Auditing Research on Current Issues: The Impact of SOX

Auditing Section Doctoral Consortium

New Orleans, Louisiana

January 13, 2005

William R. Kinney, Jr.University of Texas at Austin

Outline

• Background and assumptions

• A model for corporate governance and auditing research

• Research implications of SOX

• Specific research questions and barriers

• Conclusion and implications

1. Background and assumptions

• Research should reflect real world problems and complexity

• Big change in real world - SOX

• Need to identify new real world problems and

– new theories, – new methods, and– new data to address them

You are best qualified for the task

Information is valuable if the decision maker believes:

• Measurement criteria are relevant

• Measurement criteria are carefully applied

• Measurement display is trustworthy

. . . but:

Sarbanes-Oxley Act of 2002 challenges– Relevance of GAAP– Reliability of auditing standards– Trustworthiness of auditors, independent

directors, standards setters, financial intermediaries, and contracts that bind them

. . . this is a big new potato -- new states and new actions need new theories to explain/understand

Sarbanes-Oxley Act

• Emphasizes compliance with rules over value• Management certification of “fair presentation”• Mandates some GAAP changes• Mandates internal control assertions/attestation• Funding changes for IB/FA, FASB, Auditing

standards setting

Sarbanes-Oxley Act also

• Mandates: – Independent (non-employee) audit committee – IAC hires and fires auditor (IAC is the “client”)– Non-audit service bans– “police beat” inspections of audit engagements

• PCAOB as independent (and no cost/benefit test) : – Auditing standards setter (not just GAAS)

– Independence standards setter– Registered audit firms’ inspector and enforcer

Financial Reporting Regulators in the U.S.

SEC(Supreme)

FASB

GAAP

PCAOB

AuditStds

IndepStds.

Inspect/Enforce

COSO(Int Ctrl)

Measurement criteria Application of criteria

2. Accounting and Corporate Governance1978-2002

General public

Competitors Analysts/intermediaries

StockholdersManagement

Auditor

Independent Directors

FASB/AICPA

SEC

Congress

CustomersWorkersSuppliersLenders

FS

Management responsible for financial statements and has discretion to

• choose transactions in which to engage• choose methods to account for transactions

and events• choose how carefully to apply chosen

methods (precision and bias of estimates and judgments)

• choose to misapply methods (non-GAAP)

…is motivated to manage reported earnings and has market power over all gatekeepers!

Accounting and Corporate Governance Show me the money – pre-SOX!

Generalpublic

Competitors Analysts/intermediaries

StockholdersManagement

Auditor

Independent Directors

FASB/AICPA

SEC

Congress

CustomersWorkersSuppliersLenders

FS

$ $

$

$$

$

$

$

$

Accounting and Corporate Governance Show me the money – post-SOX!

Generalpublic

Competitors Analysts/intermediaries

StockholdersManagement

Auditor

Independent Directors

FASB/AICPA/

SEC

Congress

CustomersWorkersSuppliersLenders

FS

$ $

$

$$

$

$

$

$

$

x

x

x

x

PCAOB

Accounting scandals, ethics, and regulations

1980s precursors 1990s developments 1999-2002 regs.

Reduced stock commissionsLoose GAAP for stock-based comp. expense

Information technology (MSNBC/ CNN)

Great stock market /1993 OBRA sal. cap

GAAS allows waiving M < M*

Huge stock-based compensation

Pressure to “meet or beat EPS numbers”

Manage/manipulate by pennies per share

Auditors allow M < M*

SAS No. 89, 1999SAB No. 99, 2000Sarbanes-Oxley Act of 2002

3. Measurement Criteria Relevance

• GAAP – – is it adequate for governance?– will mgt’s certification of “fairness” help?

• COSO – does it adequately/usefully measure internal control process effectiveness?

• Are “new” measurement criteria dead?• Can registered auditors’ “direct report” under

PCAOB standards?

PCAOB Mission Statement

• Oversee the auditors of public companies in order to (a) protect the interests of investors and (b) further the public interest in the preparation of informative, fair, and independent audit reports. (emphasis added)

Question: does (b) allow PCAOB to require auditors to report on something other than management’s assertions with respect to GAAP and COSO?

Care in measurement: audit adequacy

• Audits of – process vs. output (IC vs. financial statements)– estimates and risk assessments vs. hard numbers– relationships vs. physical assets– fairness vs. GAAP

• Will the audit committee as the “client” and “can’t lie to your auditor” help?

• “Auditing Standards” vs. GAAS (law vs. acceptance)?• The cost and value of PCAOB vs. self-regulation?• Effect of “police beat” audit inspections?

Trustworthiness of:

• Use audit firm for – transactions design? systems design? internal audit outsourcing? tax advice? accounting “advice”???

• Conflicts of interest for: CEO, CFO, IA, IB/FA, corp. counsel, lenders, government officials

• Audit Committee incentives for diligence? (independent vs. invested)

• An auditor who is paid by clients?

Are NAS restrictions the best way to ensure auditor independence?

4. Research in Analytics

• Need models for: – value of process vs. state reliability– role of subjective “fair presentation” – reporting and auditing “second moments”– economics of auditing as a regulated activity– auditing in context of corporate governance– rules-based vs. risk-based auditing

standards• Barrier: extra parties and institutions hard to

model

Research in Experiments

• Questions: – Does SAB No. 99 work (Nelson et al. 2003)? – Will IAASB ED on accounting estimates

work?– Does SAS No. 99 work?– Does ERM (COSO II) improve COSO?

• Barrier: How to convince regulated audit firms that your experiments are valuable to them – what’s in it for them now?

Research in Archival Studies

• What are the effects of – fee disclosures on profits and performance?– PCAOB as standards setter and regulator (similar

to evaluating the FASB and SEC)?– SOX on innovation in auditing and standardized

business measurement?– SOX provisions on attracting new CPAs?

• Barrier - How to work with PCAOB and regulated audit firms as independent researchers – why should they help you?

5. Summary and Conclusions

• Wonderful opportunity for all – if you miss on this one you will not prosper

• Should think broadly about what value auditing can add in a SOX-regulated information environment

• Can we do it / Yes we can – if . . .