Introduction

The purpose of this book is to provide an introduction to audit theory' and research relevant to a practitioner. The book is geared to a second audit course in undergraduate or graduate programs for professional accountants that builds on a first course focusing on introducing audit standards and practice. Professional standards change, as do technology and the business environment. We aim to provide more permanent conceptual knowledge for professional accountants that will be useful throughout their careers. It is also important to be aware of relevant research in auditing, professional ethics, and accounting. One can view this book as complementing a financial accounting theory book such as Scott (2015) by focusing on the extent of verifiability of accounting information.

This book is in part inspired by our class experience in using DeFond et al. (2018) and Palmrose and Kinney (2018) as a topic for discussion and class debates. We advise users to read these as a good introduction to what is required in practical reasoning in the accounting profession. Moreover, these articles are very' useful to auditors in understanding the issues from an audit perspective, as they fundamentally' relate to changing auditor responsibilities in a rapidly changing, globalizing world. These papers also illustrate how research can bring practical insights to the profession. For example. Palmrose and Kinney (2018) argue for a traditional compliance reporting perspective where the role of the audit is to check for conformity' with detailed accounting standards. On the other hand, DeFond et al. (2018) argue for a fair presentation perspective wherein the auditor is assumed to verify that the financial reporting captures the economic substance of a firm’s activities over a period of time. These two ideas represent divergent views on the role of the auditor, each supported by impressive evidence from litigation, regulation, and research that should be convincing to a practitioner. This raises a question from professional ethics about what it may mean to act in the public interest.

This controversy' is not just of academic interest. There are increasingly' apparent problems of current audit practice, notably associated with the audit of accounting estimates. These are illustrated by' various recent Canadian, U.S., and U.K. regulators as reflected in their most recent inspection reports/studies as per the below:

• • Canada: www.cpab-ccrc.ca/Documents/News%20and%20Publications/2019%20 Fall%20lnspections%20Report%20EN.pdf
• • U.S.: www.pogo.org/investigation/2019/09/botched-audits-big-four-accounting-firms-fail-many-inspections
• • U.K.: www.iasplus.com/en-gb/news/2019/12/brydon-review-quality-and-effectivenes-of-audit.

Palmrose and Kinney' (2018) probably' represent the current viewpoint of many practitioners. However, extensive research summarized in DeFond and Zhang (2014) shows that in order for financial reporting to be relevant to capital markets, auditors and preparers should aim to capture the economic substance of firm activities to the furthest extent possible. We anticipate that this point of view will gain increasing credence as regulators around the world compete to make their markets more attractive by encouraging auditors in their countries to adopt a more market-relevant perspective on audits of financial statements. Auditors have the responsibility to evaluate the auditee financial reporting and in adverse opinion situations specify what the financial reporting should be in their reports. ISA 200 identifies a distinction between compliance and fair presentation reporting, but the guidance is vague. Here we identify research that helps clarify the distinction. We know from institutional economics that transaction costs are increasing, but that they are also necessary to support increasingly complex transactions in societies with increasingly complex accountability relationships. The issue of the auditor’s proper and changing social role in modem societies increasingly points to fair presentation reporting that is more sensitive to evolving accountabilities in financial reporting.

We have written this book to assist students, practitioners, and regulators in preparing for this changing audit environment. Specifically, we summarize research and theory that should be most relevant to practitioners and regulators and better prepare them for continuous adaptation. Standards change over time. By focusing on what may be considered more permanent knowledge in the form of theory and related research supporting it, we hope to bring an increasingly needed theory perspective to audit education and practice.

Important concepts for auditors include professional judgment, which is defined by international audit standards as: the application of relevant training, knowledge, and experience, within the context provided by auditing, accounting, and ethical standards, in making informed decisions about the courses of action that are appropriate under the circumstances of the audit engagement. An important aspect of professional judgment is professional skepticism, which is defined in international standards as an auditor’s tendency to question management representations and look for corroborating evidence before accepting these representations. In this book we focus on research and theory as it relates to implementing these crucial aspects of auditor reasoning, especially in integrating the audit, accounting, and ethical standards. In particular, we feel that insufficient attention has been paid to how auditors should evaluate fair presentation reporting based on the evidence auditors have available. As the relevance of current audited financial reporting is increasingly being called into question (e.g., see Lev 2018), we feel addressing the quality of audited financial reporting as captured in the DeFond et al. (2018) and Palmrose and Kinney (2018) debate may be a crucial means of keeping auditing relevant in the 21st century'.

The rest of this book is organized as follows. We begin in Chapter 1 with a brief overview of the origins and history of audits as part of a more general accountability relationship. Chapter 2 then outlines what is at the heart of the audit process is a form of practical reasoning based on argumentation concepts that have been used to analyze practical reasoning for 23 centuries. The chapter concludes with an outline of the dominant role of ethics in audit argumentation in a hierarchy of reasons to logically support a conclusion such as an audit opinion.

Chapters 3 to 6 explain auditor accountability mechanisms and review research in each area. Chapter 3 discusses the role of ethics and auditor reputation in the audit profession. It reviews research findings on the effect of auditor reputation on capital market, audit quality, and client loss. Chapter 4 considers how regulations affect the auditing profession and audit practices. It also presents research on specific audit regulations, such as audit report changes, audit partner name disclosure, and joint audits, where two audit firms simultaneously and yet separately audit a company and sign a common audit report. Chapter 5 focuses on the economics of auditing standards. We will discuss the role of professional standards on audit practices, including audit effort and particular audit procedures. We will also review research on how standards can be characterized and how they affect auditor behavior. Chapter 6 focuses on the role of legal liability and disciplinary penalties on the auditors’ behavior. The discussions are on the impacts of various aspects of the legal system, including legal regime, damage award size, and liability rules for audit practice. Furthermore, we also discuss the role of regulator inspections and related disciplinary actions, and their relationship with legal liabilities in shaping auditor behavior.

Chapter 7 discusses various definitions of audit quality as well as how to measure it. Chapter 8 explores the determinants of audit fees and reviews research on audit service pricing. Chapter 9 reviews the impact of audits on capital markets and credit markets.

Chapter 10 reviews research related to the audit risk model on which compliance reporting is based, while Chapter 11 considers research related to evaluating financial reporting that results in fair presentation. The main message of Chapter 11 is to recognize that there are risks of financial reporting other than audit risk, and these are captured by the uncertainty concepts such as existence uncertainty and measurement uncertainty that are introduced in the conceptual frameworks of financial reporting by the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB). Auditors need to address these in addition to audit risk. We refer to this type of financial reporting uncertainty as accounting risk (AccR.) and illustrate how it is a distinct form of judgmental misstatement uncertainty of ISA 450, and contributes to estimation uncertainty of ISA 540.