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

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?

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

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

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

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

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

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

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

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!

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

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

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

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

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

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

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

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?”

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”

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 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.

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

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

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

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 ( ) 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 –No known comprehensively collected data on audit- related corrections, deficiency remediation, common auditor mistakes, or even litigation.

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

4. What can young scholars do to help themselves? 1.Understand practice and standards to identify emerging practice problems 2.Take courses, monitor new theories or estimation that might be applicable 3.Explore specific promising solutions – assuming you can get data needed 4.Maximize research design 5.Minimize data requested

What can scholars do... (cont’d) 6.Compactly describe: what question you ask, why answer is important (think broadly), and how you’ll do it 7.Present best case for benefits and costs to firms (including long-term public benefits) 8.Speak “their” language – be a translator between various scholars and practice 9.Write a two-way agreement letter on confidentiality and publication rights 10.Implement study with proper respect

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.

5. Your thoughts?

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

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 Hint Two:

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