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Audit Quality

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  1. Audit Quality Defined

Giving a precise definition of Audit Quality is difficult. Practitioners associates Audit Quality with the audit’s level of compliance with auditing standards (Watkins, Hillison, William, Morecroft citing Krishnan and Schaucer, Tie, McConnell and Banks, Aldhizer et al., Cook). On the other hand, accounting researchers define audit quality depending upon the different dimensions of auditing. The following are the more common definitions of audit quality provided by the accounting researchers based on the different dimensions of an audit:

(1) the market-assessed probability that the financial statements contain material errors and that the auditor will both discover and report them [e.g., DeAngelo, 198Ib], (2) the probability that an auditor will not issue an unqualified report for statements containing material errors [e.g., Lee et al., 1999], (3) the accuracy of the information reported on by auditors [e.g., Titman and Trueman, 1986; Beatty, 1989; Krinsky and Rotenberg, 1989; Davidson and Neu, 1993], and (4) a measure of the audit’s ability to reduce noise and bias and improve fineness in accounting data [e.g., Wallace, 198O] (Watkins et.al. 2004).

            The practitioners definition does not fully encompass what audit quality should be. In such a definition, we would have to rely on existing standards to determine the quality of the audit. It does not put into question whether the existing standards are adequate to address audit issues that were encountered in the course of the audit. Recent changes in legislation such as the Sarbanes-Oxley Act, shows that auditing standards in the past have not been a sufficient gauge of quality in audit. Instead, if we look at the different dimensions of audit enumerated above, we can see that they all cover the dimensions of competence and independence (Watkins et al.). This means that any discussion or definition relating to audit quality should include or tackle competence and independence.

            Audit Quality must be looked at not only in terms of standards based on theory but on experiences of practitioners. Standards often need to be adjusted based on the changes in business practices and innovations in commerce. Standards are not and cannot be changed over night. It took the fiasco that was Enron and Worldcom to introduce new rules to improve the detection and minimize fraud in audit.  If audit quality is defined based on standards, it will base on a historical approach which may no longer be relevant.

            It is my opinion that auditing cannot be stagnant. Commerce is not stagnant and so audit must react timely to the ever changing world where it operates. There must be a time element in the definition of Audit Quality. Therefore, Audit Quality must be defined in terms of competence, independence and relevance or the ability to react or adjust to the needs of the engagement.

            As a continuation of the discussion of dimensions mentioned above, Audit Quality will be further discussed in terms of the dimensions of professional skepticism, the use of estimates in financial and tax reporting and the changes in the accounting profession in general and forensics accounting in particular.

  1. Audit Quality and Professional Skepticism

What is professional skepticism? Piller said it is “[a]n attitude exercised throughout the audit process that includes a questioning mind and a critical assessment of audit evidence.” This attitude means “making a critical assessment, approaching matters with questioning mind throughout the audit, assessing validity of audit evidence obtained, being alert to audit evidence that contradicts” (Piller).

How does this “attitude” affect Audit Quality? Piller said professional skepticism “reduces the risk of overlooking suspicious circumstances, over generalizing when drawing conclusions from audit observations and using faulty assumptions in determining the nature, timing and extent of audit procedures.”

To relate professional skepticism to the definition of audit quality discussed above, we should equate professional skepticism with independence. Although independence and professional skepticism is considered entirely different requirements in auditing, it is possible to view professional skepticism as a result of the auditor’s independence. If the auditor remains to be independent from the client, it is easier to maintain a questioning and critical attitude. Another way of looking at it is to look at professional skepticism as a proof or manifestation of independence. Although independence can be seen through a variety of ways, such as the lack of relationship in terms of management and financial interests, in the end, it should result in the auditors’ ability to maintain a critical attitude towards the entity being audited.

One example of how the lack of professional skepticism can adversely affect the quality of an audit is the corporate scandal surrounding the fall of Enron. In an article on how the practice of Audit Firm Rotation can be one way of preserving independence, and therefore professional skepticism, the authors discussed how the familiarity bred by long relationships between auditors and clients can tragically result in poor audit quality. (Arel, Brody and Pany 2005).  The merging that occurred because of the long-term relationship between Enron and Andersen were shown in the following ways:

Andersen auditors and consultants were given permanent office space at Enron headquarters here and dressed business-casual like their Enron colleagues. They shared in office birthdays, frequented lunchtime parties in a nearby park and weekend fund-raisers for charities. They even went on Enron employees’ ski trips to Beaver Creek, Colo. “[P]eople just thought they were Enron employees,” says Kevin Jolly, a former Enron employee who worked in the accounting department. “They walked and talked the same way … It was like Arthur Andersen had people on the inside … the lines become very fuzzy” (Arel et al. citing Herrick and Barrionuevo)

            Because of this close relationship, whenever an audit issue arose, the auditor will be torn between his professional responsibility and his sympathy with the client. Arel et al. (2005) said “[t]he auditor could identify closely with management’s perspective and not exhibit sufficient professional skepticism.”

As mentioned above, the practice of Audit Firm Rotation is one of the solutions presented for the declining audit quality attributed to long-term relationships between auditor and clients.  The practice is said to address three (3) key issues: closeness to client management, lack of attention to detail due to staleness and redundancy, and eagerness to please the client (Arel et al.). But if you look at these issues closely, particularly the last item, we can see that they are issues relating to lack of professional skepticism. If these efforts to improve audit quality are directed towards preserving professional skepticism, it is safe to assume that professional skepticism is very important in maintaining audit quality.

  • Audit Quality and Estimates in Financial and Tax Reporting

The use of estimates is necessary and pervasive in accounting; however, they raised special concerns in the field of accounting and auditing (Roxworthy). Roxworthy (citing Sougiannis and Li), said that:

“Accounting estimates potentially improve the relevance of financial information by providing managers the means to convey forward-looking, inside information to investors. But, the quality of financial information is compromised by: the increasing difficulty of making reliable forecasts in a fast changing, often turbulent economy.”

Although, coming up with the estimates is the work of an accountant, they are still a special concern for auditors because of the need for “evaluating the reasonableness of accounting estimates in the context of the financial statements as a whole” (Roxworthy). By their very nature, estimates are not accurate. There is much leeway for subjectivism in the formulation of the criteria from which estimates are based. Moreover, some estimates require complicated computations and considerations. For the purpose of an audit of the financial statement, the auditor must perform the following acts in relation to estimates: (1) identify which circumstances require accounting estimates that are material to the financial statements, (2) determine if the accounting estimates are reasonable in the circumstances, and (2) determine if the accounting estimates are presented in accordance with GAAP (Roxworthy).

Estimates became one of the primary concerns after September 11. The events of September 11 raised the following accounting and auditing issues: (1) working with clients to recover accounting records, (2) planning the audits of clients affected by September 11, (3) evaluating significant client estimates, and (4) evaluating the ability of the client to continue as a going concern (Giles and Jones). The degree of effect which estimates have on Audit Quality can be shown by the effect of events of September 11 to insurers, airlines, hospitality and tourism and other businesses.

Certain industries are required to make estimates with regards to the effects of September 11, however, these events were so extraordinary that reliance on past experiences in coming up with estimates is immediately suspect (Giles and Jones). There is a greater degree of subjectivity in coming up with these estimates since the management has no point of reference from which to base their assumptions (Giles and Jones).

According to Giles and Jones, the auditor must evaluate if management’s estimates were (1) complete, (2) reasonable and (3) based on applicable accounting principles. This is not different from the guidelines in the audit of estimates given by Roxworthy above. The only difference is the degree of difficulty by which these determinations would be made. Unfortunately, this was not discussed by Giles and Jones. They only said that “[i]n evaluating the reasonableness of management’s estimates, auditors should consider the key factors and assumptions used by management, including the possibility of management’s overreliance on economic information based on favorable future conditions” (Giles and Jones). The auditor will need to do this in the usual audit. In the case of audits performed on companies affected by the events of September 11, the auditor may not have a hard time finding any basis in determining the reasonableness of estimates. As mentioned above, these events are extraordinary, “management’s knowledge of and experience from past events and its assumptions about the implications of such events on future operating plans” will not apply (Giles and Jones).

One of the procedures in the audit of estimates provided by Roxworthy (2007) based on SAS is the review of reasonableness through independent expectation of estimates, but how would the auditor come up with an independent expectation of estimates if there are no basis for such estimates? This is the crux of the problem in auditing for companies affected by the events of September 11.

  1. Audit Quality and the Challenges and Opportunities in the Accounting Profession

Weiman discussed several challenges and opportunities in the accounting profession. Among these are: the pace of change, complexity, expectation gap and the role of the auditor, international convergence of accounting principles, regulatory burden and effect on the U.S., auditor concentration, new technology in the form of XBRL, and  enhanced business reporting.

As to the growing complexity in the accounting profession, he enumerated several sources. These sources are the following: more complex transactions and business arrangements, specialized industry accounting, rules versus principles, desire for exceptions and special treatment to suit business objectives or structure, desire for certainty in application and fear of second guessing by auditors, regulators and the trial bar (Weiman). As a result of this growing complexity, there is difficulty for preparers and auditors in applying standards and guidance, there is an increase in the number of restatements and there is less confidence in the financial reporting system (Weiman). Based on Weiman’s lecture, we can see how the growing complexity in the business world can affect the Audit Quality by making it more difficult not only to set standards but also to follow them.

Issues of complexity go into the competence of the auditors in performing the audit, so it does adversely affect the quality of the audit. To answer issues of complexity, the SEC established the SEC Advisory Committee on Complexity in Financial Reporting (CIFiR) (Weiman). In addition, the following approaches are also suggested: “encouraging the use of technology (XBRL), considering changes in enhanced business reporting (EBR), reviewing inspection and enforcement standards and processes, looking at materiality considerations and considering some type of litigation reform” (Weiman).

In his speech, Weiman also mentioned the international convergence of accounting.  principles. This convergence comes with its own unique set of challenges. Among these are: difference in environment (cultural, business and regulatory), politics, U.S. demand for detailed guidance and special industry standards, inconsistent application of IFRS, IASB funding and staffing and resistance to change (Weiman). These challenges will necessarily affect Audit Quality. Convergence will minimize complexity and complications resulting from several accounting regimes used in the world. One of the results of the convergence will be the narrowing of the differences between IFRS and GAAP, allowing for a wider area for the practice of accounting and audit (Weiman). On the other hand, Audit Quality will be affected by the challenges enumerated above, not least of which is the resistance to change of auditors and auditing firms alike. Convergence will result in changes and changes will require that re-learning of the standards of the profession. Any resistance to learning these changes will affect Audit Quality.

The concentration of auditors mentioned above can also adversely affect Audit Quality. In the U.S., the four (4) biggest auditing firms audit 75% of all public companies with 95% of market capitalization (Weiman). Some of the effects of this concentration are the lack or limited choice in auditing firm, less diligence in the conduct of the audit, restrictions in creativity, tendency of market-dominant firms focus on political process to protect and extend their position and difficulties of attracting the best and brightest accountants or auditors in industries with excessive concentration and standardization (Weiman). To address the issue of concentration, the U.S. Treasury Commission is to study concentration of human resources and capital in audit (Weiman).

  1. Audit Quality and the Globalization of Forensic Accounting

Hart defines Forensic Accounting as “an accounting assignment related to a legal action” but has grown to include fraud investigation. Like, traditional audit, independence is crucial for the credibility of the forensic accountant. Houck, Kranacher, Morris, Riley, Robertson, and Wells (2006) state that “Forensic Accounting is the use of accounting, auditing, and investigative skills to assist in legal matters.”

In the U.S., Forensic Accounting gained popularity after the corporate scandal that rocked corporate giants like Enron and Worldcom (Houck et.al. 2006). It was also known after the events of September 11 that terrorists used banks to “fund their activities, transfer money, and hide their finances” (Houck et.al. 2006). These events led to the realization of the need to equip CPAs with the necessary investigative know-how.

Although most laws are domestic, Forensic Accounting is becoming more global because of several factors. One of these is the unstoppable forces of the global economy, foreign direct investments are growing worldwide and financial markets are becoming more linked (Hart). Moreover, regulators and courts are crossing borders and international dispute resolution is becoming more common (Hart). Several realities in the global economy make for a fertile ground for fraud – the lack of transparency and the rule of law in the majority of nations, the number of emerging economies and the existence of cultures where questioning authority is still unacceptable (Hart).

As predicted by Hart, the next concentrations of investigation will be found in Financial Reporting, Anti-Money Laundering, Foreign Corrupt Practices Act and Asset Misappropriation. As such, one of the roles of a forensic accountant is to provide evidence as to accounting issues and financial damages.

This growing need for Forensic Accounting in the global market improves Audit Quality. As discussed in the article “Fraud auditing and forensic accounting”, forensic accountants have an attitude of persistence and doggedness, so much so that even if according to the study conducted by Bologna & Lindquist (cited in “Fraud auditing and forensic accounting”) only 10% of fraud is detected in regular audit, Forensic Accounting can uncover more fraud by focusing on accounts where fraud is most likely to occur. Not only does Forensic Accounting provide evidence as to accounting issues in relation to financial reporting, it provides a different attitude – skepticism bordering on suspicion – towards fraud detection in management representations.

According to Houck et. al. (2006), “[b]ecause employee and management fraud, theft, embezzlement, and other financial crimes are increasing, accounting and auditing personnel must have training and skills to recognize those crimes.” The trend towards globalization of Forensic Accounting can improve audit quality by addressing the needs of business for better fraud detection. As discussed above, audit quality does not merely mean a static compliance with a given set of standards. It must include that ability of the auditor to adjust to the needs of the engagement. The growth of the economy makes for a fertile ground for fraud and other illegal practices in business, the audit must be able to account for this unexpected consequence of progress.

Work Cited

Arel, B. Brody, R. and Pany, K. 2005. Audit Firm Rotation and Audit Quality. 8 December 2007. www.nysscpa.org/cpajournal/2005/105/essentials/p36.htm.

Giles, J. and Jones, R. n.d. Accounting and Auditing Issues surrounding the September 11 Disasters. 8 December 2007. http://www.nysscpa.org/cpajournal/2001/1100/nv/nv2.htm.

Houck, M. Kranacher, M. Morris, B. Riley, Jr., R. Robertson, J.  and Wells, J. 2006. Forensic Accounting as an Investigative Tool: Developing a Model Curriculum for Fraud and Forensic Accounting. 8 December 2007. http://www.nysscpa.org/cpajournal/2006/806/essentials/p68.htm.

Watkins, A.  Hillison. William.  Morecroft, S. 2004. Audit Quality: A Synthesis of Theory and Empirical Evidence. 8 December 2007. http://findarticles.com/p/articles/mi_qa3706/is_200401/ai_n13602083.

Piller, Bruce. Audit Quality and Professional Skepticism: How are They Related? Place and Date of delivery.

Roxworthy, Patrick. Estimation in Financial & Tax Reporting. Place and Date of delivery.

Weiman, Russell. Challenges and Opportunities in the Accounting Profession. Place and Date of delivery.

Hart, Timothy. The Globalization of Forensic Accounting. Place and Date of delivery.

Fraud Auditing and Forensic Accounting. 8 December 2007. http://faculty.ncwc.edu/TOConnor/350/350lect05.htm.

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