Auditing theory

What is noteworthy about the research reviewed in 1.4 is that the main source of theory about auditing is based on economic theory, specifically agency theory. Agency theory modeling is used to explain the conjectured relationships. Audit logic and theory focus on how auditors actually provide assurance when they have the incentives to do so. Audit theory from this perspective is much like the philosophy of other professional disciplines like law, medicine, or engineering in that it focuses on making the audit process effective rather than the incentives to make that process effective. We do not normally question the motives of a professional; instead, professional programs focus on making the professional effective at what they do. Thus although incentives are important, the heart of most professional schools is teaching the technical skills that make the professional effective as a practitioner, assuming the right incentives are normally there. A consumer of professional services tends to assume the incentives are there and that the real issue is the competence of the practitioner. This might explain why regulators have not made as much use of research findings as some researchers would like. The regulators seem to view their primary role as giving feedback to audit practitioners on how effective they are. When regulators play the primary role of providing audit incentives, they also greatly influence effective practices.

Effective practices are in part determined by logic and philosophy. Philosophy is important in identifying the goals of the audit and logical reasoning is, or at least should be, used in justifying how well those goals are achieved. For example, ISA 200.03 identifies the goal of the financial statement audit as follows: “to enhance the degree of confidence of intended users in the financial statements.” This is achieved by the “expression of an opinion on whether the financial statements are materially in compliance with or presented fairly in all material respects in accordance with the framework.”

The ethics branch of philosophy is most useful in helping identify the goals that impact others. This is captured by professional ethics standards. In developing a philosophy for a discipline, it is important to remember an important interplay between concepts and data (evidence) from philosophy of science: “data without concepts are blind and concepts without data are empty” (Norreklit 2017, 85). Scientific revolutions and lesser changes in a field occur mainly because of changing concepts reflecting new' knowledge. This can apply to auditing as well. One relatively new concept is that of argumentation with evidence to implement the practical reasoning the auditor must apply (Barnes 1991). This is the focus of Chapter 2.

The conceptual development of effective audits is primarily captured by research in auditing theory or certain aspects of it such as statistical reasoning. This has historically taken the form of book-length monographs either by accounting firms, e.g., Skinner and Anderson (1966) and Leslie et al. (1979), or by academics, e.g., Mautz and Sharaf (1961). Pioneering articles in audit philosophy include Toba (1975) and Gibbs (1978) on audit evidence, and Pratt and Van Peursem (1993) on the broader conceptual framework of auditing. The general trend over the last four or five decades is that accounting firms and practitioners have become less involved in audit theory and have been increasingly replaced by academics and regulators.

A limitation of audit philosophy as it has evolved so far is that it has ignored the subject matter of financial statement auditing, which is the accounting theory and standards. Auditors must not only gather sufficient appropriate evidence but also use that evidence to effectively evaluate the financial reporting asserted by management. The trend to link audit quality with accounting quality as discussed in DeFond and Zhang (2014) suggests that a theory' of auditing may not be separable from the theory', if there is one, underlying the subject matter of the audit. This integration has largely' been missing in the literature. We outline such an integration based on proposals in Mautz and Sharaf (1961) and Smieliauskas (1999) on the fair presentation concept of audit theory in Chapter 11.

It may be that auditing should be embedded in a theory of corporate governance, the legal system, and other institutional aspects of an economy' and culture, especially if auditing is viewed as a trust-promoting activity (Eilifsen and Willekens 2008). For example, cultural aspects of society that may have an impact include power distance and uncertainty' avoidance as will be discussed in Chapter 2. Such influences can impact the level of assurance and materiality, and this was already reflected in the 10 audit standards that existed at the time the first basic philosophy' of audit study came out in 1961. The authors Mautz and Sharaf (1961) describe their pioneering study as the first attempt to develop a theory of auditing. The key' concepts they focused on were: independence, ethical conduct, evidence, due care, and fair presentation. Interestingly, other than due care and evidence, little of the empirical audit research deals with these concepts. Moreover, other research on audit theory has tended to focus on evidence issues, e.g., Toba (1975), Kissinger (1977), and Steele (1992). Pratt and Van Peursem (1993) provide a more complete conceptual framework for auditing. Their proposed conceptual framework includes postulates (assumptions) of auditing and key' concepts that represent “general ideas fundamental to the study of auditing” (ibid., 27, Figure 1.1). Key assumptions include verifiability, independence, and that standards of accountability' exist. We will explore these in more detail in this book.

In our view, what is missing from many audit conceptual frameworks is a fuller development of the fair presentation concept, especially in light of the current debate about its interpretation. The Mautz and Sharaf (1961) fair presentation concept thus seems to be a key feature of audit theory' largely missing from subsequent theory research, although the recent audit quality concept may incorporate it. However, fair presentation is much more clearly linked to underlying accounting theory' and this in turn suggests thataudit and accounting theory may need to be linked more closely. This idea is summarized along with other key concepts from prior research in Table 1.1.

Dennis (2015) provides an updated view of audit theory. He argues for an audit theory as a form of practical reasoning with specified objectives. The overall objective is to enhance the credibility of financial statements through the expression of an opinion on fairness of presentation on relevance and reliability of the information in the financial statements (ibid., 76—77). He notes that different evidence is required for confirming predictions to evidence on past events (ibid., 94). He notes the importance of a causal story in providing a convincing explanation of linking the evidence to the audit conclusion (ibid., 104). The conclusion should be the best explanation of the evidence (ibid., 107). The events to be confirmed are those associated with the financial statements (ibid., 113). Materiality judgments are needed to judge user decision-making needs (ibid., 129) and the needs of the public interest (ibid., 147). The professional judgment of the preceding involves a process of non-deductive practical reasoning. Ideally all the above should be documented in the audit file so as to create a record of the inferential process used to support the audit opinion.

Barnes (1991) makes the case that the practical reasoning applied to audits is best implemented using the concept of argumentation from philosophy. Argumentation theory is used extensively in law and practical reasoning of all types. Stephen Toulmin is considered the most influential theoretical scholar on argumentation (Wikipedia,

Table 1.1 Concepts of auditing

Source: A modification and extension of Pratt and Van Peursem (1993,18), Table 2.

“Argumentation theory”). Toulmin (1958) and Toulmin et al. (1984) developed the original model of argumentation, elements of which we use here, and later extended it to develop an evolutionary model of conceptual change. Toulmin aimed to provide good argumentation for a conclusion that is able to withstand criticism. Toulmin’s (1972) later work incorporates the role of innovation in a field and he viewed argumentation as a form of competition in which ideas survive and evolve on the basis of the arguments supporting them. According to Toulmin (1972), a process of conceptual change in a field such as accounting is comparable to Darwin’s model of biological evolution. Under this view an analysis of argumentation can be a way of creating new knowledge in the accounting field. The relevance of an argumentation approach is perhaps best illustrated by the fact that virtually all published research in the field of auditing/accounting involves argumentation to convince the reader of a particular conclusion or finding.

An important distinction is that between argumentation and explanation: an argument must justify the conclusion because the conclusion is in doubt, whereas in an explanation the conclusion is not in doubt but it answers the “why” question about the conclusion (i.e., why we have the conclusion). For example, all accounting and auditing research is implemented by using argumentation. Standard setting at the international level is increasingly using a clarity format in which the objectives of a standard are stated at the beginning so that practitioners can better understand the purpose of the standard in implementation. The standard can thus be used as part of the argument if it relates to the purpose of the standard.

After considering other research in the next chapter, we develop an overall framework for audit argumentation to guide auditor reasoning with evidence and its documentation in the audit file.

End-of- chapter question

Organize a debate in class with no more than four students on each side of the debate. One side of the debate argues for the compliance reporting perspective advocated by Palmrose and Kinney (2018), while the other side argues for the fair presentation perspective as advocated by DeFond et al. (2018). It is okay for both sides to read both papers in developing their arguments. After the debate there should be a class vote helping to resolve which perspective of the auditor’s social role should be followed by practicing auditors: by standard setters in developing auditing, or perhaps accounting standards?

Another option is to have each student write up a critical analysis of the two articles.