Summary Auditing and Assurance – The year 2021 – 2022
Contents
Summary Auditing and Assurance – Year 2020 – 2021 ......................................................................... 1
1 Lecture week 1: Overall Class, Intro week .................................................................................... 3
2 Paper week 1: Paper Kausar Shroff White 2016 ........................................................................... 8
3 Lecture week 2: Overall Class, Audit Market Developments ...................................................... 15
4 Paper week 2: Paper Chaney and Philipich 2002, Shredded Reputation: The cost of audit failure
18
5 Paper week 2: Paper Jeroen van Raak, The effect of audit market structure on audit quality and
audit pricing in the private-client market ................................................................................................... 24
6 Paper week 2: Paper Cameran et al. 2015, Are There Adverse Consequences of Mandatory
Auditor Rotation? Evidence from the Italian Experience. ........................................................................... 33
7 MISSING: Paper week 3: Paper Trompeter et al. (2013) A synthesis of fraud-related research 39
8 Paper week 3: Paper Markelevich and Rosner 2013, Audit Fees and Fraud Firms ..................... 40
9 Lecture week 4: Auditing Risk Model & Client acceptance ......................................................... 47
10 Paper week 4: Paper Ruhnke Smidt, 2014. Misstatements in Financial Statements: The
Relationship between Inherent and Control Risk Factors and Audit adjustments. .................................... 58
11 Paper week 4: Paper Albrecht et al. 2018, Do Auditors Recognize the Potential Dark Side of
Executives’ Accounting Competence? ........................................................................................................ 63
12 Paper week 4: Paper Beck & Mauldin 2014, Who’s really in charge? Audit committee versus
CFO power and audit fees ........................................................................................................................... 69
13 Lecture week 5: Assertions & audit objectives and audit evidence. And the link to Risk,
Materiality & Evidence. ............................................................................................................................... 74
14 MISSING: Paper week 5: Knechel et al. (2013) Audit quality: Insights from the academic
literature 83
1
, 15 Paper week 5: Keune & Johnstone 2012, Materiality judgments and the Resolution of Detected
Misstatements: The Role Of Managers, Auditors, and Audit Committees ................................................. 84
16 Paper week 5: Ettredge et al. 2014, Fee pressure and audit quality .......................................... 89
17 Lecture week 6: Audit completion .............................................................................................. 93
18 MISSING: Paper week 6: Gray et al. (2011) – Perceptions and misperceptions regarding the
unqualified auditor’s report by financial statement preparers ................................................................ 104
19 Paper week 6: Marshall et al. 2019, An incomplete Audit at the Earnings Announcement:
Implications for Financial Reporting Quality and the Market’s Response to Earnings ............................. 105
20 Paper week 6: Christensen et al. 2019, The Loss of Information Associated with Binary Audit
Reports: Evidence from Auditors’ Internal Control and Going Concern Opinions .................................... 110
21 Case 2.3: Flash Technologies, Inc. ............................................................................................. 114
22 Case 4:4. Waste Management, Inc. ........................................................................................... 122
23 Case 1:1 Ocean manufacturing, INC. ......................................................................................... 127
24 Case 12:1 EyeMax Corporation. ................................................................................................ 135
25 Case 8.1: Laramie Wire Manufacturing ..................................................................................... 139
26 Case 12.4 Surfer Dude Duds, Inc. .............................................................................................. 144
27 FINAL (GROUP) ASSIGNMENT week 6: Christensen et al. 2019, The Loss of Information
Associated with Binary Audit Reports: Evidence from Auditors’ Internal Control and Going Concern
Opinions 147
2
,1 Lecture week 1: Overall Class, Intro week
Auditing is a subcategory of assurance. Each week we discuss audits in the news. This week we refer to
Wirecard. It was concluded that Wirecard was a fraud company and said they had 2 billion on a bank
account but it was fake, the money did not exist at all. This led to a write of 1.9b writes off of cash.
Wirecard went bankrupt.
What is an Assurance Engagement?
“An engagement in which a practitioner aims to obtain sufficient appropriate evidence to express a
conclusion designed to enhance the degree of confidence of the intended users other than the
responsible party about the subject matter information”.
Not only an audit is an assurance engagement, but we will mainly focus on audit engagements.
So: An audit engagement in which an auditor aims to obtain sufficient appropriate audit evidence to
express a conclusion (audits opinion in which auditor explains if FS gives a true and fair view) designed to
enhance the degree of confidence of the intended users (for example shareholders) Other than the
responsible party (Management board) about the subject matter information (The FS).
International auditing and Assurance Standards Boards (IAASB).
Assurance, Attestation, and Direct Engagements
Audit engagement → High level of assurance.
Review engagement → Less insurance for users of
the FS.
Pronouncements issued by the IAASB
We will focus on ISA 100 – 999,
International Standards on Auditing.
3
,Financial statement audits, the objective of an audit of FS.
To enhance the degree of confidence of intended users in the financial statements (intended users are
also governmental buddies, tax authorities, media, personnel, bankers, financial analysts. They are all
interested). This is achieved by the expression of an opinion (auditors opinion) by the auditor on whether
the financial statements are prepared, in all material respects, in accordance with an applicable
financial reporting framework (Standards as GAAP and all). In the case of most general-purpose
frameworks, that opinion is on whether the financial statements are presented fairly in all material
respects, or give a true and fair view in accordance with the framework. An audit conducted in
accordance with ISAs and relevant ethical requirements enables the auditor to form that opinion. (ISA
200)
Parties to an Audit Engagement
The FS should be prepared in accordance with the financial statement principles and standards. And the
Auditor should look at the reliability of the financial statements. It’s the client who hires the auditor. In
the shareholder meeting, they introduce the auditor. The issues are reported from the auditor to the
external users.
Explaining Assurance practices
Why do we need this Assurance, why do shareholders ask for audits of financial statements. The
conditions:
→ Information Risk: Information may be false (maybe fraudulent), biased (overoptimistic of
consecutive), inaccurate(errors or notes inaccurate), irrelevant, incomplete
→ Consequences: Can impact shareholders, borrowers, suppliers, customers, etc.
→ Complexity: Complex transactions & valuations, summarizing data, etc.
→ Remoteness: Lack of expertise, time, and access
4
,History of Auditing
Modern Auditing
- The need for capital increased beyond the
combined resources of the owners of companies
→ Increased reliance on external financing (debt + equity)
→ Separation between management and ownership
- First professional body (society of accountants) was founded in Edinburgh in 1853
- US – Securities and Exchange Commissions (SEC): Securities Acts of 1934 required “certification” of
financial statements.
- Netherlands (2019):
→ 12.099 audits of PIEs
→ 7.771 auditors of non-PIEs
→ 15.510 CPAs in 2018 (4.548 active in public audits)
Modern Auditing: The need for regulation
The shift from self-regulation to government-imposed regulation. It is because of frauds and bankruptcy
they made this growth in regulation.
→ Sarbanes-Oxley Act of 2002 (SOX): PCAOB, certification by management, Audit of Internal Controls
→ 8th EU Directive enacted in 2006: Educational requirements and Independence (non-audit services,
cooling-off period, mandatory partner rotation)
Audit market reform in response to the financial crisis. It was not an accounting crisis in 2008, but
companies blamed auditors where they were during the time to prevent it from happening.
→ Revised auditors’ report incl. key audit matters paragraph
→ Mandatory firm rotation
This shows there is a need for regulation for stakeholders to trust the audit profession
5
,Audit in crisis
→ Failure to issue going concern (GC) opinions during the financial crisis:
Wachovia, HBOS, Dexia, Fortis
→ Major financial scandals and failures: Carillion, Steinhoff, Tesco, Imtech,
Vestia, etc.
Also, a reason why there is a demand for regulations. As a consequence of this
crisis, the audit looks into improvements in the profession. Many papers give
suggestions to introduce improvements to the professions. For example, what
is the part of the auditor to fill in the gap of preventing Fraud, it this possible?
Also about going concern is going to be discussed. Another issue is that
academics and the audit profession, what are audit quality indicators. So a call
for change.
The value of an Audit
- Demand comes from the regulation (exogenous) and from within the economy (endogenous)
- Value depends on public confidence in the competence and independence of the auditor.
Origin of Economic Demand
- Agency theory; The stewardship (monitoring) hypothesis
- Information hypothesis
- Insurance (deep pockets) Hypothesis
1. Agency theory
Producers are agents (Stewards) of capital providers, who are principals.
→ Example: Managers of public companies “work” for shareholders, hence managers are agents, and
shareholders are principals.
Assume that (assumptions):
- Everyone maximizes his or her own self-interest.
- Everyone has “rational expectations” (i.e., has perfect judgment and foresight)
Agents (managers): Require compensation to work hard.
Agents (managers): tend to shirk (not work hard) Because principals (shareholders) cannot readily
monitor their work levels.
→ this creates a conflict of interest
What can principals do? Anticipating agents’ shirking, principals propose to reduce the amount of
compensation given to agents. But.. Anticipating principals’ compensation reduction proposals, agents
make assertions and hire attesters (auditors, attesters give principals comfort that agents are working
hard). Hence, assurance demand arises endogenously (from within the market system). Audits reduce
adverse selection and moral hazard between managers and capital providers.
So looking at the information hypothesis. The benefits of reliable information:
→ It reduces risk (estimation error): Lower risk premium, the risk that the information is unreliable is
lower, so the risk premium is lower
→ Leads to the improvement of (internal) decision making: Finding errors, improve internal accounting
& decision making
6
,Demand for audits:
→ Normal conduct: the absence of audit may signal negligence or fraud on behalf of management
(everybody has an auditor and opinion about reliability and only one company does not have, raises
questions).
→ In-house general counsels: liability protection to clients
→ Reputation protection by auditors, increases reliability (from information theory) cost of capital
lower, reputation is really important!
→ Deep pockets theory. If an auditor issues an unqualified opinion, confirming that FS gives a true and
fair view. In case afterward, it's concluded that there is a material misstatement, the auditor is sewed
(mostly). First the manager, but they prob. Have not have enough cash so u can further sew the auditor.
7
,2 Paper week 1: Paper Kausar Shroff White 2016
In this, they show that voluntary audits can serve as a signal or screening mechanism that gives us
information about the riskiness of a company.
We know from prior literature that financial statement audits increase the quality and reliability of
financial statement disclosures. This means that the reporting quality is higher for companies with the FS
audit than for companies without an audit. This is because audits reduce information asymmetry and the
cost of capital (verification effect)
The authors argue that the choice to obtain an audit can provide incremental information to creditors.
→ They believe that choice of voluntary audit provides insight into the future prospects of the company
→ Audits are costly, so it is expected that firms only choose to be audited voluntarily if the benefits
outweigh the costs
Many companies are subject to mandatory audits, so impossible to study the impact of voluntary audit
choice. In the UK increased audit exemption threshold in 2004: This means that companies that are
required to have an audit until 2004, didn’t need an audit anymore after 2004. These companies choose
to have an audit voluntarily
This study empirically tests the impact of audit choice of financing frictions. They believe that relaxation
financing frictions should result in bad investment efficiency and higher finance flexibility.
Hypothesis development
The verification benefit of an audit is that it reduces financing friction (e.g. adverse selection, moral
hazard). Thereby improving resource allocation and contracting efficiency
→ Increased credibility of financial statement disclosures
Likely that voluntary decision to be audited conveys incremental information to external stakeholders
This is based on two different theories
1. Signaling theory:
→ Firm wants to signal that it is a high-quality investment opportunity
→ However, such a signal is only credible if it’s a costly signal. This means that Firms will only spend
money on an audit if they expect to reap (greater) benefits in the future
2. Screening literature:
→ External financers may require an audit to see if the firm can withstand an audit (test). The idea is that
low-quality firms will not choose to undergo a costly audit, because the risk of failing audits is too high.
This leads to the following Hypothesis: A Firm’s choice to voluntarily obtain an audit provides
information about the firm’s future prospect that reduces financing frictions, leading to an increase in
debt and investment
8
,Settings:
UK: Concerns that audits created disproportionally high costs for small companies
1994: Private companies are not required to be audited if sales were below 1million pounds and the
assets did not exceed 1.4million pounds
Amendment to companies act: Companies with fiscal years after January 30, 2004, were allowed to opt-
out of an audit if: sales did not exceed 5.6 million ponds and assets did not exceed 2.8million pounds
For this study, this setting is the “ideal setting” because:
1. Privately owned companies relied heavily on external financing
→ Any relaxation of financing constraints is likely to have a major impact on investment and financing
decisions (constraint limits or controls what you can do. Financial constraints are specific and objective
obstacles rather than being general or subjective in nature. )
2. Audits are especially costly for these firms (credible signal) not only related to audit fees but also to
management time
3. Regulatory change allows authors to keep the verification (assurance) effect constant.
→ Only focus on incremental effect of audit choices (incremental effects: 1 an increase or addition, esp.
one of a series. 2 the act of increasing; augmentation. 3 (Maths) a small positive or negative change in a
variable or function)
Data
Authors rely on financial statement data from FAME (Bureau van Dijk)
First: Identify firms that qualify for new audit exemption (treatment firms)
→ Sales less than 5,6mil pounds and assets below 2.8m pounds
→ At least sales of 1 mil pounds and assets of 1,4m pounds
Next: Identify the control firms
→ Find matched control firms so:
→ Companies that still require an audit post-2004
→ Companies that had a voluntary audit before and after 2004
→ They exclude companies in the financial industry
→ Drop if financial data is missing
9
, Figure that shows treatment and control samples. In the middle, we see a treatment sample. This relates
to companies who had a mandatory audit till 2001-2003, and are no longer required after 2004. But
these companies chose to remain audited on a voluntary basis. The first is a mandatory audit control
sample. So both time periods have mandatory audits. The second control sample has voluntary audits
before 2004 and after 2004.
Why are control groups required?
→ Simple analysis of only treatment firms would not allow excluding potential confounding effects (e.g.
changing economic conditions or investment opportunities)
→ Difference-in-difference methodology resolves this, as both treatment and control firms would be
similarly influenced by changing market conditions (so that’s why we choose this design)
Why are treatment firms matched with firms in control groups?
→ Because matching has to be done based on investment and financing determinants.
→ Hence, all companies in the sample should be similarly affected by systematic increases (or decreases)
in investment opportunities.
→ Unlikely that treatment group is affected by changing market conditions while both control groups
would be unaffected
Research design:
Ai, At, and Aind are intercepts. So the author wants to examine whether treatment firms, companies
subject to changes in regulation, have different investment opportunities after changes in regulations.
(Treatment_FIRM * Post_Regi,t)
10
