Research Implications of the Auditing Standard Board's Current Agenda. (Commentary).

This commentary provides insights into auditing standards issues derived from our work with the Auditing Standards Board (ASB) over the last six years. Our roles as the academic members of the ASB included bringing to the ASB's attention research bearing on the issues being addressed and stimulating

Our discussion is structured around recommendations to the ASB included in the Report and Recommendations of the Panel on Audit Effectiveness (2000) (the Panel). Chairman Arthur Levitt of the Securities and Exchange Commission initiated formation of the Panel to assess whether independent audits of public companies' financial statements adequately serve and protect the interests of investors. These recommendations are having a significant effect on the ASB's agenda and will likely shape its agenda over the next several years. Specifically, we address the following four areas in which academic research seems particularly useful: (1)

1. The audit risk model and linkage of risks to audit procedures

2. Fraud risk assessment

3. Going-concern considerations

4. Analytical procedures

THE AUDIT RISK MODEL AND LINKAGE

The Panel made a number of recommendations regarding the current audit risk model, which describes the components of the risk that the auditor will unknowingly fail to appropriately modify his or her opinion on materially misstated financial statements (AICPA 2000, AU 312.02). At the account level, audit risk consists of:

* Inherent risk--the susceptibility of an assertion to a material misstatement, assuming there are no related controls;

* Control risk--the risk that a material misstatement that could occur in an assertion will not be prevented or detected on a timely basis by internal control; and

* Detection risk--the risk that the auditor will not detect such misstatements.

Mathematically, the model is often viewed (2) as:

Audit Risk = Inherent Risk * Control Risk * Detection Risk

It is interesting to note that the ASB deviated somewhat from this model in Statement on Auditing Standards (SAS) No. 82 on the consideration of fraud in a financial statement audit. SAS No. 82 requires the auditor to identify risks indicated by various factors and design "focused tests" that are reactive to those risks. This process of reacting to identified risks is not well articulated with the overall audit risk model.

While concluding that the audit risk model is "appropriate," the Panel (2000, 10) indicated that the model needs "enhancing and updating." In its recommendations to the ASB, the Panel (2000, 14) states that auditing standards should be made more "specific and definitive" without necessarily paying blind homage to the existing audit risk model. The members of the Panel clearly believe that the existing audit risk model and the related auditing standards do not provide sufficient guidance to direct auditor judgment.

Another impetus to reexamine the audit risk model appears in the recently issued report of the Joint Working Group (JWG) composed of members from the American Institute of Certified Public Accountants, the Auditing Practices Board of the United Kingdom and the Republic of Ireland, and the Canadian Institute of Chartered Accountants. The JWG was formed by these organizations to:

* study the methodologies of the large auditing firms;

* understand what drives the development of the methodologies; and

* consider the effect of their development on the way audit firms apply the audit risk model. (JWG 2000)

In discussing the implications of their study of firm methodologies, the JWG researchers question whether current audit methodologies are well described by existing auditing standards (JWG 2000,22).

Responding to these issues, the ASB initiated a comprehensive reexamination of the audit approach embedded in auditing standards, as a possible first step toward creating a new approach. Although a new audit approach has not emerged, we do have some observations.

Observations Regarding a Possible New Audit Approach

Our first observation relates to the scope of risks considered by the auditor. The large accounting firms developed audit approaches calling for a broad consideration of the audit entity's risks. These firms' methodologies begin the audit with an assessment of the audit entity's "business risk," typically defined as the risk that the entity will fail to meet one or more of its objectives (JWG 2000, 24). Because firms believe that this approach results in a more effective audit, the ASB will likely conclude that consideration of business risks is an appropriate requirement for auditing standards. Specifically, auditors will be required to obtain a broad understanding of the audit entity and its environment to identify significant business risks that could result in material misstatements of the financial statements. Then, the auditor will be required to determine and corroborate management's actions to manage those risks. Establishing high-level controls, purchasing insurance, or entering into outsourcing arra ngements are examples of actions that may serve to mitigate or reduce risks.

Finally, the auditor will design tests of controls and substantive tests to address the financial statement implications of the business risks as well as the normal risks of material misstatements inherent in any set of financial statements. In designing audit tests, the contemplated new approach recognizes that certain risks require audit tests focused or designed specifically to address the identified risk. Other risks are adequately addressed by performing "normal" auditing procedures.

Existing research on the audit risk model, summarized by Bell and Wright (1995), provides some insights into the auditor's ability to perform the type of analysis currently contemplated by the ASB. As an example, research on the auditor's ability to identify and assess inherent and fraud risk factors has implications for the auditor's ability to identify general business risk factors. However, research that examines more specifically the judgment process involved in linking assessments of an entity's business risk to financial statement risk is needed. In addition, we are aware of no significant research on the effectiveness of management's actions to manage or control specific business risks, especially on the effectiveness of high-level controls.

Developing an improved audit approach responds to the Panel's (2000, 20) recommendations regarding inherent risk. Under the ASB's proposed approach, the auditor will no longer be allowed to default to an assessment of inherent risk at the maximum without considering what can go wrong at the account or assertion level. Moreover, additional guidance likely will be provided on the degree of auditor knowledge and nature of evidence needed to support assessing inherent risk below the maximum. Research on the relationship between business and inherent risk and financial statement misstatement will help the ASB frame its analysis of these issues.

Observations Regarding Retention of the Current Audit Risk Model

A second observation about the ASB's deliberations is that the existing audit risk model likely will be retained, at least in some form. The existing model is satisfactory for describing conceptually the potential trade-offs between control testing and substantive testing. For example, it convincingly answers questions about the increase in substantive testing required as the allowable detection risk decreases. Indeed, given certain assumptions, one may use it to derive actual audit sample sizes. But the model provides only limited operational guidance for required changes in the timing of audit tests, and even less guidance for changes in the nature of audit tests resulting from an increasingly "risky" situation. Audit practice often requires changing the nature of a procedure in response to a risky situation, rather than expanding the procedure or increasing the number of items sampled. Although the existing audit risk model provides for such alterations in procedures, it offers little detailed guidance to assist the auditor.

Whether a revised audit risk model could more directly address the nature and timing of audit tests, in addition to the extent of such tests, is uncertain. The Developing and Performing Tests of Assertions Task Force, a joint task force of the ASB and International Auditing Practices Committee, will attempt to address this question. Specifically, this task force is charged to develop the basic principles and essential procedures for a standard that provides better, more extensive, and comprehensive guidance to the auditor on how to use the results of risk assessments to determine the nature, timing, and extent of tests of controls and substantive tests. The task force also will respond to the recommendations in the Panel report regarding the linkage of risks and audit procedures, and designing tests of controls and substantive procedures.

Existing research deals extensively with the audit risk model. Several studies address and question the propriety of the multiplicative nature of the model (see Bell and Wright 1995; Dusenbury et al. 2000). Studies of auditor judgment reveal that auditors make reasonably consistent judgments about levels of risk and existing risk factors that affect the financial statements. However, in the various studies auditor-subject reaction to risk generally involves adjusting the extent of procedures rather than adjusting the nature of the procedures (Bedard 1989; Mock and Wright 1993). Because the existing audit risk model may be partially to blame for these phenomena, research on alternative audit risk models (perhaps conditional in nature), and behavioral research that might improve the auditor's ability to react to risks in audit program design, will be worthwhile.

FRAUD RISK ASSESSMENT

The Panel (2000,86) devotes an entire chapter to its findings and recommendations regarding earnings management and fraud, observing that the SAS No. 82 risk assessment and response process is ineffective because it does not "direct auditing procedures specifically toward fraud detection." The Panel also asserts that generally accepted auditing standards contain inadequate guidance for implementing the concept of professional skepticism. Thus, the Panel (2000, 87-92) recommends that the ASB require the following in all audits:

* Discussion by the audit partner with other engagement team members about the vulnerability of the entity to fraud--both "what could go wrong" and "how fraud might be perpetrated";

* A "forensic-type fieldwork phase";

* Retrospective audit procedures involving an analysis of selected opening balance sheet accounts of previously audited financial statements, such as those based on estimates and judgments; and

* Review and documentation of the retrospective and forensic-type procedures and the process of debriefing engagement team members assigned to perform those procedures by the audit partner and assessment of the adequacy of the related follow-up procedures and conclusions.

Detecting fraud in a financial statement audit is the subject of much empirical research. Research on the auditor's responsibility to detect fraud, summarized by Nieschwietz et al. (2000), indicates that there is a great deal of confusion among users, regulators, and even auditors about the auditor's responsibility for detecting fraud. Thus, it is especially important for any auditing standard on fraud to clearly define the auditor's responsibility in order to adequately guide auditor performance and set expectations of users and regulators.

Some implications for the revision of SAS No. 82 can be found in existing research. For example, several studies directed at determining and validating fraud risk factors are summarized by Nieschwietz et al. (2000). Research finds that auditors differ in judgments about the amount of fraud risk signaled by specific red flag indicators (Hackenbrack 1993; Shelton et al. 2001). More sophisticated decision models, such as logit models and expert systems, are found to improve auditors' abilities to distinguish the risk of management fraud (Eining et al. 1997). Prior research also provides some insight into how auditors modify audit plans in response to assessments of fraud risk (e.g., Zimbelman 1997; Nieschwietz et al. 2000; Mock and Turner 2001). The results of these studies are mixed with respect to whether auditors adequately adjust the nature of audit tests for increased risk of fraud. This issue is significant since altering the nature of audit tests is generally believed to be a necessary step in improving t he effectiveness of the audit in detecting intentional misstatements in many situations (e.g., see Bloomfield 1995; Fellingham and Newman 1985; Johnson et al. 1993).

By far the most controversial Panel recommendation is the proposal that forensictype procedures be applied in all audits. Although the ASB will likely require certain procedures directed at the risk of management override of internal control in all audits, it is likely that the bulk of any mandated procedures will be tied to engagements with certain risk profiles. A significant difficulty with this approach is the inability to properly identify profiles that represent a high risk of fraudulent misstatement of the financial statements.

Additional research that identifies and evaluates the effectiveness of fraud risk factors will be useful to the ASB's reconsideration of the SAS No. 82 fraud risk factors. In addition, further research on predictive models may provide insights into the risk profiles that should trigger additional forensic-type procedures, and provide guidance to the ASB and practicing auditors on weighting or combining risk factors when making fraud risk assessments. SAS No. 82 will be significantly improved if guidance is provided about the importance of various fraud risk factors in predicting fraudulent financial reporting.

Research may also provide insights about how the level of professional skepticism of the auditor may be altered in general and in specific situations. As an example, Green and Choi (1997) found that auditors' fraud detection ability is improved by using a neural network fraud classification model that generates few false classifications in the absence of fraud, and signals auditors to perform additional substantive tests when fraud is present. Because they rarely encounter instances of fraud, auditors must condition themselves not to become complacent. In addition, they must accept disproportionate false alarm rates in order to maintain audit effectiveness when fraud is present (Deshmukh et al. 1998). Further research on techniques that alter professional skepticism and increase the auditor's ability to detect fraud will be useful.

GOING-CONCERN CONSIDERATIONS

The Panel analyzed 126 engagements--49 of which included entities with significant risks of viability--and found in all cases the engagement teams were alert to information that could signal an evaluation of whether substantial doubt about the entity's ability to continue as a going concern existed. While acknowledging that auditors understood those signals, the Panel (2000, 60) concluded that:

corroboration of management representations and, more frequently, documentation were cited as areas needing improvement, particularly in connection with the evaluation of prospective financial information that was significant to management's plans.

Consistent with this conclusion, the Panel recommends that both the ASB and audit firms provide expanded guidance and specific examples of procedures to be followed when assessing management's plans for mitigating the adverse conditions and events that raised the auditor's substantial going-concern doubt.

Evaluating Management Plans

Many studies address how often companies fail with and without a going-concern modification prior to the failure, and the characteristics of companies that fail. (3) Holder-Webb and Wilkins (2000) summarize earlier studies and suggest that approximately 57 percent of companies filing for bankruptcy after issuance of SAS No. 59 received going-concern modifications. Figure 1 illustrates the auditor's consideration of the going-concern assumption set forth in SAS No. 59. As described above, the Panel results indicate that identification of conditions and events (step 1 in Figure 1) does not appear to be the reason that 43 percent do not receive going concern modifications. The problem is in the performance of Steps 2 and 3. That is, identifying possible substantial doubt (Step 1) is not as much of an issue as assessing the likelihood of successful implementation of management's remedial plans.

In response to the Panel recommendations in the going-concern area, the ASB recently publicly exposed an amendment to SAS No. 59. This proposal would require the auditor to document the conditions or events that cause the substantial doubt about the entity's ability to continue as a going concern, the audit work performed to evaluate management's plans, the auditor's conclusions about the entity's ability to continue as a going concern for a reasonable period of time, and the consideration of the effect of that conclusion on the financial statements, disclosures, and audit report (AICPA 2001, 16-17). Adoption of this proposed amendment should drive audit practice to a more thorough examination of the feasibility of management's plans.

The Panel report indicates that assessing the likelihood of effective implementation of management's plans is a problem area. In this regard, SAS No. 59 includes general guidance in Paragraphs 8 and 9. Although several studies address the consideration of management's plans (e.g., Mutchler et al. 1997; Riley et al. 2000; Behn et al. 2001), they are "exploratory" in that they lead to only very general conclusions. Obtaining CPA firm participation to address the topic is one approach to performing research in this area, but obtaining such access may be difficult. An alternate approach could use publicly available information in the notes to the financial statements and in other management disclosures, such as management's discussion and analysis, (4) to identify management's plans and determine how those plans were implemented and their effects. Such research can provide information needed by the ASB to develop guidance to auditors evaluating such plans.

Defining "Going Concern"

The Panel report also addresses the fact that the term "going concern" is not defined in SAS No.59 by recommending that the Financial Accounting Standards Board define the going-concern concept. At first glance, defining going concern seems simple--a company that files for bankruptcy, sells its assets, and dissolves is not a going concern. Although this situation ordinarily meets everyone's idea of what is not a going concern, it is too narrow a definition for an environment in which companies under financial stress often are purchased or reorganize and continue in operation. In addition, companies often have considerable latitude in determining whether and when to file for bankruptcy and whether to continue in operation throughout the process.

Other perplexing situations arise from the ambiguity surrounding going-concern status. Consider, for example, a situation in which the management/owners of a restaurant in operation for many years open four new restaurants in various parts of a large metropolitan area. Assume that after several years the expansion strategy is not working, and the company is considering closing the four new restaurants at a major loss. In essence, the company plans to liquidate 80 percent of its assets, and continue in existence as it has in the past--as a single restaurant. Is this situation a candidate for a going-concern modification? Does the fact that the company is not going to file for bankruptcy affect the situation?

When SAS No. 59 was issued, ASB members realized that without a definition of going concern, the guidance in the Statement was limited, but there was no consensus on any one definition. Research presenting up-to-date real-world summaries and analyses of "failures" might allow the ASB to address this area more thoroughly. For example, it seems that current finance-related empirical results on the nature of company failures could provide standard setters, including the ASB and the FASB, with background information to help resolve this issue.

Another difficulty not directly addressed by the Panel is the lack of a definition of the "substantial-doubt" trigger for going-concern modifications. Bell and Wright (1995, 167- 168) review studies that calculate an average response and conclude that auditors believe that the level of uncertainty needed for a going-concern modification is approximately a 60 percent likelihood of failure. Yet there is wide variability in interpreting the term "substantial doubt." What represents a perception of 60 percent likelihood of failure may differ significantly among auditors. Divergence in "failure risk thresholds" could be addressed empirically. Research could also address alternative, better-defined concepts for triggering the going-concern modification. For example, one might use the trigger of "probable" from FASB Statement No. 5, or the concept of "more likely than not."

ANALYTICAL PROCEDURES

The Panel report includes a variety of recommendations relating to analytical procedures. To the ASB, the Panel recommends that auditing standards be made more specific about what auditors need to do to design and perform analytical procedures in differing circumstances:

* Provide guidance on how to design substantive analytical procedures for different types of accounts and assertions.

* Clearly articulate how relevant audit concepts, such as planning, materiality, control risk assessment and testing of controls, and desired levels of assurance, influence the design and performance of analytical procedures.

* Provide guidance on linking analytical procedures in the overall review stage to the auditor's conclusions reached in the audit and the sufficiency of the audit evidence that supports those conclusions.

* Develop more guidance on when it is appropriate/inappropriate for the auditor to rely on management's explanations during the course of the audit and on obtaining additional evidence to corroborate those explanations.

* Specify appropriate documentation requirements.

The Panel report also makes several recommendations to audit firms on operationalizing the above suggestions.

The ASB is addressing these recommendations. The Auditing Practice Release titled Analytical Procedures (AICPA 1998) is revised and elevated to an Audit Guide to increase its authority and visibility. This document provides significant guidance on the performance of substantive analytical procedures. In addition, the ASB issued an exposure draft to amend SAS No. 56 by requiring the following documentation when an analytical procedure is used as the principal substantive test of a significant financial statement assertion (AICPA, 2001, 16):

* The expectation and how it was developed;

* Results of the comparison of the expectation to the recorded amounts or ratios developed from amounts; and

* Any additional auditing procedures performed in response to significant unexpected differences arising from the analytical procedure and the results of such additional procedures.

Analytical Procedures Used in Audits

Bell and Wright (1995) provide a comprehensive review of research on the use of analytical procedures. A number of studies summarized in that review have relevance to standard setters, such as the role of unaudited values on auditors' expectations and auditors' acceptance of the wrong explanation for a fluctuation. In addition, subsequent articles extend this research. See, for example, Hirst and Koonce (1996), Anderson and Koonce (1998), and the review article by Bedard et al. (1999). Continued research on analytical procedures could produce helpful guidance for firms, and possibly standard setters, on areas such as developing expectations and assessing the effects that differences between expectations and recorded amounts have on the design of other audit procedures. Also, this research may provide insights about what auditors should do to substantiate management's explanations for significant differences.

As Bell and Wright (1995) observe, research raises a number of concerns about the effectiveness of analytical procedures. This becomes particularly important when auditors wish to rely heavily on analytical procedures to audit an account or assertion to the exclusion of, or significant reduction in, detailed tests of transactions and balances. There is a need for more work in this area that integrates materiality, control risk assessment, and assessment of the desired level of assurance. Chen and Leitch (1998, 1999) summarize a number of studies of the effectiveness of analytical procedures and the use of more sophisticated expectation models to improve the effectiveness of analytical procedures.

Additional research is needed to help guide the ASB as it addresses the effectiveness of analytical procedures. A starting point might be to obtain a more complete understanding of the analytical procedures used today in practice and to integrate past research findings into an evaluation of their likely effectiveness. In addition, in response to Panel concerns, studies that model factors such as the concepts of planning, materiality, control risk assessment and control testing, and the desired levels of assurance are likely to be particularly helpful. (5)

Analytical Procedures for Other Purposes

The above discussion presumes the use of analytical procedures in a periodic audit of historical financial information. Analytical procedures are likely to play an expanded role as clients begin to make more current information publicly available. For example, assume that a client begins placing monthly, weekly, or even daily sales data on its web site, perhaps even offering users a "view" of its database. Users might desire some form of CPA assurance on those data. The jointly sponsored American Institute of Certified Public Accountants/Canadian Institute of Certified Accountants (1999) Research Report, Continuous Auditing, emphasizes both the need for highly reliable controls as well as automated audit procedures. Automated analytical procedures seem particularly appropriate in such circumstances since the use of tests of details of transactions and balances may be restricted by time constraints. While various analytical procedures seem potential candidates for continuous audits, those that integrate data-m ining techniques appear to hold particular promise. As an example, the auditor might monitor the accuracy of the allowance for uncollectible accounts by developing analytics that involve drilling down into the characteristics of recorded accounts receivable. Empirical research in this area may go a long way toward facilitating economically feasible continuous auditing.

CONCLUSIONS

We described a few of the projects on the ASB's current agenda that arose from the recommendations of the Panel on Audit Effectiveness. At the time of this commentary the ASB's agenda items also include the development of a GAAS hierarchy, audit documentation, auditing revenues, auditing financial instruments, investment performance statistics, and nonfinancial information. As can be seen by the content of the ASB's agenda, it is an exciting time for standards setting. It is likely that the standards issued over the next few years will have as pervasive an effect on audit practice as did the "expectation" gap standards issued in the late 1980s. These developments provide a unique opportunity for academics to undertake research that can significantly improve the audit process. While it is unlikely that new empirical research could be undertaken in time to influence the current deliberations of the ASB, this should not deter research on the core audit issues described in this commentary. It is clear that severa l of these issues are recurring in nature--the auditor's responsibility for detection of fraud alone was reconsidered three times in the last 13 years. In addition, conceptual papers and manuscripts that distill implications from existing research could certainly assist the ASB in the shorter run.

Kurt J. Pany is a Professor at Arizona State University and O. Ray Whittington is a Professor at DePaul University.

(1.) Other areas in the Panel's report with recommendations to the ASB include multilocation audits, assessing control risk, guidance regarding confirmations, auditing revenue, auditing reserves, materiality, waived adjustments, analysts' expectations, reliance on internal auditors, establishment of a GAAS hierarchy, and audit documentation.

(2.) An alternate formulation of this model presented in AU 350 presents detection risk in terms of two components--(1) the risk that analytical procedures and other relevant substantive tests fall to detect material misstatements and (2) the allowable risk of incorrect acceptance of a substantive test of details.

(3.) Weil (2001) questions why auditors issued modified reports for going-concern status in only three of ten recent publicly traded "dot-corn" failures.

(4.) Mutchler (1985) used information included in the MD&A field of the Disclosure Database.

(5.) A study by Ettredge et al. (2000) addresses the effects of interim review procedures on the timing of adjustments to quarterly earnings. Given that a review is composed primarily of inquiry and analytical procedures, their findings that timely reviews at the end of each of the first three quarters reduce the extent of fourth-quarter adjustments provides limited evidence on the effectiveness of analytical procedures.

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