit practitioners and researchers.

The Role and Functions of Audit Committees in the Indian Corporate Governance: Empirical Findings

Abstract: This paper examines the composition, focus and functions of audit committees (ACs), the effects of meetings and the criteria used in the selection of members by Indian listed companies from 73 questionnaire responses. The survey was carried out during February–March, 2002. The study reveals that so far only 56.2% of companies have established an AC despite the fact that it is now mandatory. Of those companies which have ACs, 68.3% have between three and six members on ACs. However, only 14.6% of companies have independent non-executive directors on the committee, while 90.2% have non-executive directors. This shows a lack of independent representation on the committees. The functions of ACs are quite diverse and are classified in three areas: financial statements and reporting, audit planning, and internal control and evaluation. The review of annual audited financial statements, discussion and recommendations of audit fees and review of the effectiveness of internal control were rated very highly by the respondents. The review of note disclosure and scope of external audit work are other important functions performed by ACs. The most important areas for focus are compliance with the standards and regulatory bodies, probing material items and undisclosed liabilities. However, there are statistical differences between medium and large sized companies in the performance of their role. The main criteria used for membership of an AC are: experience and knowledge of business, experience of holding similar positions and accounting and finance expertise. Ownership in the company was not perceived as an important criterion. The majority of companies’ AC meetings are held monthly or quarterly. MANOVA analysis reveals that the frequency of AC meetings has an effect on the internal control functions. The study concludes that the concept of an AC is not new in India but their formation is slow and their composition lacks independence. AC functions are still concentrated in the traditional areas of accounting and their role is not changing fast enough to make the corporate governance more effective.

Tests of Control in the Audit Risk Model: Effective? Efficient?

Abstract: Lately, the Audit Risk Model has been subject to criticism. To gauge its validity, this paper confronts the Audit Risk Model as incorporated in International Standard on Auditing No. 400, with the real life situations faced by auditors in auditing financial statements. This confrontation exposes serious deficiencies in the Audit Risk Model, especially regarding tests of control. One conclusion is that internal controls that cannot be reperformed by an auditor, should be disregarded in assessing control risk. Another conclusion is that tests of the other internal controls are far more effective in focusing specific substantive tests, than in assessing control risk with the aim of reducing the size of a random sample. The paper concludes with a proposal for restructuring the audit process.

Does the Adoption of a Business Risk Audit Approach Change Internal Control Documentation and Testing Practices

Abstract: The purpose of this study is to investigate the impact of the adoption of a business risk audit approach on internal control documentation and testing. Data were collected from senior auditors before and after a change to a new business risk approach to determine if auditors’ preferred internal control documentation format, as well as the number of formats commonly used, had changed. In addition, corroborating data were collected from 23 experienced managers and partners regarding preferred documentation format and extent of control testing and reasons for changes in control evaluation and testing approaches. The results suggest that auditors use narratives significantly more often and rely on other formats significantly less than previously. In addition, results indicate that the primary reason auditors choose to rely on narratives is to enhance audit efficiency, and second, because the flexibility of this format works well with the new audit approach adopted. These findings have implications for audit effectiveness, since recent research suggests that significant internal control deficiencies may be overlooked if auditors rely on a single format. Finally, auditors indicated that the frequency of testing of controls has significantly increased as a result of the enhanced audit focus on business processes.

The Market for Professional Services in Indonesia

Abstract: This paper reports the results of a study which investigates the market for professional services in Indonesia, a country which has not been investigated in the by audit fee literature prior. A well-developed research model used in the prior literature has also been applied in this study, and the empirical findings suggest broad similarities in the pricing of professional services in Indonesia and other countries previously studied. In addition to extending the results of prior research to a country not previously studied, this paper examines whether the large auditors fee premium documented in other countries exists in Indonesia, especially after the major Asian financial crisis of 1997/98, since then almost all companies in this geographical area exercise tight budget controls. The results suggest that no audit fee premium is accrued to Indonesian Big 5 auditors, in contrast to the large audit firm fee premium documented in many other countries.

Discretionary Pricing in a Monopolistic Audit Market

Abstract: This paper investigates the possibility of discretionary audit pricing in a monopolistic public sector market. The underlying rational of the fee determinant model has different expectations (in terms of profit-seeking behaviour, loss functions and liability exposure) from that implicitly employed in the broader audit fee literature, but incorporates the same variables. The opportunity for discretionary pricing is considered in the context of different types of auditees for which the auditor has varying degrees of monopoly power. Results are consistent with audits having lower (higher) input cost where loss exposure is lowest (highest) and acceptable audit risk is highest (lowest), and with the cost savings being appropriated by the auditor where monopoly power is the greatest and with fee discounting for agencies for which the auditor faces the greatest threat of competition.

The Role of Quality Auditing in the Continuous Improvement of Quality: Lessons from Pakistani Experience

Abstract: Internal auditing is widely recognized as an important business tool in the area of quality management. This article examines the technique and role of internal audits in the continuous improvement of the quality of the sports goods industry in Pakistan. Toward this goal, a survey of 100 ISO 9000 certified companies was conducted at the end of 2001 and 88 usable questionnaires were obtained. It was observed that about 70 percent of the firms have established internal quality audit departments with an average duration of 2.5 years. Since then, the rejection rate has been reduced to an average 2.8 percent from the initial 7.9 percent defects. Moreover, the internal auditors are well trained, their professional skills are highly rated and they enjoy good relations with the production staff and/or auditees. The management of the sports goods industry benefited in terms of reduction in cost, defects, non-conformity, rejection and also better and improved ways of doing their routine work. It is anticipated that the finding of this study will work as a benchmark for other industries in the region.

Audit Reports on Financial Statements Prepared According to IASB Standards: Empirical Evidence from the European Union

Abstract: This paper examines the audit report of 147 firms from the European Union that prepare their financial statements in compliance with the standards developed by the International Accounting Standards Board. Bearing in mind that the consolidated accounts of listed companies will follow IAS from 2005 onwards, the purpose of this paper is to provide some insight into the current outcome of the statutory audit on this information. Interesting conclusions are drawn from this empirical study with regard to the auditing standards applied, the wording used and the differences observed between reports produced by auditors from the big firms and reports from different European countries. The need to harmonise the auditing field is discussed under the results obtained, with the final aim to contribute to the standard-setting debate on the creation of a high quality financial reporting system in the European Union.

The Impact of Generating Initial Hypothesis Sets of Different Sizes on the Quality of the Initial Set, and the Resulting Time Efficiency and Final Judgment Accuracy

Abstract: This study examines the impact of generating initial hypothesis sets of different sizes on the quality of the hypotheses generated (i.e., the ability to consider both the direction and accounts that are over- or understated). We also examine the time efficiency, information search effectiveness, and the final judgment accuracy, conditional on the quality of the initial hypothesis set. Sixty auditors performed an analytical procedures task where they were asked to generate and test either a specific number of initial hypotheses (one, three, or six), or any number of hypotheses desired in order to uncover an error seeded in the financial statements. The results indicate that the three hypotheses group initially generated hypotheses of the highest quality and maintained the hypothesis quality after efficiently searching information and generating additional causes. The one hypothesis group improved the quality of their hypotheses only after generating and testing several causes. However, auditors who generated six hypotheses or any number desired (as in audit practice) considered hypotheses of lower quality in the initial set, and did not improve the hypotheses quality after going through the information search stage. These results suggest that the size of the initial hypothesis set can lead to differences in the gains that accrue from the hypothesis generation and information search stages of diagnostic decisions.

Auditors’ perceptions of responsibilities to detect and report client illegal acts in Canada and the UK : a comparative experiment

Abstract: This paper investigates the theme of the role and influence of auditing standards on auditing practice by means of a comparative case study focused on two different standard setting regimes. Specifically, the Canadian and UK standards concerned with the detection and reporting of client illegal acts are considered. Fifteen short vignettes are developed each describing an illegal act and reflecting the distinctive factors highlighted by the respective auditing standards. We find that the regulation of the auditing profession through the mode of auditing standards does have an identifiable impact on auditor behavior. The impact of standards on auditors’ perceptions of their responsibilities in the area of illegal acts is clearer for detection than it is for reporting. Additionally, auditors continue to perceive a clear distinction between fraud and other illegal acts and recognize a higher degree of res-ponsibility for illegal acts involving fraud than for others. At the other end of the spectrum auditors do recognize some degree of responsibility in connection with illegalities that do not fall within the ambit of auditing standards. Auditors are also influenced in their judgments on the general nature of an illegal act rather than on how the illegality fits the framework adopted by the appropriate auditing standard.

Determinants of the Timing of Interim and Majority of Audit Work

Abstract: This study investigates the effect of the risk of material misstatement at the financial statement level on audit program planning. Using an inventory-production cycle case study, we engaged forty-eight auditors to assess the risk of material misstatement at the financial statement level. The auditors incorporated their assessments in planning the total number of audit hours and the timing of performance of interim tests and the majority of audit work. To further investigate the sources of variation, we classified auditors by their level of audit experience and tolerance-for-ambiguity, and analyzed the effects of these variables on the audit program planning. The results indicate that the risk of material misstatement is statistically significant in explaining changes in the total number of audit hours and the timing of the majority of audit work. Moreover, experience and tolerance-for-ambiguity were significant in explaining changes in the timing of interim tests and majority of work. Interaction between experience and tolerance-for-ambiguity was also significant in explaining the variation in the total number of hours planned for the overall audit work. This result indicated that inexperienced auditors with a low tolerance-for-ambiguity planned more audit procedures than the more experienced auditors with a high tolerance-for-ambiguity. Implications for audit practice and research are discussed.