Auditing

Description

Respond to the summaries/analyses of your classmates. each comment should be about 50-60 word response  In your responses, please include an explanation and/or a reasoning – don’t just answer “I agree” or “I disagree” without any further analysis.

1. The purpose of this study was to examine litigation risk impacts on real earnings management (REM). The author specifically wanted to find out whether litigation risk discourages managers from taking part in REM.  The author started by defining REM and pointed out different organizations that had experienced this situation. A brief introduction on how litigation impacts the REM is provided, the introduction reveals that litigation risk can deter managers’ attempts to mislead their investors. The study included a detailed literature review and concentrated on areas such as; the REM methods, the link between a misleading disclosure and REM, lawsuits class action involving REM, and the court ruling Ninth Circuit.

After analyzing the secondary research and identifying the gap, the author came up with the hypothesis of the study. The hypothesis of the study was; REM in Ninth circuit firms’ headquarters relative to those on other circuits remain the same even after the 1999 ruling. The subsequent analyses of the study were designed to test this two-sided hypothesis. The sample of this research was selected from all publicly listed firms, and this was available in the Compustat database.

The test compared four years before the court ruling and four years after the Ninth Circuit ruling. According to the researcher, the restriction to this specific period limited concerns on potential confounding events consequences if longer horizons were to be analyzed. The multivariate study tests employed a difference-in-differences out a research design, comparing changes in the REM after the ruling and corresponding control firms change. The test used three REM measures, namely; abnormal discretionary expenses, unexpected production costs, and aggregate measure that combined the two.

The researcher tabulated the findings for easier analysis. After analyzing the results, the researcher found that the real earning management in Ninth Circuit increased significantly after the ruling relative to any other firm and consistent with the litigation risk that is deterring REM. The results also revealed that REM raised further after the verdict when firms issued optimistic disclosure. This evidence was reliable with REM deterring litigation, constraining management’s ability to publish misleading and sanguine disclosure. Such exposure was seen to conceal opportunistic and myopic motives that are underlying REM.

The researcher also documented that any increase in REM caused by a reduction in the risk of litigation is highly pronounced if managers acquire higher incentives that manipulate their incomes. It is also more pronounced when the governance mechanisms are not strong. In conclusion, the researcher came up with courses of action that can be applied to preventing a manager’s violation of fiduciary duties. Such actions included exercising proper governance by encouraging exit or vote measures. Shareholders were encouraged to file lawsuits against directors and management teams violating their duties.

The researcher viewed the litigation as action with a serious reputation, especially in directors and management career implications. According to the author’s opinion, which is supported by the findings, litigation can act as a deterrence role.  According to the researcher, previous studies had not explored the effect of litigation on REM. From the researcher’s perspective, finding out the effect of litigation on REM is paramount due to the sensitivity of REM.

The paper provided a robust verification that litigation can deter REM. The results further indicated that this deterrence effect comes due to REM’s links with excess disclosures that are optimistic. According to the researcher, managers manipulating real actions carry the risk of misrepresenting the true circumstances of those actions since the misrepresentations can be subjected to lawsuits. The author cautioned that the findings do not imply that any increase in the litigation risk is necessarily the efficient method of constraining the opportunism of managers under any circumstances.

2. In this article, “Does litigation deter or encourage real earnings management,” from The Accounting Review, Sterling Huang, Sugata Roychowdhury, and Ewa Sletten analyze the impact of litigation risk on real earnings management (REM). Since the impact of litigation risk on REM is not obvious in advance, the authors of the study conducted colossal statistical analysis, comparison and testing of hypotheses, using the landmark example of the Ninth Circuit Court, which issued in 1999 “a surprising ruling requiring plaintiffs to prove that defendants acted with “deliberate recklessness”.

Since this requirement significantly increased the obstacles to successful corporate litigation, the authors compared the changes in REM of companies located in the Ninth Circuit with changes in companies owned by other judicial regions. The sample spanned four years before and four after the 1999 litigation risk mitigation ordinance for firms in the Ninth Circuit. As a result of this painstaking analysis, it was found that litigation risk deter REM. In their analysis, the authors consider REM as real actions of managers who deviate from normal operational and management processes to increase the company’s revenues, profit, margin.

These actions include overproduction, channel-stuffing and aggressive reduction of discretionary expenses. The analysis also showed that the deterrent effect of litigation arises from the association of REM with overly optimistic disclosure. Thus, based on their “business judgment” in the disclosure notes, managers can provide legal cover for REM. But since, historically, management is often overly optimistic in its explanations, such statements may subsequently be considered misleading and may become the subject of legal dispute.

This manipulation of the company’s profitability can only have a positive effect in the short term and cause irreparable damage to the company’s reputation and value in the market in the long term. Managers must remember that they bear the risk when they have to explain to investors, shareholders, lenders, financial analysts the rationale for their short-term actions that have led to increased profits, but have damaged the long-term value of the company.

In addition, the results of this analysis indicate that the company is more susceptible to REM due to weak corporate governance, unstable and ineffective system of internal controls in the preparation of financial statements. In other words, if a system of internal controls gives managers and directors the opportunity to manipulate the profitability of the company, then it can be said with greater confidence that managers will take advantage of this. In addition, due to the principle of business judgment, REM is more opaque than accrual, which is also tightly controlled with the adoption of Sarbanes-Oxley (SOX).

Thus, in order to reduce the risks of violation by managers of their duties, reduce the risks of manipulation of financial statements by means of explanations deliberately misleading the public and all stakeholders, shareholders can take specific actions by voting, strengthening the role of internal audit in the company, improving corporate governance and the system of risk management.Since litigation can lead to serious reputational and career consequences for management and directors, increasing litigation risk is also an effective way to curb manipulation of a company’s profitability, especially when “managerial incentives to overstate earnings are stronger and corporate governance is weaker”.

3. Huang, Roychowdhury, and Sletten examined if litigation deterred or encouraged real earnings management. The researchers based the study on reports and surveys where executives admitted to preferring and occasionally using various strategies of managing earnings relative, including aggressive reduction of discretionary expenses and an overproduction to influence accruals (Huang et al., 2020, 252). As such, Huang et al. held that methods of managing earnings should concern stakeholders because of massive existing evidence showing external stakeholders face challenges in establishing REM, and it negatively influences the general performance of firms and stocks in the future (Huang et al., 2020, 255). The researchers analyzed the effects of litigation related to abnormal discretionary expenses on Ninth Circuit firms and non-Ninth Circuit firms.

Three thousand three hundred and eighty-seven of the firms analyzed were distinct, while fifty thousand two hundred and twenty-five firms were based on annual observations between 1995 and 2003 (Huang et al., 2020, 257).  The researchers used multivariate tests to analyses the results. The study’s findings showed that litigation has a deterrence role and negatively influences the directors of a firm’s career and reputation.

The study provides deep insights into the connection between litigation and prospects of firms about REM. The findings justify arguments on existing literature that litigation limits the performance and growth of firms. The study is reliable and valid because it involves primary resources that show trends in REM of firms within the specified time. Also, the article is structured in subsections hence making it easy for the reader to follow. However, the authors use a relatively sophisticated language that can be comprehended easily by only experts. Additionally, the study fails to account for instances where a decline in litigation risks limits the application of the findings in general litigation relating to REM in firms.

4. In essence, the COVID-19 crisis has metamorphosized from a health crisis to an economic crisis. Organizations have had to re-think the nature of doing operations so as to sustain their business during and after the crisis. This implies that even those in the audit and accounting professions, have to re-configure how to carry out tasks such as gathering audit evidence and completing an engagement with a client. Traditionally, audit evidence has been physically collected by the auditors by parties external to the client. However, at the moment, public health guidelines require the observance of such things as social distancing as well as quarantines.

This then means that auditors cannot freely move about client’s offices in the name of collecting evidence. As a result, there needs to be a review in the nature of audit evidence collection processes, with the view of reducing or eliminating, physical contacting between the parties. Like other professions, auditors need to be empowered with guidelines that enable them to work remotely.  Another important element of an auditor’s work is inventory observation and validation.

This is also a challenge when individuals have to observe social distancing requirements, including the minimization of unnecessary travel. However, still, audit guidelines can be creatively crafted to allow the physical validation of inventory by auditors. For instance, with roll back and roll forward procedures, auditors can be able to estimate inventory quantities, especially if earlier observations were made not too long ago. Also, technology can be leveraged to validate inventory through the use of video streaming and video recording platforms to enable Auditor First View (AFV) observations on inventory.

While using videos for inventory observation is a new idea, and somewhat controversial especially with regards to conventional audit procedures, the audit, and accounting profession should bear in mind that these are extraordinary times calling for extraordinary measures. However, the validity of these video recordings and/or video live streams should need to be established and ascertained by for example requesting various simultaneous picture angels and/or views.

Additionally, these could be used by auditors to carry out real-time observations of how the client conducts certain activities. It is important to note that some novel procedures picked up during this crisis period will prove invaluable in the years to come. As an example, video lives steaming of an inventory validation exercise should be encouraged in the post-COVID-19 period. In fact, some of the tasks of an AFV that conventionally required the physical presence of an auditor could be substituted by the use of technologies as drones as long as relevant reconfigurations are made to suit the audit profession. Besides, document collection shall need to be re-configured to enable such aspects as digital paper-receiving platforms as well as provision of dated pictures by the client staff. Going to the future will enhance the efficiency of the audit process making some activities in the audit procedures redundant.

Finally, needless to say, the working world today is heavily dependent on virtual meetings as a means to conduct office meetings, as well as brainstorming and training sessions. Therefore, auditors and everyone in the workforce should need to increasingly familiarize themselves with virtual meeting platforms. This calls for some significant level of tech-savviness on the part of auditors as the world has now been catapulted in adapting to the fourth industrial revolution which is the digital revolution.

5. Resolving how to efficiently perform a historically in-person job when social distancing is the current climate of the world, while also being within GAAP and FASB compliance is what the Auditing profession was facing during the onset of COVID-19.  Historically most of auditing work requires physical presence on-site at clients’ offices and facilities.  Much of an auditor’s task consist of (but not limited to) in-person reviews, data collection, physical observations, obtaining source documents, face-to-face interviews, etc.

The article by Appelbaum, Budnik & Vasarhelyi describes the ways Auditors and Accounting incorporated modern technology to perform their job functions and how auditors had to slightly revise the generic risk assessments. ‘First Person View” (aka Auditor First View (AFV)), drones and video-conferencing tools (Zoom, Microsoft Teams, Skype) were alternative solutions for in-person reviews, observations and in-person interviews.  AFV is simply a live stream, usually with a GoPro on someone’s head, which enables the auditor to see firsthand what is being done.  This method has been used to observe inventory counts and to evaluate tangible assets such as PPE.

Drone were helpful in giving an auditor an overview of inventories/PPE and can be fitted with censors and an ‘electronic nose’ to detect abnormalities.  Video-conferencing was utilized more to conduct in-person interviews with the clients.  The video-conferencing was also used internally for brainstorming sessions.

Lastly, obtaining source documents was an easier transition as most documents are already electronically stored on networks or data warehouses.  Pictures with the current date (forensically examined, of course) and secured email confirmations with banks, vendors and lawyers sufficed. Assessing risk was also modified since COVID-19’s presence proposed issues which otherwise wouldn’t have been present.  Was the company’s financial situation strong enough to endure?  How is its liquidity?  Were its suppliers negatively affected thus indirectly interrupting this client’s supply chain?  Did the pandemic improve this client’s performance? How much market securities is owned, and how much of its value decreased?  What about its on-going concern?

Auditors need to consider these factors to provide clear judgment if a company’s financial statements are true and fair.  The article showcases how fluid an auditor’s task is and how contingent it is on the current environment.  Things stay the same for long stretches of time, but things can happen in a second’s notice that changes everything. Given the ‘short-notice’ of social distancing, Auditors and Accounting responded very well incorporating and finding new ways to fulfill their professional obligations remotely through technology.  It is good start and opens up the conversation of how to make it better and more accurate for future usage.

In utilizing technologies, privacy and security issues must be examined since Auditors handle sensitive and confidential materials.  Due to the short notice of social distancing, thus lack of time for sufficient testing, it brings highlights how secure and thorough these methods were and in which areas need improvement.  Where is footage saved and for how long?  Can AFV really be an equal replacement from physical visits?  It limits viewing to only what the employee is looking at (or wants you to see), whereas in-person, an auditor can look at places not captured in the frame. Viewing and picture quality comes into debate with AFW and drones.

There is a novelty with physical presence that cannot be captured/replaced with electronics.  Trival things such as interpersonal interactions are effected as well.  For example, interviews taken through video-conferencing lessens the power of non-verbal cues which is a major factor in interviewing techniques.   The nature of the Auditing and Accounting is very fluid and reactive to the environment.  During Hurricane Irene, the auditing methods used during that time were uniquely to that situation.  Now with COVID-19, auditing methods are mended to adapt to the pandemic’s situation.  Auditing practices are contingent; though similar crisis will yield the same results but every so often, a completely new disruption will occur.  It brings into questions can Auditors and Accounting ever be 100% prepared than just playing defense.

6. In this article, “Auditing and Accounting during and after the COVID-19 crisis,” from The CPA Journal, Deniz Appelbaum, Shaun Budnik, and Miklos Vasarhelyi analyze the impact of business shutdowns and quarantine activities related to the global Covid-19 pandemic on conducting Auditing, in particular on the process of collecting evidences, conducting inventories, interviews, observation and other traditional audit procedures. The authors raise the question of how effective an auditor can be in conditions of social distance, in conditions of physical restrictions on access to assets, personnel, and documents.

As a result of discussions on this topic that is very relevant today, and in the near future, the authors conclude that modern technologies unambiguously allow the auditor to effectively conduct “remote virtual auditing” and even improve its quality and expand the audit opportunities. The authors emphasize that in a pandemic, using technologies for virtual remote auditing, the auditor acquires additional “add-ons,” namely, his eyes are supplemented with high-resolution cameras, ears with video conferencing tools, moving capabilities with drones, and analytical abilities are supplemented with “artificial intelligence (AI ) video assessment tools, and other technologies that can assist in conducting a remote audit examination ”.

In the current conditions of social distancing and quarantine, the most critical importance is compliance with the requirements for the collection of audit evidence, which serve as the basis for the audit conclusion. So, with the help of drones and “first-person view tools”, the auditor can carry out procedures where his physical presence is required (such as an inventory of assets, assessment of their condition, storage conditions). It’s a pity that the camera does not transmit smells, but I think it will be fixed in the near future. Existing software for automatic calculation of inventories (for example, CountThings) allows not only to ensure the fulfillment of the goals of asset counting, but also significantly increase the efficiency and accuracy of this procedure.

The collection of documents, in my opinion, is not a big problem, since most documents are contained in electronic form, signed with an electronic digital signature and protected by encryption. Monitoring of the implementation of a process is provided by “live video streaming tools”, and interviews can be carried out through Zoom, Skype, etc. Although, in truth, such remote audit tools have some drawbacks, for example, during an interview, it may be difficult to recognize elements of non-verbal communication, and video or photo files can be edited to hide possible violations.

For the reliability of audit evidence in digital format, auditors should use software that confirms the veracity and authenticity of such files. Since this “not normal time” can become “normal” for many years to come, auditing authorities should accept the fact that video files form the basis of audit evidence. Auditors should not only use modern technology, but also constantly improve skills in their use;

when planning annual audit assignments, take into account the risk assessment associated with Covid-19, as well as the possibilities and limitations of digital technologies when conducting audit procedures. Auditors also need to provide adequate capacity for storing video evidence in the cloud and reliable cybersecurity using virtual auditing tools. With all this, auditors, of course, should not forget about the importance of critical thinking, professionalism, objective, honest and independent assessment, which, fortunately, Covid-19 crisis did not affect.