Auditing Standard No. 2 vs. Auditing Standard No. 5: Implications for Integrated Audits and Financial Reporting Quality Acito, Hogan, and Imdieke Discussion by Allen Blay
Introduction and Summary This paper provides a link between the two risks of material problems in an integrated audit Material Weaknesses in internal controls Material Misstatements in the financial statements Under AS 5, decrease in audit effort leads to increase in link between unreported predicted material weaknesses and undetected misstatements.
Goals of the PCAOB and an Integrated Audit PCAOB exists to improve quality and reliability of financial reporting information available to the markets and increase investor confidence. Ultimate goal of an integrated audit is to provide reasonable assurance that: Financial Statements presented fairly ICFR is in place and functioning reasonably well (secondary?) Big Question: How can we get to an adequate level of investor confidence at a reasonable cost?
AS 2 vs. AS 5 AS 5 introduced risk-based, top-down approach to ICFR audit Decrease in reported MW from ~14-16% to 2-3% Could a risk-based approach really be the driver of this? Big Question: What effect does this have on overall financial reporting quality?
AS 2 vs. AS 5, cont. Other HUGE change not focused on in prior research: What exactly is a material weakness in ICFR? AS 5 provided auditors with a reference list of indicators detected material misstatement poor oversight any fraud by top management restatement of previous year
Control Deficiencies Frequency Where is a significant deficiency? Where is a material weakness? AS 2 AS 5 Severity
End Result Fewer MW disclosures More useful and accurate MW disclosures(?) More efficient use of resources? More investor confidence? Closer link between undisclosed MW and undetected MM by design??? Empirical question!
Hypotheses H1: No link between AS2, AS5 and frequency of disclosing MW Is this really the null? Any reasonable chance the alternative is not true? Did the definition of a material weakness, in substance, change? Was this the intent of the PCAOB? Is there any way to separate the intended effect from the unintended? Enter H2!
Hypotheses, cont. H2: There is no change in the relation between undisclosed MW and undetected MM between AS 2 and AS 5 What is an undetected MM? How does this relate to reporting quality? Are restatements the best measure? Suggestion: Much more discussion of financial reporting quality needed to motivate H2.
Empirical Approach First, estimate predicted MW separately by standard period If definition of MW changed, did relevant variables also change? What is the effect of requiring Compustat data on distribution of MW? Are you losing a whole bunch of small firms with MW? Lots of other stuff was going on during this time period. Can you argue/provide better support that you are isolating the standard change?
Empirical Approach Next, take predicted, but not issued MW and regress them on restatements Model 2 is almost identical to model 1 new controls may also be related to MW (e.g. Lev, M and A) Estimated separately by standard period Isn t this a joint test of the research questions and the quality of Model 1 in the two standard periods?
Results H1 and H2 both hold, however. Estimation of Model 1 is problematic in AS2 period. 41% of non-mw firms were predicted to have a MW This is much higher than in AS5 period Despite substantially higher # of MW in AS2 period Does this indicate that predicted MW variable is much noisier in AS2 period? Perhaps this drives support for H2 Larger # of incorrect positives -> smaller correlation with restatements. Only control variable sig. (p<0.05) in AS5 period was leverage likely correlated with MW
Audit Quality, once again Conclusion of study: AS5 decreased auditor effort leading to lower audit quality Restatements decreased substantially in AS5 period Isn t this indicative of higher audit quality? Isn t the real concern overall quality of F/R? Perhaps a lower incidence of Adverse ICFR reports was the goal of the PCAOB with AS5? Did adverse ICFR opinions hurt investor confidence more than the benefit? Consider other measures of audit quality Other studies don t really find much difference in AQ measures, but samples are small
Final Thoughts PCAOB is finding deficiencies in more audits post-as5 Many of these involve the audit of both ICFR and FS Why are restatements down so much if audits aren t working? Is it perhaps the case that auditors are better judges of risk than the PCAOB examiners? Disclaimer: I don t necessarily believe that Perhaps an analysis of the costs of AS2 vs. AS5, coupled with an analysis of Type II errors would shed some light on relative trade-offs Disclaimer again: I don t necessarily believe in Type II errors
Auditing is SOOOO Exciting!