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Audit Quality

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Integrated Reporting and Audit Quality

Part of the book series: Contributions to Management Science ((MANAGEMENT SC.))

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Abstract

The concept of audit quality has been widely discussed in both theory and practice regarding the features and items that characterize the effectiveness of audit procedures and services. Recently, audit quality has received massive attention by the mass media, practitioners, firms, regulators and scholars, especially after the financial crisis of 2008. Within this field, one of the most crucial activities that auditors perform in the audit process is the assessment of audit risk, in order to identify and evaluate the components of audit risk and the interdependencies among them. Several research streams emerge from the literature. This Chapter focuses on the following: the relationship between audit risk and audit fees; the audit risk evaluation in the client-acceptance decision; the link between audit risk and corporate governance; and the audit risk model in light of the global financial crisis. The Chapter ends with a new proposal for measuring audit risk; in particular, audit risk could be measured from a qualitative and quantitative point of view. Qualitative features of the audit risk model are related to the corporate governance system in place within the firm and the quality of the internal control system, while quantitative features refer to the size of the company, usually measured by total revenues, total assets or total shareholders’ equity.

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Notes

  1. 1.

    The ISA clarified the objectives of external auditors as follows: “The objectives of the auditor are: (a) To form an opinion on the financial statements based on an evaluation of the conclusions drawn from the audit evidence obtained; and (b) To express clearly that opinion through a written report that also describes the basis for that opinion.” (ISA 700: 654).

  2. 2.

    The auditor’s report shall include a section with the heading “Opinion.” (ISA 700: 660).

  3. 3.

    The internal control system is responsible for verifying the reliability of overall financial accounting disclosure and safeguarding internal assets from intentional and non-intentional losses. In the U.S., Sect. 404 of the Sarbanes Oxley Act (SOX) introduced a mandatory judgement by audit firms on management’s assessment of the overall internal control system. One of the most common definitions of internal control system is that proposed by the COSO Report. This model defined five components, namely: (1) control environment; (2) risk assessment; (3) control activities; (4) monitoring; and (5) information and communication. In 1992, the COSO report defined the internal control system as follows: “Internal control is broadly defined as a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: effectiveness and efficiency of operations; reliability of financial reporting; compliance with applicable laws and regulations” (COSO 1992: 3).

  4. 4.

    For a complete analysis of inherent risk and control risk see Sect. 3.2.1.

  5. 5.

    SOX states that “The auditor is prohibited from providing the following non-audit services to an audit client including its affiliates: Bookkeeping; Financial information systems design and implementation; Appraisal or valuation services, fairness opinions, or contribution-in-kind reports; Actuarial services; Internal audit outsourcing services; Management functions or human resources; Broker-dealer, investment adviser, or investment banking services; and Legal services and expert services unrelated to the audit.” (SOX 2002).

  6. 6.

    Materiality is a widely discussed concept in both the theory and practice in the fields of accounting and auditing (Messier Jr et al. 2005). The Financial Accounting Standards Board’s Discussion Memorandum (FASB 1975: 3) states: “The concept of materiality pervades the financial accounting and reporting process. It influences decisions regarding the collection, classification, measurement, and summarization of data concerning the results of an enterprise’s economic activities.” In the auditing process, materiality is useful to evaluate the results of the auditing tests (Messier Jr et al. 2005). The determination of the threshold is under auditors’ discretion and the materiality is defined at the beginning of the audit process, representing the “amount by which the account or class of transactions can be misstated and not be considered material” (Messier Jr et al. 2005: 156).

  7. 7.

    The ISA defined inherent risk as follows: “The susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls” (ISA 200: 77).

  8. 8.

    The ISA defined control risk as follows: “The risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.” (ISA 200: 77).

  9. 9.

    The ISA defines detection risk as follows: “Detection risk relates to the nature, timing and extent of the auditor’s procedures that are determined by the auditor to reduce audit risk to an acceptably low level. It is therefore a function of the effectiveness of an audit procedure and of its application by the auditor. Matters such as: 1) adequate planning; 2) proper assignment of personnel to the engagement team; 3) the application of professional skepticism; and 4) supervision and review of the audit work performed, assist to enhance the effectiveness of an audit procedure and of its application and reduce the possibility that an auditor might select an inappropriate audit procedure, misapply an appropriate audit procedure, or misinterpret the audit results.” (ISA 200: 90).

  10. 10.

    The PCAOB (2003: 1248) states “Policies and procedures should be established for deciding whether to accept or continue a client relationship and whether to perform a specific engagement for that client. Such policies and procedures should provide the firm with reasonable assurance that the likelihood of association with a client whose management lacks integrity is minimized. Establishing such policies and procedures does not imply that a firm vouches for the integrity or reliability of a client, nor does it imply that a firm has a duty to any person or entity but itself with respect to the acceptance, rejection, or retention of clients. However, prudence suggests that a firm be selective in determining its client relationships and the professional services it will provide.” The AICPA (2007) states ”The firm should establish policies and procedures for the acceptance and continuance of client relationships and specific engagements, designed to provide the firm with reasonable assurance that it will undertake or continue relationships and engagements only when the firm: a. is competent to perform the engagement and has the capabilities, including time and resources, to do so; b. can comply with legal and relevant ethical requirements; and c. has considered the integrity of the client and does not have information that would lead it to conclude that the client lacks integrity.” AICPA (2007: 2847).

  11. 11.

    The accounting standard provides a description of going concern principle in International Accounting Standard (IAS) 1 (Disclosure of Accounting Policies 1975), which states that a firm has to prepare its financial statements under going concern conditions. If management has significant doubts about the ability of the entity to continue as a going concern, the uncertainties must be disclosed in the auditor report.

  12. 12.

    Board Function Audit Committee Independence is the percentage of independent board members on the audit committee as stipulated by the company. The data source is ESG Asset 4, Thomson Reuters Datastream.

  13. 13.

    Board Function Audit Committee Management Independence is a variable which answers to the following question: “Does the company report that all audit committee members are non-executives?”. The data source is ESG Asset 4, Thomson Reuters Datastream.

  14. 14.

    Board Structure—Experienced Board is the average number of years each board member has been on the board. The data source is ESG Asset 4, Thomson Reuters Datastream.

  15. 15.

    Board Structure Independent Board Members is the percentage of independent board members as reported by the company. The data source is ESG Asset 4, Thomson Reuters Datastream.

  16. 16.

    Corporate Governance score measures a company’s systems and processes, which ensure that its board members and executives act in the best interests of its long term shareholders. It reflects a company's capacity, through its use of best management practices, to direct and control its rights and responsibilities through the creation of incentives, as well as checks and balances in order to generate long term shareholder value. The data source is ESG Asset 4, Thomson Reuters Datastream.

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Authors and Affiliations

  1. Department of Economics and Management, University of Pavia, Pavia, Italy

    Chiara Demartini

  2. Faculty of Economics, Università degli studi Internazionali di Roma, Rome, Italy

    Sara Trucco

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  1. Chiara Demartini
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Demartini, C., Trucco, S. (2017). Audit Quality. In: Integrated Reporting and Audit Quality. Contributions to Management Science. Springer, Cham. https://doi.org/10.1007/978-3-319-48826-4_3

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