Auditing research and social structure: our comparative advantage

January 13, 2011

Bill Kinney University of Texas at Austin

Outline• Social structure as a way of thinking about

practice-based auditing predictions

• IAASB agenda and other sources of predictions

• Social structure inherent in prior research

• What you can do to help yourselves

• Your thoughts?

1. Getting started

Hint: “One gets the biggest potatoes on the first pass through the field” (Irish agricultural economics principle per Frank O’Connor, University of Iowa)

Suppose that you have an idea (a problem): you observe undesirable “facts” or peculiar “facts” or claims

• What research barriers must be overcome:– Availability of: Causal theories (or other predictions)?

Data?Estimation methods?

– Research design (how to combine the above)?– Exposition (if you can’t explain it, you fail)?

• Who will want to read your paper (and why)?• What is your comparative advantage?

Sources of predictions (or theory)

Laws, regulations,Transparency,Enforcement, Market mechanisms,Contracts/incentivesMores, Culture

Economics Psychology

Societal structure

Auditing research domain

Laws, regs, governanceContracts/ incentivesProfessional standardsProfessional Oversight: external internalFirm organization, mores

Accounting Auditing

Professional structure

Financial reporting laws, regulations, and standards across borders

A, Inc. B, Inc. C Corp.

• US national FRF&AudStds• NYSE rules• US private lit.

• UK national FRF&AudStds• LSE rules• UK private lit.

US law/ Sec. reg.

UK law/ Sec. reg.?

US culture/ contracts/ governance

FR law/ Sec. reg.?

G, Inc. H, Inc. I Corp.

• FR national FRF&AudStds• Borse rules• FR private lit.

FR culture/ contracts/ governance

D, Inc. E, Inc. F Corp.

UK culture/ contracts/ governance

EU law/ EC directives/ Sec. reg.??

Who will interpret and enforce theseFRFs and AudStds? Will they differ?

Global Financial Reporting Framework and Auditing Standards

ICAEW panel on AuQ

• measurement method relevance

• care in measurement process

• trustworthiness of measurement display and process

2. Information Quality (value) . . .

(GAAP/ IFRS, SA, ISO, EPA)

(Mgt. reput AudStds)

(Mgt. reput./ Aud. reput./ Prof. reput./ Exchg rules/ SEC/ monit. Culture . . .)

Depends on decision maker’s perception of

Assurance Engagement (IFAC)

An engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria.

IAASB, Assurance Framework, 2008

IAASB Assurance standards

• Level of assurance/opinion: – Reasonable (positive assurance)– Limited (negative assurance)

• Who measures or evaluates:– Management or third party (attest)– Practitioner (direct assurance)

• Independence rules apply to all assurance engagements

Color code for assurance charts*

Denotes management or entity

Denotes assurance practitioner

Denotes party other than management or assurance practitioner

*Be especially attentive to independence implications!

Audits of historical financial information (ISAs)

Practitioner/ verifier

Investors

FRF (IFRS)

Assurance contract

Financialstatements

management measurement verification

EntityManagement

Entity mgt or Audit comm.

EntityManagement

FinancialCondition/ Perform

Assurance contract

Reviews of historical financial information (ISRE 2400)

Practitioner/ verifier

Investors

FRF (IFRS)

Assurance contract

Financialstatements

management measurement verification

EntityManagement

Entity mgt or Audit comm.

EntityManagement

FinancialCondition/ Perform

Assurance contract

Audits of Internal Control - Attest

ICFR process quality

EntityManagement

Entity mgt or Audit comm.

Practitioner/ verifier

Investors?

COSOAssurance contract

ICFRreport

management measurement verification

EntityManagement

Assurance contract

Audits of Internal Control - Direct

ICFR process quality

EntityManagement

Entity mgt or Audit comm.

Practitioner/ verifier

Investors?

COSOAssurance contract

ICFRreport

management measurement verification

Practitioner/ Measurer

Assurance contract

Audits of GHG Emissions (ISAE 3410)

GHG emissions

EntityManagement

Entity mgt or Audit comm.

Practitioner- verifier

Investors/Regulators Trad ptnrs

StatedAssurance contract

GHGInventory

management measurement verification

Entity Mgt/ Practition-meas/ other

Assurance contract

Performance Audits (GAO/NAO: ISAE 3000)

AGENCYManagement Congress

Congress

StatedAssurance contract

Performance report

management measurement verification

Gov. Account-ability Office

AGENCYPerformance

Assurance contract

Gov. Account-ability Office

Non-assurance engagement – HFI Compilation

EntityManagement

Parliament

FRF

Performance report

management measurement verification

Practitioner/ Measurer

Fin. condition/ performance

Other promising professional structure elements

• Auditing accounting estimates (e.g., Fair values):– ISA 540, CIFiR recommendation, PCOAB response

• Group audits:– ISA 600– Global cooperative inspections by PCAOB, FRC, etc.– Group-level ICFR (huge threat, huge potential, almost

zero theory, field studies, archival studies)

• PCAOB inspections practices and expectations:– Large firms/ small firms, no recognition of firm QC– global cooperation/access and “Lehman Brothers?”

3.a Do non-audit services reduce financial reporting quality?

• Many say yes – some are in high places• Prior to 2000, limited public data in US• SEC staff encouraged NAS research

involving restatements in 2000 and sponsored “independence research”

• None of Big Six “wanted” to help, but agreed to “because our firm wants know the answer and are willing to take the risk”

Auditor independence and non-audit services: Was the U.S. government right?

(Kinney, Palmrose, Scholz)

Does an audit firm’s dependence on fees for FISDI, internal audit, and certain other services to an audit client reduce financial reporting quality?

The answer is important because a) the Sarbanes-Oxley Act presumes so, banning such services to audit clients, and b) some registrants now voluntarily restrict tax and other legally permitted services.

Using fee data from 1995-2000 for restating and similar non-restating registrants, we find no consistent association between fees for FISDI or internal audit services with restatements, but find significant positive association between unspecified services fees and restatements and significant negative association between tax services and restatements.

Non-public data: 944 matched firms for 1995-2000

(Kinney, Palmrose, Scholz, JAR 2004)

Lower quality financial reporting

Auditor dependence on client NAS fees

1

Restatement

3

5

Industry, size, audit policies, acquisitions, etc.

4

Conceptual

Operational

Control

Independent Dependent

(1. +)

Tax: - Non-audit fees

2

(five categories)

Predictive Validity Boxes - causal theory testing

5

Control Other potentially influential variables Vs and Zs

4

2 3

Operational X

Operational Y

Operational

Theoretical X (X )

Theoretical Y (Y)

Conceptual1

Independent Dependent

+

+

Predictive Validity Boxes - policy testing

5

Control Other potentially influential variables Vs and Zs

4

2 3

Operational X

Operational Y

Operational

Conceptual New policy Desired behaviors

1

Independent Dependent

0, <0

>0

identical Needcreativity

3.b Do mandated audits add value?• 1996 – proposed legislation: Rep. Dan Frisa (R NY):

– Blackwell, Noland, Winters JAR 1998: Cost of capital lower by .25%

– Kinney JAR 1978, Kinney and Martin AJPT 1994: reduce NI and NA by 2 to 8 times materiality

– AICPA research program (1996-1996)• 2002 – SOX lowers professional transparency:

– Audit standards set “not in sunshine” – no ex ante research on viability of proposed standards!

– ICFR costs/benefits: SEC survey 2009; Bedard and Graham 2010.

– No known comprehensively collected data on audit-related corrections, deficiency remediation, common auditor mistakes, or even litigation.

3.c Is regulating (only) auditors enough?

• Libby, Kinney (TAR 2000) – SAS 89 work?• Nelson, Smith, Palmrose (TAR 2005) – SAB

108 problem known by ASB since 1983, but not publicly addressed until 2005

• Kinney, Shepardson (JAR 2011) – is SOX 404(b) necessary for meaningful MW disclosure?

• Effect of SOX provisions (CEO/CFO certifications, lying to auditor, corp gov, ICFR reporting) on Inherent Risk and auditor corrections, prevention, deficiency identification is largely unexplored.

Is regulating management necessary (or cheaper than) regulating auditor?

4. What can young scholars do to help themselves?

1. Understand practice and standards to identify emerging practice problems

2. Take courses, monitor new theories or estimation that might be applicable

3. Explore specific promising solutions – assuming you can get data needed

4. Maximize research design5. Minimize data requested

What can scholars do . . . (cont’d)

6. Compactly describe: what question you ask, why answer is important (think broadly), and how you’ll do it

7. Present best case for benefits and costs to firms (including long-term public benefits)

8. Speak “their” language – be a translator between various scholars and practice

9. Write a two-way agreement letter on confidentiality and publication rights

10. Implement study with proper respect

Overall advice:

• Think about social (or societal) structure– What is it, how did it get there and why?– How does it conditions and interacts with

accounting and auditing structures– What would happen if structure changed?

• Exploit your knowledge of the structure and differences around globe.

5. Your thoughts?

Your main contribution is:

1. New data

2. New estimation

3. New theory (or new problem)

Hint one:

Whatever it is, Exploit it!

Broaden your contribution (and reader interest) by:

1. Making your theory elaborate

2. Using multi-methods and multi-measures

3. Generalizing your approach across contexts, disciplines, cultures, and time

Hint Two:

In introducing your paper, tell the reader:

1. What (specific) problem will be addressed

2. Why the (specific) problem is important

3. How you will address the (specific) problem (and what you found)

Hint Three:

(One page, double-spaced, 12 pt. font, normal margins, and include an informative title!)