Auditing research and social structure: our comparative advantage

1. Auditing research and social structure: our comparative advantage Bill Kinney University of Texas at Austin January 13, 2011

2. 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?

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

4. Sources of predictions (or theory) Economics Psychology Laws, regulations, Transparency, Enforcement, Market mechanisms, Contracts/incentives Mores, Culture Societal structure

5. Auditing research domain Accounting Auditing • Laws, regs, governance • Contracts/ incentives • Professional standards • Professional Oversight: • external • internal • Firm organization, mores Professional structure

6. Financial reporting laws, regulations, and standards across borders EU law/ EC directives/ Sec. reg.?? FR law/ Sec. reg.? • FR national • FRF&AudStds • Borse rules • FR private lit. UK culture/ contracts/ governance FR culture/ contracts/ governance D, Inc. E, Inc. F Corp. G, Inc. H, Inc. I Corp. Who will interpret and enforce these FRFs and AudStds? Will they differ? US law/ Sec. reg. UK law/ Sec. reg.? • UK national • FRF&AudStds • LSE rules • UK private lit. • US national • FRF&AudStds • NYSE rules • US private lit. Global Financial Reporting Framework and Auditing Standards US culture/ contracts/ governance A, Inc. B, Inc. C Corp. ICAEW panel on AuQ

7. 2. Information Quality (value) . . . Depends on decision maker’s perception of (GAAP/ IFRS, SA, ISO, EPA) (Mgt. reput AudStds) (Mgt. reput./ Aud. reput./ Prof. reput./ Exchg rules/ SEC/ monit. Culture . . .) • measurement method relevance • care in measurement process • trustworthiness of measurement display and process

8. 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

9. 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

10. 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!

11. Audits of historical financial information (ISAs) verification management measurement Entity Management Entity Management Entity mgt or Audit comm. Assurance contract Financial Condition/ Perform Assurance contract FRF (IFRS) Financial statements Practitioner/ verifier Investors

12. Reviews of historical financial information (ISRE 2400) verification management measurement Entity Management Entity Management Entity mgt or Audit comm. Assurance contract Financial Condition/ Perform Assurance contract FRF (IFRS) Financial statements Practitioner/ verifier Investors

13. Audits of Internal Control - Attest verification management measurement Entity Management Entity Management Entity mgt or Audit comm. ICFR process quality Assurance contract Assurance contract COSO ICFR report Practitioner/ verifier Investors?

14. Audits of Internal Control - Direct verification management measurement Entity Management Practitioner/ Measurer Entity mgt or Audit comm. ICFR process quality Assurance contract Assurance contract COSO ICFR report Practitioner/ verifier Investors?

15. Audits of GHG Emissions (ISAE 3410) verification management measurement Entity Mgt/ Practition-meas/ other Entity Management Entity mgt or Audit comm. GHG emissions Assurance contract Assurance contract Stated Investors/ Regulators Tradptnrs GHG Inventory Practitioner- verifier

16. Performance Audits (GAO/NAO: ISAE 3000) verification management measurement AGENCY Management Gov. Account- ability Office Congress Assurance contract Assurance contract AGENCY Performance Stated Performance report Gov. Account- ability Office Congress

17. Non-assurance engagement – HFI Compilation verification management measurement Entity Management Practitioner/ Measurer Fin. condition/ performance FRF Performance report Parliament

18. 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?”

19. 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”

20. 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.

21. 2 3 Tax: - Non-audit fees Restatement (five categories) 5 4 Industry, size, audit policies, acquisitions, etc. Non-public data: 944 matched firms for 1995-2000(Kinney, Palmrose, Scholz, JAR 2004) Independent Dependent 1 Lower quality financial reporting Auditor dependence on client NAS fees Conceptual Operational Control (1. +)

22. Independent Dependent 1 Theoretical Y (Y) Theoretical X (X) Conceptual 2 3 5 Operational X Operational Y Operational 4 Other potentially influential variables Vs and Zs Control Predictive Validity Boxes - causal theory testing + +

23. Desired behaviors New policy 2 identical 3 5 Operational X Operational Y Operational 4 Other potentially influential variables Vs and Zs Control Predictive Validity Boxes - policy testing Independent Dependent 1 Conceptual >0 Need creativity 0, <0

24. 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.

25. 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, corpgov, ICFR reporting) on Inherent Risk and auditor corrections, prevention, deficiency identification is largely unexplored. Is regulating management necessary (or cheaper than) regulating auditor?

26. 4. What can young scholars do to help themselves? • Understand practice and standards to identify emerging practice problems • Take courses, monitor new theories or estimation that might be applicable • Explore specific promising solutions – assuming you can get data needed • Maximize research design • Minimize data requested

27. What can scholars do . . . (cont’d) • Compactly describe: what question you ask, why answer is important (think broadly), and how you’ll do it • Present best case for benefits and costs to firms(including long-term public benefits) • Speak “their” language – be a translator between various scholars and practice • Write a two-way agreement letter on confidentiality and publication rights • Implement study with proper respect

28. 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.

29. 5. Your thoughts?

30. Hint one: Your main contribution is: 1. New data 2. New estimation 3. New theory (or new problem) Whatever it is, Exploit it!

31. Hint Two: 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

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