2019B01 - Internal control quality and audit quality

Using Earnings Conference Call Discussions to Assess Internal Control Quality

KEY TAKE-AWAYS We show that the content of discussions between financial analysts and managers in earnings conference calls is informative about the quality of firms’ internal controls. When internal control quality is low, information quality and reliability suffer. However, high quality information is necessary for financial analysts in order to accurately forecast firm performance. Consequently, earnings conference call discussions are thematically different in such cases. We use a topic modeling approach to capture this thematic difference. The resulting model significantly predicts internal control material weaknesses out of sample, beyond determinants identified by prior research. We also show that the content of earnings conference call discussions is thematically linked to the nature of internal control material weaknesses, and that the predictive power of earnings conference call discussions is higher when management forecasts are less accurate. Finally, we document that the content of earnings conference call discussions is associated with audit fees. Overall, our results suggest that analysts may serve as an external monitor of internal control systems, thereby safeguarding financial reporting quality.

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Internal Control Deficiencies and Audit Staffing

KEY TAKE-AWAYS We analyze how engagement lead partners staff audits with types of internal control deficiencies (ICD). Previous literature suggests that audit teams react to the discovery of ICDs by increasing effort in order to keep audit quality constant. However, audit effort is a multifaceted construct due to the heterogeneity of auditor characteristics within an audit team. We argue that the hours worked by expert personnel, such as high-ranking auditors and specialists, represent a scarce resource for the audit firm. In the internal control setting, engagement lead partners are likely to use this resource when audit teams encounter wide-scope ICDs, such as entity wide and ITrelated ICDs. Using proprietary data on the audit processes of Big 4 audit firms in the Netherlands, we find evidence in line with this argument. When wide-scope ICDs are encountered during the audit, more audit hours are worked by expert auditors. In contrast, only non-expert auditors work more audit hours in engagements with narrow-scope ICDs, such as account level ICDs. In additional analyses, we find that the combination of expert audit effort and ICD scope is associated with audit outcomes and audit quality. Overall, we provide novel evidence on audit staffing in the presence of internal control deficiencies.

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Internal control quality and audit quality: the role of financial analysts

This project studies the role of internal control quality during the audit process and proposes a new source which auditors can use to gain information on control risk. The study aims at understanding the relevance of internal control quality for audit quality and identifying an information channel which may help auditors to assess internal control quality more accurately and efficiently. Since financial analysts are typically macroeconomic experts and have profound industry knowledge, they are arguably able to form a relatively precise assessment of fraud risk. In this context, the team views fraud risk and internal control quality as two sides of the same coin. Financial analysts have an incentive to acquire information on fraud risk (including governance and controls) as undetected fraud negatively affects the quality of financial statements, which are an essential information source of financial analysts’ earnings forecasts. Moreover, analysts explicitly and implicitly include their assessment of fraud risk during earnings conference calls as well as in their analyst reports, which provide an overview of the information that analysts collected of their covered firms and include buy or sell recommendations. Consequently, they argue that the information provided by financial analysts may be a valuable information source for auditors to more accurately and efficiently assess inherent and control risk.

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Internal Control Quality and Audit Quality

This literature review highlights the role of internal controls in the audit process. We find that internal controls are of high economic importance for both the auditor and the client firm, as audit failure has severe consequences on both sides. In general, auditors can reduce the negative effects of weak internal controls on corporate financial reporting quality through increasing audit effort, which is associated with an increase in audit fees. However, increased effort does not fully preclude financial misstatements, i.e., a substantial risk of financial misstatement remains. While the reasons for this are not fully clear, the audit of internal controls is an extremely complex matter. In addition, auditors are subject to significant time and personnel constraints during the audit. This leads us to believe that the use of additional sources of private information on internal control quality could have strong positive consequences for both the auditor and, subsequently, the client firm. We suggest that financial analysts, their discussions during earnings conference calls and the information provided in their reports may be a valuable source of information for auditors. In particular, financial analysts’ assessment of fraud risk may help auditors to more efficiently and accurately assess internal control quality.

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