[Professional standards for analytical procedures call for auditors to hypothesize likely causes of unexpected patterns in financial statement balances and to develop plans to investigate (SAS 56). Therefore, audit efficiency and effectiveness depend on competency in recognizing patterns in financial data and in hypothesizing likely causes of those patterns to serve as a guide for further testing. Yet our knowledge of how well auditors accomplish these crucial steps has been limited by the difficulty of developing research tasks with criteria for evaluating auditor performance. The purpose of this study is to relate processes of pattern recognition and hypothesis generation to quality of performance in an analytical task. To accomplish this purpose, we conducted a laboratory study in which 21 auditors were asked to think aloud while performing an analytical procedures task. The case contained a seeded error that caused a fairly complex pattern of discrepancies between projected and unaudited financial ratios and balances. Think-aloud verbal protocols provided a trace of subjects' reasoning processes, and the seeded error provided an outcome criterion to evaluate the hypotheses they generated. This design supplies evidence needed to evaluate pattern recognition and hypothesis generation processes that lead to correct and incorrect outcomes. Results indicated that three auditors made acquisition errors and four failed to combine crucial cues into a pattern. Of the 14 auditors who recognized the pattern, six proposed a hypothesis consistent with the pattern. Thus, hypothesis generation was the stage at which process errors most frequently occurred, and the least experienced auditors had the most difficulty at that stage. Specific process problems that inhibited generation of a correct hypothesis included: addressing only part of a recognized pattern, and/or fixating on a certain error type. Thus, protocol analysis allowed insight into which stages in the process proved most difficult for the auditors and why, providing a focus for further research and decision aid development. This research responds to the call for inclusion of criterion outcomes in audit judgment research (e.g., Libby 1981; Ashton 1982; Biggs 1985; Davis and Solomon 1989). The importance of criterion outcomes can be seen in the advances made in decision research in medicine (e.g., Johnson et al. 1982; Patel and Groen 1986; Lesgold et al. 1988). and physics (e.g., Chi et al. 1982; Robertson 1990). In medicine especially, the ability to relate diagnostic processes to outcome quality has contributed to the theory and practice of medical decision making (Kassirer 1989) in ways that have been unavailable in auditing.]

We examine detection and severity classification of internal control deficiencies (ICD) identified under Section 404 of the Sarbanes-Oxley Act of 2002. While the cost/benefit balance of auditor testing of internal controls is highly controversial, prior research has not examined auditor versus client detection of ICD, nor has it examined factors auditors consider in judging ICD severity. We find that auditors detect about three-fourths of unremediated ICD, usually though control testing. This finding contrasts with extant research inferring control deficiency detection effectiveness from publicly available data, underscoring the value of Section 404 auditor testing in improving financial reporting quality. Auditors judge greater severity when a misstatement has already occurred. In the absence of a misstatement, severity is contingent on client and ICD characteristics, implying a more complex and nuanced judgment process without objective evidence of control failure. We also find that clients often underestimate ICD severity, but this tendency is lower among well-controlled companies with a well-designed Section 404 process.

The auditor must trade off potential losses from both ineffectiveness (failure to detect client errors) and inefficiency. However, auditing standards do not specify how the auditor is to achieve an appropriate balance between these two conflicting objectives. This paper presents a multiple criteria decision‐making (MCDM) model of an audit planning decision in which an effectiveness vs. efficiency trade‐off is required. The key advantage of the MCDM model developed here is that an optimal solution is obtained without requiring ex ante specification of a loss function by the auditor. Thus, the model addresses a previously recognized problem (e.g., Menzefricke, 1984) that loss functions may vary depending on characteristics of the audit. In this paper, we develop a model of the auditor's sampling plan selection problem incorporating multiple decision criteria, use the model under a variety of simulated audit conditions, and compare our results with previous research. Résumé. Le vérificateur doit parvenir à un compromis entre les pertes pouvant être occasionnées à la fois par l'inefficacité (non‐détection d'erreurs commises par l'entreprise cliente) et l'inefficience. Les normes de vérification ne précisent cependant pas comment le vérificateur doit parvenir à un équilibre approprié entre ces deux objectifs conflictuels. Les auteurs proposent un modèle de dècision à critères multiples qui s'applique à la décision de planification de la vérification exigeant un compromis efficacité‐efficience. Le principal avantage de ce modèle est qu'il permet d'obtenir une solution optimale sans exiger la formulation ex ante par le vérificateur d'une fonction de perte. Le modèle porte done sur une question sur laquelle se sont déjà penchés les chercheurs (Menzefricke, 1984, par exemple): les fonctions de perte peuvent varier selon les caractéristiques de la vérification. Les auteurs élaborent ici un modèle qui s'applique au problème de sélection par le vérificateur d'un plan d'échantillonnage incorporant des critères de décision multiples. Ils utilisent le modèle en simulant diverses situations de vérification et comparent les résultats obtenus avec ceux des travaux précédents.

The article relates processes of pattern recognition and hypotheses generation to auditors' quality of performance in an analytical task. Professional standards for analytical procedures call for auditors to hypothesize likely causes of unexpected patterns in financial statement balances and to develop plans to investigate. Therefore, audit efficiency and effectiveness depend on competency in recognizing patterns in financial data and in hypothesizing likely causes of those patterns to serve as a guide for further testing. In the article, researchers conducted a laboratory study in which 21 auditors were asked to think aloud while performing an analytical procedures task. The case contained a seeded error that caused a fairly complex pattern of discrepancies between projected and unaudited financial ratios and balances. Think-aloud verbal protocols provided a trace of subjects' reasoning processes, and the seeded error provided an outcome criterion to evaluate the hypotheses they generated. This design supplies evidence needed to evaluate pattern recognition and hypothesis generation processes that lead to correct and incorrect outcomes.

The audit review process is a key quality control mechanism. Recent evidence from practice suggests that regulatory risk has made reviews more critical, and audit supervisors are struggling with how to effectively deliver the “tough message”. We contribute to the audit review literature by providing an in-depth understanding of the subordinate's perspective, focusing on the understudied topic of negative feedback and factors that might moderate its effects. We investigate these issues using an experiential questionnaire soliciting subordinate auditors' reactions to highly salient actual review experiences. We find both adverse and beneficial reactions to more negative feedback, including worse attitudes toward coaching relationships, more attempts to manage supervisors' impressions, but greater performance improvement efforts. These reactions are moderated by the subordinate auditor's feedback orientation (i.e., receptivity), and sometimes by the supervisor's goal framing (i.e., emphasis on learning versus performance). Collectively, participants more often chose engagement over workpaper reviews to represent their most salient experiences, and some results differ between these review contexts. Qualitative analysis identifies both similarities and differences in key attributes of these review types. These results are important, as the audit review literature predominately considers workpaper review, and no study compares the two review contexts.

We examine client acceptance and client continuance decisions of a large audit firm to provide empirical evidence on the extent and nature of risk avoidance that the firm uses to purposefully manage its client portfolio. Our results support several key new inferences regarding audit firm portfolio management decisions. First, the results show that this firm is shedding the riskier clients in its portfolio, consistent with the risk avoidance theory of audit firm portfolio management. Second, the results show that the firm's newly accepted clients are less risky than its continuing clients. Although results of both the client continuance and client acceptance decisions imply a less risky portfolio emerging over time, there are greater differences in risk between continuing and discontinued clients than between continuing and newly accepted clients. Third, we find that audit risk factors are more important in audit firm portfolio management decisions than are financial risk factors. Finally, we find no evidence that audit pricing affects the client acceptance and continuance decisions of this firm, controlling for risk and other client characteristics.

The financial security of the investing public relies on high‐quality service by broker‐dealers (BDs), investors' gateway to the financial markets. The SEC has long required auditors to attest to BDs' internal controls and compliance with regulations (including those privately owned). Following the unraveling of the Madoff Ponzi scheme in 2008, the SEC required auditors of all BDs to register with the PCAOB, and Congressional initiatives signaled imminent transition from private (AICPA) to public (PCAOB) oversight. We investigate whether audit quality increased following this transition by measuring whether auditors report material internal control and compliance problems for BD clients where a deficiency presumably existed (i.e., BDs sanctioned by the Financial Industry Regulatory Authority for transgressions against stakeholders). Overall, we do not find increased reporting quality following the regulatory shift but do observe variation by auditor group and BD ownership. While reporting quality for global network firms (GNFs) increases slightly, lower reporting quality observed prior to the regulatory shift for specialist audit firms (having large BD portfolios but small overall size) is exacerbated afterward. This finding complements results of PCAOB inspections and other research identifying audit quality problems among small, industry‐specialized firms in non‐public client settings. Focusing on deficiencies likely more difficult to detect, we find lower reporting quality for private relative to publicly affiliated BDs prior to PCAOB oversight, and lower reporting quality for very small audit firms relative to GNFs following the regulatory shift.

Concern about effective auditing of fair value measurements (FVMs) has risen in recent decades. Building on prior interview-based and experimental research, we provide an engagement-level analysis of challenging FVMs, using quantitative and qualitative data on audit phases from risk assessment to booking adjustments. Challenging FVMs have high estimation uncertainty, high subjectivity, significant/complex assumptions, and multiple valuation techniques. Estimation uncertainty is associated with higher inherent risk assessments, which are, in turn, predictive of client problems identified during the engagement. The use of a valuation specialist by auditors, associated with higher inherent risk and client specialist use, is a key decision: procedures performed by specialists have the highest yield in identifying problems. Auditor-client discussion of an adjustment increases with problem identification and auditors' expressions of residual concern about uncertainty post-testing. However, booked audit adjustments are infrequent; the only factors explaining income-decreasing adjustments are better evidential support and breadth of problems identified.

This paper investigates auditors' assessments of earnings manipulation risk and corporate governance risk, and their planning and pricing decisions in the presence of these identified risks. To conduct this investigation, we use engagement partners' assessments of their existing clients made during the participating public accounting firm's client continuance risk assessment process. We find that auditors plan increased effort and billing rates for clients with earnings manipulation risk, and that the positive relationships between earnings manipulation risk and both effort and billing rates are greater for clients that also have heightened corporate governance risk. These findings provide evidence that auditors assess situations involving both an aggressive management and inadequate corporate governance, and that there is a relationship between those assessments and auditors' planning and pricing decisions.

This paper examines whether risk-management strategies (specifically, the use of specialist personnel and higher billing rates) moderate the effect of risk on client acceptance decisions, thereby assisting auditors in bringing prospective client relationships to acceptable risk/return levels. We propose a conceptual model of the client acceptance decision process, and use archival data on one firm's actual client acceptance decisions to test the model. Our results demonstrate the selective use of risk-management strategies in the client acceptance decision, based on the nature of the risks present for each particular client. Specifically, plans to charge a higher billing rate are associated with a reduction in the negative relationship between client acceptance likelihood and both going-concern risk and public trading status, and plans to assign specialist personnel are associated with a reduction in the negative relationship between client acceptance likelihood and both fraud risk and error risk. Therefore, we provide evidence that while risky clients are less likely to be accepted overall, the application of particular risk-management strategies to particular risks increases the likelihood of accepting such clients.