The life expectancy of an audit engagement decreases when firms make relatively large income-increasing and income-decreasing accruals. Internal control weakness also shortens the life of the audit engagement, and weak internal controls may subsume the effect of abnormal accruals.
What’s Inside?
The authors examine whether abnormal accruals, either income increasing or income decreasing, affect audit engagement length. They then control for the impact of internal control weakness on audit engagement life expectancy.
How Is This Research Useful to Practitioners?
Accruals that are reported in the financial statements are negotiated with auditors. Management, with the incentive to meet or beat earnings expectations, is biased toward income-increasing accruals. Auditors, who are concerned with litigation risk, prefer income-decreasing accruals. This conflict between auditors and their clients can cause either party to shorten the audit engagement.
The authors’ findings suggest that abnormal accruals shorten the audit engagement. Changing auditors can be costly for both companies and auditors because it requires start-up costs and because significant up-front client-specific investments are associated with the early years of an audit engagement. The longer the engagement, the more efficient the audit.
The Sarbanes–Oxley Act of 2002 (SOX) requires that management review the adequacy of the firm’s internal control system and that auditors provide an opinion on management’s findings. The authors report evidence that internal control inefficiencies shorten the audit engagement. Although it may be complicated and ambiguous to determine whether financial statements have excessive accruals, reports disclosing any significant internal control weakness are easily observable.
How Did the Authors Conduct This Research?
The authors apply a multiperiod hazard/duration model to study the effects of abnormal accruals on the audit engagement life expectancy. A sample of 56,827 firm-year audit engagements from 1988 to 2009, including ongoing engagements, is examined.
Three different variables representing abnormal accruals are tested in three different multiperiod hazard/duration models. The results provide evidence that both income-increasing and income-decreasing abnormal accruals shorten the audit engagement life span.
Previous researchers have found an association between internal control weakness and poorly estimated accruals that are not subsequently realized as cash flows. The authors add a control variable to their models—internal control weakness, which is found in the SOX disclosure and audit opinion of the internal controls assessment. Internal control weakness is statistically significant in reducing the audit engagement life expectancy in all models, but adding the variable diminishes the explanatory power of the abnormal accruals on the audit engagement life expectancy.
This finding suggests that internal control weaknesses might subsume the impact of abnormal accruals in explaining audit engagement life expectancy. The authors caution against generalized conclusions because the sample size is greatly reduced when the internal control variable is added to the formula.
The authors are the first to explore determinants of audit engagement life expectancy. Therefore, caution should be exercised in interpreting the results. The findings are informative for future research regarding cross-sectional variation in future expected audit engagement tenure.
Abstractor’s Viewpoint
Income-increasing accruals that are larger than expected might be an indication that management is trying to manage earnings. But SOX-mandated disclosure requirements, and the auditors’ opinion thereof, should prevent some earnings manipulation. Similarly, income-decreasing accruals that are larger than expected may be a result of auditors’ detecting unusual risks in company operations.
Abnormal accrual detection is not straightforward. The discrete auditor’s opinion of a company’s internal control system might be the most efficient source to detect some conflict between the auditor and management, which could result in the termination of the audit engagement.