The Routledge Companion to Auditing

David Hay, W. Robert Knechel, Marleen Willekens, David Hay, W. Robert Knechel, Marleen Willekens

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781136210341
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Auditing has been a subject of some controversy, and there have been repeated attempts at reforming its practice globally.

This comprehensive companion surveys the state of the discipline, including emerging and cutting-edge trends. It covers the most important and controversial issues, including auditing ethics, auditor independence, social and environmental accounting as well as the future of the field.

This handbook is vital reading for legislators, regulators, professionals, commentators, students and researchers involved with auditing and accounting. The collection will also prove an ideal starting place for researchers from other fields looking to break into this vital subject.

1

Introduction

The function of auditing

David Hay, W. Robert Knechel and Marleen Willekens

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Overview of the topic and its importance

Auditing is important because financial reporting misstatements are dangerous. Auditing has economic benefits, some of which are not always immediately obvious, for both individual companies and the national (or global) economy as a whole. It helps in understanding auditing to be aware of those benefits and the explanations for its existence.

Auditing is an assurance service which improves the quality of information or its context. Financial reporting information is ‘better’ – more credible, more reliable – because an audit firm has examined evidence about the assertions making up the financial statements and convinced management to make changes that improve the accuracy and informativeness of financial statements. This allows financial statement users to better rely on the information because it has been vetted by an auditor whose conclusions are stated in the audit report.

A simple explanation of the benefits of auditing is provided by Willekens (2007), using the market for used cars as a parallel. Buying a used car is risky. Most car buyers are not experts, and cannot judge whether assertions made by the car salesman are reasonable. In the same way, shareholders and other stakeholders in a company are not able to find out whether assertions made by the directors are also reliable. In the case of the company, the assertions might be about how much profit the company is making or how liquid is its financial position. Assertions are made through the financial statements.

The used car buyer has the choice of not buying the car and taking the bus to work instead; or (s)he could get an expert to investigate and give an opinion on the assertions made by the seller. To help the deal to go through, the seller might even pay for a trustworthy expert to provide a report (e.g., CARFAX in the USA). In much the same way, potential investors have the option of not buying shares if they are uncertain about the reliability of the accounts. Or they can rely on an auditor, as the expert on financial statement assertions, to give them a report on management-provided information. It might be in management’s interests to engage a respected auditor if that helps investors to decide to commit their funds to the company. The auditor does not give an opinion of the worth of the company or whether it is a wise investment. Rather, the audit report provides assurance that what management says is reliable.

The used car example is helpful up to a point. But auditing of financial statements takes place in a setting of much greater complexity. It is more complex than buying a used car because of the number of people involved and the ambiguity of financial information. If there are many shareholders and other stakeholders, it is not feasible to allow them all to examine the company’s records in detail. There is also a wide range of parties involved in running the company – directors, audit committee members, management, all with their own self-interest, as well as their own views of what are the company’s best interests. In addition, there is a well-known expectation gap, whereby many users have a different idea of what the auditor can do compared to what the auditor intends. In addition, the amounts involved may be very large, and the underlying financial and accounting issues can be very complex. In many cases, there are operations and stakeholders in a variety of different international jurisdictions. And finally, auditing is usually controlled by regulation and professional standards.

There are a number of economic explanations for auditing similar to the used car example discussed above, and these explanations overlap. They all provide reasonable explanations as to why managers might find it to be in their interests to submit to an audit, which they do implicitly when taking a job in a large company. In addition, in many cases auditing is required by law. The regulation of auditing can be explained by the legislators looking after the interests of stakeholders who may not be able to influence the decisions of a company directly but have their own interests in the behaviour and performance of a company. The next section discusses fundamental theories underlying the benefits of auditing.

Summary of current state of research findings

Explanations for companies to choose auditing

Auditing can be seen as having an information role; an agency role; an insurance role; an organizational control role; a confirmation role; and a risk management role. These are the economic explanations for auditing. In all of these, managers might voluntarily submit to being audited because it is in their own interests. In addition, in many settings auditing is compulsory – but the economic explanations for why auditing is desirable still apply, and companies may engage an auditor for something more than the absolute minimum level of audit effort required by standards. The reasons why auditing is often compulsory are also important in understanding the function of auditing, and explanations for compulsory auditing are discussed in the next subsection.

The information (or signalling) explanation

Better information leads to better, more informed decisions, by both managers and outsiders. Auditing can be a way both to improve information, and to show that it is better. Company managers have better information about the value and quality of the business that they run than do outside investors or stakeholders. This imbalance in knowledge about a business is called ‘information asymmetry’. But if managers make statements in the financial report that claim that their business is a better investment than others, their claims may not be believed. One way of overcoming this information asymmetry is for them to engage an auditor to provide assurance about their statements. Appointing an auditor is then a signal to investors that they can place more credibility on the company’s financial statements. Where auditing is compulsory, then managers can provide a signal of higher quality by appointing an auditor of higher quality – perhaps a large international firm or a firm that is considered a specialist in the client’s industry. This can be a means of signalling insiders’ knowledge of superior performance and reduced measurement error (Wallace, 1987).

The agency (or monitoring) explanation

Shareholders are aware that managers may act in their own interest, and could report misleading information as a result. If so, the shareholders might discount the information they receive, and pay a lower price for shares than the financial fundamentals would justify if the financial reports could be trusted (if they can be persuaded to invest at all). It becomes worthwhile from a manager’s point of view to provide auditing as a form of bonding of the manager, or monitoring on behalf of the shareholders. A similar explanation might apply when the managers are asking for a loan – they can expect a better response, and perhaps a lower interest rate, if they have audited financial statements. Where auditing is compulsory, they can reduce agency costs by providing auditing of more than the minimum standard required. Monitoring, bonding and other contracting explanations are supported by previous studies that provide evidence that auditing (or similar assurance services) is associated with high agency costs, indicated by greater size, higher debt leverage or lower managerial ownership (Chow, 1982). In 1994, a senior partner in the US firm of KPMG wrote that ‘auditing adds tremendous value’ (Elliott, 1994). Elliott estimates that audits reduce the cost of capital by 1 per cent to 3 per cent.

The insurance (or ‘deep pockets’) explanation

Chow et al. (1988) suggest that providers of external financing and custodians of others’ funds may demand audits as a way of increasing the chance of recovering certain types of losses. For example, an audit provides a ‘target’ that they might be able to sue to recover their investment losses. They can sue those directly involved, including directors and management, but these people may not have the resources to make up the losses of investors. Auditors are seen as the ‘deep pockets’ defendant (who will have greater funds available after the company has failed than most managers or directors individually) and, as a result, auditors can face costly litigation even when they have little or no responsibility for the losses. This view treats the audit almost like a put option against future bad behaviour or misleading reporting.

The organizational control explanation

Organizational control for the benefit of internal management is another explanation for auditing, especially in smaller companies that may be family-owned or have less complex financial structures. In a small organization, the owner or manager controls operations by direct supervision and personal observation. As an organization grows larger, control becomes more difficult. Delegation becomes necessary, and there is a risk of moral hazard and opportunism. Abdel-Khalik (1993) proposes that owners seek voluntary audits as a compensatory control system for organizational loss of control in hierarchical organizations. He finds evidence to support this explanation because there are significant relationships between audit fees and number of layers of hierarchy and size.

The confirmation hypothesis

A further explanation is provided by the ‘confirmation’ hypothesis. The confirmation hypothesis examined by Ball et al. (2012) states that audited financial reporting and the disclosure of managers’ private information are complementary. An early study, Ball and Brown (1968), showed that earnings announcements have little impact on share prices. That paper, and others like it, appeared to leave little room for auditing to be of value to the financial markets – audited financial information arrives too late for it to be useful. The confirmation hypothesis suggests that it is still necessary for announcements to be independently verified at a later stage. Firms that commit to higher audit fees (a measure of greater financial statement verification) are regarded as more credible. Ball et al. (2012) provide evidence to support the confirmation hypothesis by showing that firms which make more frequent and more specific management forecasts also commit to greater financial statement verification by independent auditors, and these firms also have larger market reactions associated with their management forecasts. Ball et al. (2012) argue that committing to higher audit fees is associated with management forecasts that are more frequent, specific, timely, accurate and informative to investors.¹

Risk management

It is also useful to see auditing as a critical element in an organization’s risk management strategy. Auditing can be useful for organizations whose stakeholders are subject to higher risk. Other mechanisms are also used to reduce risk, such as internal audits and processes, audit committees and independent directors. The interaction of these various mechanisms can sometimes have complex results, because the audit committee members and external directors become stakeholders themselves, and also seek to minimize risk. Knechel and Willekens (2006) show that demand for external auditing, illustrated by audit fees, increases in situations where there are multiple stakeholders. Because individual decisions about control processes and procedures may shift benefits and costs across groups of stakeholders, the net investment in auditing may increase when multiple stakeholders become involved in corporate governance decisions. Each stakeholder benefits from a greater level of control, while being able to shift a share of the costs to the other stakeholders. Knechel and Willekens (2006) found evidence that audit fees are higher when a company has an audit committee, discloses a relatively high level of financial risk management, and has a larger proportion of independent board members. Audit fees are lower when a company discloses a relatively high level of compliance risk management. These results are consistent with other studies.

Evidence

Evidence for or against these explanations is not easy to come by, since auditing is highly regulated in most settings. Nevertheless, even when auditing is mandatory, firms are free to choose which auditors they hire. There are many arguments suggesting that larger audit firms are of higher quality, especially the Big 4 international auditing firms (Deloitte, Ernst & Young, KPMG and PwC). These firms have more incentive to maintain high quality to protect their brand name, and more to lose if there is an audit failure. They also charge higher fees, which also suggests that they are more highly valued. More recent studies have also considered whether audit firms specializing in a particular industry provide higher quality audits.

Research studies have shown that there are associations between companies choosing higher quality auditors and the incentives of the companies under the information and agency explanations. For example, companies choosing larger (higher quality) auditors have less initial public offering (IPO) under-pricing, and higher earnings response coefficients² (Beatty, 1989; Teoh and Wong, 1993). A study using historical data from a period before auditing was compulsory found that debt contracts were associated with engaging an independent auditor (Chow, 1982).

These explanations, as they have developed over recent decades, have also had a practical effect on how judges in lawsuits against auditors view the role of the auditor. Pacini et al. (2002) review the trend in auditors’ liability in the United Kingdom, Canada, Australia and New Zealand. They show that in the second half of the twentieth century, judges in cases involving auditors initially showed a trend towards an insurance explanation for auditing, and tended to increase the responsibility and liability placed on auditors, and allowed stakeholders with a relatively distant relationship with auditors to claim for losses. Later judgments moved more towards contracts-based monitoring views of auditing, and restricted liability to those contracting for the audit and to a very limited class of third parties.

The economic explanations for the value of auditing are relevant to understanding current issues because they portray auditing as something that is beneficial in itself, not a necessary evil that must be imposed by regulation. In the issues discussed in later chapters, such as whether auditors should be req...

Table of contents

• Cover Page
• Half Title page
• Series page
• Title Page
• Copyright Page
• Contents
• List of Figures
• List of Tables
• Notes on Contributors
• Preface
• Acknowledgements
• 1 Introduction The function of auditing
• Part I The social environment of auditing
• Part II The impact of regulation of auditing
• Part III Research on the process of auditing
• Part IV Issues concerned with audit reporting
• Part V Alternative auditing services
• Part VI Conclusion
• Index