Accounting, Organizations and Society xxx (2015) xxx–xxx

Commentary on ‘‘The effect of an audit judgment rule on audit committees’

questioning on accounting estimates’’ (Kang, Trotman, and Trotman)
Sandra C. Vera-Muñoz
248 Mendoza College of Business, University of Notre Dame, Notre Dame, IN 46556-5646, United States
articleinfo
​ vailable online xxxx
Article history: A
abstract
These discussant comments address the Kang, Trotman, and Trotman study on whether introducing an audit judgment rule – which is analogous to the business
judgment rule applied to corporate officers and directors – and deploying innovative audit procedures affect audit committee members’ questioning on accounting
estimates. I believe that the authors have identified a very relevant and timely topic for analysis. In addition, the authors have done a good job motivating the
importance of the topic given the increasingly regulated post-Sarbanes-Oxley environment. In these comments, I attempt to place the Kang, Trotman, and Trotman
study into context and facilitate generation of research ideas by others. My comments are divided into three sections: introduction, the evolving roles and
responsibilities of audit committees and independent auditors, and comments on research design and some directions for future research.
© ​2015 Elsevier Ltd. All rights reserved.
Introduction
The roles and responsibilities of independent auditors and audit committees have been evolving over the last two-and-a-half decades, owing in
part to the changing eco- nomic and regulatory landscape that has shaped this per- iod. First, the wave of corporate scandals in the 1990s provided
impetus for new regulatory bodies and regula- tions that were built on the premise that public companies’ stakeholders should understand and
have confidence in the work of independent auditors and audit committees.​1 ​In addition, owing to the volatility of the global markets, business
transactions have become increasingly complex, which has led to a growing use of judgments and complex
accounting estimates for fair value measurements, asset impairments, and valuation allowances, among others (​U.S. Department of the Treasury,
2008​). This emphasis on judg- ments and accounting estimates in the financial reporting frameworks has led auditors’ decisions to be increasingly
informed by the use of risk-based audit methodologies. In turn, high-risk areas of audit engagements are increasingly being scrutinized by the
Public Company Accounting Oversight Board’s (PCAOB) inspections.
With the above institutional context as a backdrop, ​Kang, Trotman, and Trotman (current issue) ​(hereafter KTT) is based on the premise that
auditors in general expe- rience difficulty in auditing complex accounting estimates, thus suggesting that ​audit quality ​in this area may be com-
promised (​Griffith, Hammersley, Kadous, & Young, 2015​).
E-mail address: ​sveramun@nd.edu

KTT (current issue) ​reports the results of an experiment ​1 ​For reviews of the extant accounting literature on auditor communi-
that is appropriately motivated by the need for evidence ​cations with the audit committee, see ​Cohen, Gaynor, Krishnamoorthy, and
on the effects of (1) introducing (vs. not introducing) an ​Wright (2007)​; on the expanded role of audit committee members, see ​DeZoort, Hermanson, Archambeault, and
Reed (2002) and Vera-Muñoz (2005)​.
audit judgment rule (AJR) and (2) deploying innovative (vs. standard) audit procedures on audit committee
http://dx.doi.org/10.1016/j.aos.2015.04.002 ​0361-3682/​© ​2015 Elsevier Ltd. All rights reserved.
Please cite this article in press as: Vera-Muñoz, S. C. Commentary on ‘‘The effect of an audit judgment rule on audit committees’ question- ing on accounting
estimates’’ (Kang, Trotman, and Trotman). ​Accounting, Organizations and Society (​ 2015), ​http://dx.doi.org/10.1016/ j.aos.2015.04.002
Contents lists available at ​ScienceDirect

Accounting, Organizations and Society

journal homepage: www.elsevier.com/locate/aos
2 ​S.C. Vera-Muñoz / Accounting, Organizations and Society xxx (2015) xxx–xxx
Please cite this article in press as: Vera-Muñoz, S. C. Commentary on ‘‘The effect of an audit judgment rule on audit committees’ question- ing on accounting
estimates’’ (Kang, Trotman, and Trotman). ​Accounting, Organizations and Society (​ 2015), ​http://dx.doi.org/10.1016/ j.aos.2015.04.002
Legal/Regulatory Compliance:
Sarbanes-Oxley Act of 2002; Exchanges; PCAOB standards (e.g., ​AS 16​) and inspections; proposed SEC concept release on enhanced audit committee
disclosures Environmental factors:
Financial/Enterprise risk Speed/complexity of global business processes/transactions Time and resource constraints
KTT (2015) ​2 ​× ​1 + 1 design: Audit judgment rule (AJR):
absent vs. present ​Audit procedures: ​innovative
vs. standard (only when an AJR present)
KTT (2015) ​Contemporaneous factors regarding ACM’s background:
Audit experience/expertise Financial literacy
A​UDIT ​Q​UALITY
Fig. 1. ​The evolving roles and responsibilities of audit committees and independent auditors in overseeing the integrity of the financial reporting process.

2​
For a review of PCAOB research, see ​Abernathy, Barnes, and Stefaniak (2013)​
​ .
Public ​Independent Auditors
P​ROFESSIONAL
Company ​S​KEPTICISM
Audit Committees
members’ (ACM) professional skepticism regarding the
overall comfort with the financial statements, as they reasonableness of a significant accounting estimate related
believe that audit quality is higher when an innovative to an inventory write-down. The study uses a 2 ​x ​1+1
audit procedure is deployed (H2a). However, given an design: an AJR is introduced (vs. not introduced) when a
AJR is introduced, the study finds no significant difference standard audit procedure is deployed; and an innovative
in the number of questions asked by the ACM to the exter- audit procedure is deployed when an AJR is introduced.
nal auditors, regardless of whether or not an innovative The AJR for auditors, suggested by ​Peecher, Solomon,
audit procedure is deployed (H2b), although the ACM’s ​and Trotman (2013)​, is analogous to the business judgment
questions appear to have probative value. rule (BJR) applied to corporate officers and directors. The
This commentary proceeds as follows. First, I will put in BJR is based on the premise that if in the course of manage-
context the importance of the research question addressed ment, officers and directors arrive at a decision that is
by ​KTT (current issue) ​by discussing briefly the evolving within their and the corporation’s authority, and for which
roles and responsibilities of both independent auditors there is a rational basis ‘‘​and they act in good faith​, as the
and ACM in overseeing the integrity of the financial report- result of their independent discretion and judgment, and
ing process. Next, I will comment on some aspects of the uninfluenced by any consideration other than what they
research design used by ​KTT (current issue)​, and will offer honestly believe to be in the best interests of the corpora-
some directions and broad questions for future research. tion,’’ then a court will not second-guess the judgment of
My discussion is guided by ​Fig. 1​. the officers and/or directors; nor will a court ‘‘surcharge the directors and officers for any resulting loss’’
(​O’Connell and Boutros, 2002, p. 385​).
The evolving roles and responsibilities of audit ​KTT (current issue) ​finds that, given a standard audit
committees and independent auditors ​procedure is deployed, the ACM perceive greater account- ability when an AJR is introduced (vs. not
introduced). This
As shown in ​Fig. 1​, several issues related to legal/regu- is because the ACM believe that introducing an AJR causes
latory compliance, coupled with environmental factors the accounting estimate for an inventory write-down to be
have influenced the evolving roles and responsibilities of less conservative and the independent auditors’ due dili-
both the audit committees and independent auditors over gence to be negatively impacted by the AJR (H1a).
the last two-and-a-half decades.​2 ​Multiple regulators, However, the ACM do not ask more questions to the audi-
including the Securities and Exchange Commission (SEC), tors, the Chief Financial Officer (CFO), or the chief internal
the PCAOB, and the various exchanges have oversight over auditor when an AJR is introduced (H1b). ​KTT (current
both audit committees and independent auditors. The ​issue) ​also finds that the auditors’ deployment of innova- tive (vs. standard) audit procedures
when an AJR is intro- duced increases (albeit marginally) the ACM’s perceived
S.C. Vera-Muñoz / Accounting, Organizations and Society xxx (2015) xxx–xxx 3​
Please cite this article in press as: Vera-Muñoz, S. C. Commentary on ‘‘The effect of an audit judgment rule on audit committees’ question- ing on accounting
estimates’’ (Kang, Trotman, and Trotman). ​Accounting, Organizations and Society (​ 2015), ​http://dx.doi.org/10.1016/ j.aos.2015.04.002 ​Sarbanes–Oxley Act of
2002 (SOX) enacted by the SEC for-
in adding a surprise element to the more predictable stan- mally charged audit committees with ‘‘overseeing the
dard audit procedures.’’ accounting and financial reporting processes of the issuer
An unintended consequence of these two different nar- and audits of the financial statements of the issuer’’ (SOX,
ratives is that the manipulation may have unintentionally Section 2, Definitions, Number [3][A], ​U.S. House of
introduced between-condition differences in the engage- ​Representatives, 2002​) and established the PCAOB.
ment partner’s objective: to attenuate inspectors’ criticism Although the PCAOB has no regulatory authority over audit
of the audit (i.e., ‘‘defensive auditing’’) in the standard committees, the consequences of the Board’s inspections,
audit procedures condition, versus to increase audit effec- auditing standards, and other initiatives potentially impact
tiveness in the innovative audit procedures condition. To the incentives of independent auditors and audit commit-
the extent that these different narratives may have caused tees, as well as the incentives of the issuers and their finan-
different perceptions of the engagement partner’s objec- cial reporting process (​Abernathy et al., 2013; Church &
tive in the ACM’s minds, and/or to the extent that the ​Shefchik, 2012; DeFond, 2010; Palmrose, 2013​).
objectives of the participating ACM were aligned or misa- At the same time, the increasing emphasis on judg-
ligned with their perceptions of the engagement partner’s ments and ​estimates ​in the financial reporting frameworks
objectives, this confounding factor makes it difficult to dis- and the use of risk-based audit methodologies have led the
entangle whether the results are due to the audit proce- PCAOB to increase their focus on the communications
dures manipulation itself, or to the effects of between auditors and audit committees. In particular, in
unintentionally introducing differences in the engagement 2012 the PCAOB issued Auditing Standard No. 16 (​AS 16​),
partner’s objective. ‘‘Communications with Audit Committees’’ (​AS No. 16,
A second concern regarding the audit procedures ​PCAOB, 2012​). ​AS 16 ​is intended to increase existing audi-
manipulation relates to the fact that the narrative in the tor communication requirements by requiring the auditor
standard ​procedures condition gives examples of tests that to communicate with audit committees certain matters
rely exclusively on internal data. In contrast, the narrative regarding the company’s accounting policies, practices,
in the ​innovative p​ rocedures condition gives examples of and estimates, including: a description of the process and
tests that rely on both internal and external data. Similar significant assumptions management used to develop crit-
to the concern mentioned above, this potentially con- ical accounting estimates that have a high degree of sub-
founding factor makes it difficult to disentangle whether jectivity, any significant changes management made to
the results are due to the intended manipulation itself, or the processes or assumptions, a description of manage-
to the participating ACM’s preferences for internal data ment’s reasons for the changes, and the effects of the
vs. both internal and external data. changes on the financial statements (​AS No. 16, PCAOB,
Notwithstanding the above construct validity concerns, ​2012​, p. A1–7, A1–8). These enhanced communications
KTT (current issue) ​provides preliminary evidence of an between the auditors and ACM highlight the importance
association between auditors’ deployment of innovative of ACM’s ability to exercise professional skepticism when
audit procedures, given an AJR is introduced, and ACM’s inquiring about management’s assertions related to
perceptions of overall comfort with the financial state- accounting estimates.
ments. More research is needed to provide empirical evi- dence on whether there is an association between deployment of innovative audit
procedures and ACM’s pro- ​KTT (current issue) ​research design and some directions
fessional skepticism. Some broad research questions that ​for future research
arise are: Would the enhanced communications between independent auditors and ACM (e.g., as required by ​AS Innovative audit procedures
16)​ assist the latter in understanding the nature and scope of innovative audit procedures? Would such increased As mentioned earlier, ​KTT
(current issue) ​examines the
understanding provide impetus for more widespread use effects of deploying innovative (vs. standard) audit proce-
of innovative audit procedures, particularly for financial dures on ACM’s professional skepticism when an AJR is
statement accounts most often impacted by audit deficien- introduced. They find that using more innovative audit
cies? Do enhanced communications between auditors and procedures marginally increases ACM’s perceived overall
ACM increase (a) the likelihood of PCAOB inspectors’ comfort with the financial statements, but find no associa-
acceptance of innovative audit procedures?; and/or (b) tion between auditors’ use of innovative audit procedures
the efficacy of PCAOB inspections? In addressing these and ACM’s professional skepticism. These results may be
questions, future studies might draw on the literature on explained by construct validity issues in the operational-
resistance to innovation (​Sharpe, 2013; Sung & Choi, ​ization of the audit procedures variable, which raises some
2014​) to predict the effects (both positive and negative) concerns regarding the interpretation of the results. In par-
of using innovative audit methodologies on PCAOB’s ticular, the narrative in the ​standard p​ rocedures condition
inspections. indicates that the audit engagement partner ‘‘notes that
As discussed earlier, given the increasingly regulated the audit inspectors expect standard procedures, and that
post-SOX environment, PCAOB inspections tend to penal- standard procedures are helpful in reducing their criticism
ize audit firms’ reputations (e.g., when deficient judgments of the audit.’’ In contrast, the narrative in the ​innovative
are documented by inspection agencies). One consequence procedures condition indicates that the audit engagement
of this is the prevalence of ‘‘overly cautious audits or ‘de- partner ‘‘notes that innovative audit procedures are helpful
fensive’ auditing’’ (​U.S. Department of the Treasury, 2008​,
4 ​S.C. Vera-Muñoz / Accounting, Organizations and Society xxx (2015) xxx–xxx
Please cite this article in press as: Vera-Muñoz, S. C. Commentary on ‘‘The effect of an audit judgment rule on audit committees’ question- ing on accounting
estimates’’ (Kang, Trotman, and Trotman). ​Accounting, Organizations and Society (​ 2015), ​http://dx.doi.org/10.1016/ j.aos.2015.04.002 ​p. VII: 28). At the same
time, PCAOB inspections do not
either dissatisfaction or increased difficulties with their reward exceptional or best practices that would improve
audit committees’ time and expertise to oversee the major longer-term audit quality, nor do they provide incentives
risks on their agendas in addition to carrying out their core for audit firms to undertake research and development of
oversight responsibility (​KPMG, 2015​, p. 15). new methods of auditing as the environment changes
Taken together, the above discussion is consistent with (​Kinney, 2005​). Some broad research questions that arise
the argument that, to the extent that time and resource are: Given the penalties-oriented incentives of PCAOB
constraints hinder ACM’s ability to get the information inspections, how do independent auditors and audit com-
they need effectively and efficiently (e.g., from the external mittees balance the cost-and-benefit tradeoffs of develop-
and internal auditors, CEOs and CFOs), their ability to exer- ing and deploying innovative methodologies for auditing
cise professional skepticism will also be negatively the reasonableness of complex, future-oriented accounting
impacted. Results of post hoc analyses of demographic fac- estimates? A fruitful area for future research is the use of
tors in ​KTT (current issue) ​provide preliminary evidence of data analytics, which shows promise for auditors (e.g., for
a potential ACM background effect (e.g., external audit internal controls testing, fair value measurement, and rev-
experience, partner experience, financial knowledge) on enue recognition), as data analytics afford auditors the
their professional skepticism. These results point to some opportunity to look at larger samples of data and to find
fruitful areas for future research. For instance, future stud- anomalies for further investigation.
 ies could examine the individual and joint effects of time Finally, as noted above, the design in ​KTT (current issue)
constraints, ACM background, AJR, and innovative audit is not a fully-crossed, 2 ​x ​2 design (i.e., AJR introduced vs.
methodologies on ACM’s professional skepticism. A broad not introduced; innovative vs. standard audit procedures).
research question is: Do tradeoffs exist between audit A fully-crossed design would allow examining the effect of
committee makeup, time constraints, and professional deploying innovative (vs. standard) audit procedures on
skepticism? ACM’s professional skepticism given the current regime (i.e., when an AJR is not introduced), or whether this effect obtains only
when an AJR is introduced. This is important
Professional skepticism of auditors and audit committee ​because existing U.S. standards (e.g., ASB, PCAOB) do ​not
members ​preclude auditors from using innovative audit procedures under the current regime. A fully-crossed design would
In connection with its 2012–2016 Strategic Plan, the also allow testing for the interaction between audit proce-
PCAOB has identified as a near-term priority a project to dures and the AJR.
‘‘enhance the ability of audit committees to evaluate the independence, objectivity, and ​skepticism ​of their auditors’’ ​Time and resource
constraints
(​Center for Audit Quality, 2013​, p. 5). Furthermore, in 2015 the SEC is expected to issue a concept release that will The speed and complexity of
business and risk over-
address ways of enhancing audit committee disclosures, sight are straining many audit committee agendas. As
including matters such as whether the audit committee new financial and enterprise risks (e.g., cybersecurity, for-
should report on its role in the financial reporting supply eign corruption) continue to multiply, the workload of the
chain along with the CEO, CFO, and audit firm, and whether audit committees continues to expand beyond their core
auditors or someone else should be required to assess and role of overseeing a company’s financial reporting. The
report on the duties and operational effectiveness of the audit committee has arguably become the ‘‘kitchen junk
audit committee. drawer’’ for many corporate boards (​Rapoport & Lublin,
KTT (current issue) ​examines whether a proposed AJR ​2015​). Consistent with this argument, a global survey of
affects audit committee members’ professional skepticism; audit committee members recently released by public
however, their study does not examine whether the pro- accounting firm KPMG cautions audit committees ‘‘to be
posed AJR affects ​auditors​’ professional skepticism. wary of ‘mission creep,’ and to consistently question
Importantly, when audit committee members in the afore- whether new and ongoing issues belong on the audit com-
mentioned KPMG survey were asked to rate their audit mittee’s agenda. Does the allocation of risk oversight activ-
committee’s oversight effectiveness in challenging man- ities make sense in light of how the risk and regulatory
agement and ​applying s​ kepticism, 93% of the 1500 respon- environment has changed recently?’’ (​KPMG, 2015​, p. 18).
dents gave ratings ranging from ‘‘generally’’ to ‘‘highly’’ Indeed, when asked, ‘‘To which group has the board
effective (​KPMG, 2015​, p. 25). In contrast, when asked assigned the majority of tasks directly related to the over-
about their general level of satisfaction that their external sight of several categories of risk?,’’ the respondents in the
auditor demonstrates objectivity and appropriate ​skepti- ​KPMG global survey ranked the audit committee as being
cism t​ hrough their actions and discussions, over one-third primarily responsible (relative to the full board and to
of the 1500 respondents said that they were either ‘‘less other committees of the board) in four areas: legal/regula-
than satisfied’’ or ‘‘not satisfied’’ (​KPMG, 2015​, p. 20). tory compliance, financial risk, anti-bribery and corrup-
These results point to a gap between ACM’s perceptions tion, and risk management process. Further, the KPMG
of their ability to ​apply ​professional skepticism when scru- survey reports that three quarters of the 1500 respondents
tinizing the work of external auditors, and their percep- said the amount of time required to carry out their respon-
tions of auditors’ ability to demonstrate general sibilities has increased at least ‘‘moderately’’ over the past
objectivity and skepticism through their discussions and two years. Additionally, 40% of the respondents expressed
interactions with the ACM.
S.C. Vera-Muñoz / Accounting, Organizations and Society xxx (2015) xxx–xxx ​5
consequences of auditors’ and ACM’s professional skepticism. ​KTT (current issue) ​is
As shown in ​Fig. 1​, because both auditors and audit committee members p in the right direction.
are responsible for overseeing the integrity of the financial reporting process, research that
examines factors that affect how audit committee mem- bers assess independent auditors’nowledgments
professional skepticism is needed. Some potential research questions that arise are: Do
differences in the ACM’s experience/expertise and financial literacy differentially affect The author gratefully acknowledges the helpful com- ments and
their assessments of auditors’ professional skepticism? Do ACM’s early profes- estions sional of Lisa Koonce (Editor), and the generous financial support of Deloitte &
skepticism assessments of auditors facilitate their ability to constructively engage cheboth
LLP and of KPMG LLP through its Department of Accountancy’s Faculty
parties in areas of common interest and to get the information that ACM need effectively
owship program.
and efficiently? Do enhanced communications between ACM and external auditors about
difficult or con- tentious matters (e.g., as suggested by ​AS 16​) affect (posi- tively or
rences
negatively) the ACM’s assessments of auditors’ professional skepticism? By publishing
further research on these questions, academics can provide useful insights on the nathy,
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Please cite this article in press as: Vera-Muñoz, S. C. Commentary on ‘‘The effect of an audit judgment rule on audit committees’ question- ing on accounting estimates’’ (Kang,
Trotman, and Trotman). ​Accounting, Organizations and Society (​ 2015), ​http://dx.doi.org/10.1016/ j.aos.2015.04.002