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The effect of an internal audit function on audit effort.

ABSTRACT

This study utilizes workpaper evidence from a Big 4 firm to examine how the degree of reliance placed on an internal audit function influences the nature, timing and extent of external audit effort. After controlling for assessed misstatement risk, the degree of reliance is found to significantly influence the timing, but not nature and extent of evidential effort. When the degree of reliance is assessed as high, the external auditor shifts effort from year-end procedures to interim procedures. Because tests of controls are conventionally performed at interim, and substantive tests at year-end, this shift seems to suggest that a "reliance approach" to auditing is followed in the presence of a reliable internal audit function.

INTRODUCTION

The Public Oversight Board Panel on Audit Effectiveness was established in recognition that the effectiveness of external audits is an important issue in the operation of capital markets (AICPA, 2000). One means of increasing the effectiveness of audits would be for the external auditor to make better use of the internal audit function (IAF). Felix, Gramling and Maletta (2001) find that internal audit characteristics have a significant influence on external audit fees, indicating that external auditors utilize the IAF in compiling evidential evidence. Where Felix et al. (2001) examines the influence of IAF characteristics on external audit fees, the objective of this paper is to provide evidence on the effect of the IAF on audit effort decisions. Specifically, we examine how the degree of reliance placed on the IAF, by the external auditor, impacts the nature, timing and extent of audit evidence gathered. The evidence used in this study is unique in that it is obtained from documented utilization of the IAF from the external auditor's working papers.

The recent proposal by the New York Stock Exchange requiring firms to employ an IAF illustrates the importance an IAF plays in corporate governance (IIA, 2003). If the external auditor deems the IAF reliable, it can have an affect on the external financial statement audit. Extant literature has provided primarily indirect evidence on the influence an IAF can have on a financial statement audit due to the lack of availability of audit workpapers. This evidence includes surveys and experimental studies (e.g., Whittington and Margheim, 1993). In contrast with these prior studies, this paper uses data from working papers to provide evidence on the degree to which an IAF affects evidential requirements in the financial statement audit.

SAS 65 (1991) provides the external auditor with guidelines concerning the assessment of the competence and objectivity of the IAF and the subsequent use of internal audit reports and personnel during the audit. In accordance with this guidance, the data-granting firm requires their auditors to assess and document a level of reliance on the IAF. We hypothesize that the level of reliance placed on the IAF will influence evidential planning decisions either indirectly through preliminary risk assessments, and/or directly through the use of prior and concurrent procedures conducted by the IAF. Different levels of reliance on the IAF should result in differences in the nature, timing and extent of audit evidence collected.

This study examines the direct affect of the reliance on an IAF on these three evidential planning characteristics independently within the revenue cycle audit program, while controlling for potential trade-offs between nature, timing and extent decisions. Our findings indicate that reliance on an IAF significantly impacts the timing decision (i.e., as the external auditor's reliance on the IAF increased, evidential effort shifted from year-end to interim period testing.)

This study contributes to the extant literature in several ways. Prior literature has provided mixed results using field-based evidence to examine the expected relationship between risk assessments and evidence plans (Bedard, Mock & Wright, 1999). This study also uses a unique external auditor assessment of an auditee characteristic (level of reliance on the IAF), and examines its influence on external auditor effort decisions.

The next section discusses prior literature and develops pertinent hypotheses. Research design and data is discussed in the next section followed by the results, and then the conclusions.

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

The Audit Process and the IAF

SAS 47 (1983), SAS 65 (1991), and the data-granting audit firm's guidance, suggest that an IAF can influence the financial statement audit in two ways. First, the existence of a reliable IAF could affect preliminary risk assessments, indirectly affecting evidential effort. Second, prior and concurrent IAF work could be used as a substitute for audit procedures directly influencing evidential effort. We expect that the extent to which the IAF affects the audit depends upon the degree of reliance the external auditor places on it.

When planning and performing compliance and substantive tests, the external auditor may utilize audit-relevant activities performed by the IAF. If the external auditor decides this use of the IAF would be efficient, the auditor should assess the competence, work performance, and objectivity of the personnel, and determine how their work might affect the nature, timing and extent of audit procedures (SAS 65). While acknowledging that the evidential process is iterative, the data-granting firm's guidance indicates that a general degree of reliance on the IAF must be established and documented before substantive examination. Characteristics relating to the competence and work performance of the IAF include education, experience, and quality of documentation. When assessing objectivity, the external auditor considers organizational factors influencing the effectiveness of the IAF. These factors include whether the IAF reports to the audit committee or management, and whether the IAF has the autonomy to plan an investigation without prior management authorization. Prior literature has found that these IAF characteristics significantly contribute to the reliance assessment (i.e., Brown, 1983; Schneider, 1984, 1985; Margheim, 1986; Messier & Schneider, 1988; Edge & Farley, 1991; Maletta, 1993). These studies attempt to rank the importance of these characteristics, however, the findings are inconsistent (Krishnamoorthy, 2002). The relative weight the external auditor places on these factors is beyond the scope of this paper.

The Indirect Affect of Risk Assessments

The opinion formulation process is a dynamic, complex sequence of events. Certain pre-planning analyses are conducted to gather necessary information to plan an effective and efficient audit program, including the preliminary assessment of inherent and control risks. The Audit Risk Model (ARM) (SAS 47) does not precisely define auditee risk factors or the manner in which they map into inherent and control risk (i.e., Fellingham and Newman, 1985; Waller, 1993; AICPA, 2000). (1) Audit firm guidance on the depth of knowledge, activities, or procedures necessary to assess these risks is also broad and varied (i.e., Joyce and Libby, 1982; Houghton and Fogerty, 1991).

The external auditor may consider the IAF in the assessment of inherent risk. SAS 47 and SAS 53 (1988) illustrate client and engagement attributes that should be considered in the assessment of inherent risk. These factors summarize the client's economic environment, management characteristics, operating characteristics, and audit engagement characteristics. The external auditor may view a firm with an IAF as having a higher degree of management control consciousness than a firm without an IAF. The existence of an IAF alone does not necessarily warrant consideration by the external auditor. However, the existence of a reliable IAF, and thoughtful use of the IAF's recommendations, may demonstrate management's willingness to invest in oversight and experienced, diligent accounting personnel. This may potentially lead to a lower inherent risk assessment, decreasing evidential requirements.

The external auditor may consider the IAF in the assessment of control risk. The control risk assessment is the external auditor's perception of the likelihood that a material misstatement will not be prevented or detected by the entity's internal controls. Internal control consists of five interrelated components for which management is responsible: the control environment, risk assessment, control activities, information and communication, and monitoring (SAS 78, 1995). The control environment sets the tone of an organization, influencing the control consciousness of the entity's employees, and is the foundation for all other components of internal control (AICPA, 2000). In many companies, the primary role of an IAF is to address these other components (e.g., internal risk assessment, developing and testing control activities, information and communication, and monitoring). The presence of a reliable IAF is likely to result in a stronger control structure, potentially leading to a lower control risk assessment. This may lead to the external auditor requiring less persuasive evidence (nature), more interim evidence (timing), and less overall evidence (extent) to achieve audit objectives.

The external auditor's assessment of the risk of material misstatements is used to develop the evidential plan. Misstatement risk is a combination of the inherent and control risk assessments. It may be viewed as the external auditor-assessed likelihood that a material error will flow through to the financial statements. We use misstatement risk, calculated as the multiplicative combination of inherent and control risk, in our analysis to represent an important external auditor assessment that may be influenced by the IAF, and subsequently affect evidential planning decisions.

The Effect of the IAF on Evidential Effort Choices

In developing the audit plan the external auditor intends to efficiently and effectively obtain sufficient, competent evidence to support an audit opinion. The external auditor may consider the use of certain audit-relevant work performed by the IAF which may change the nature, timing and extent of audit procedures necessary to meet this objective. The audit relevant work may speak to the need for more persuasive evidence, the need for more interim controls testing, and result in reduced external auditor effort.

SAS 31 relates the nature of audit evidence to persuasiveness and independence. If the IAF is considered reliable and objective, the external auditor may consider the financial information provided by management to be more credible, potentially reducing the demand for more persuasive (independent) verification. Because more persuasive information can be more costly, the perceived need for less independent information can improve the efficiency of the audit. Based on the potential for reliance on the IAF provided in both GAAS and IIA Standards, we hypothesize as follows:
H1: The higher the degree of reliance on an IAF, the less persuasive
the evidence required by the external auditor.


The timing of audit procedures refers to the distribution of audit effort between interim procedures and year-end procedures (AICPA, 2000). Tests of controls are conventionally performed at interim, and substantive tests are typically performed at year-end. The external auditor may opt to decrease substantive procedures if reliance on internal controls appears to be warranted. In circumstances where controls are in operation, pertain to the assertion at issue, and are likely to prevent and detect material misstatements, the external auditor may choose to test and rely on those controls as a means to reduce substantive testing. The Institute of Internal Auditor's Professional Practice Standards state that internal audit work should examine and evaluate the adequacy and effectiveness of the system of internal controls, and the quality of performance in carrying out assigned control responsibilities. (2) Thus, procedures performed by the IAF may provide the external auditor with valuable information on whether relevant internal controls are in place and operating effectively. (3) Therefore, when the IAF is deemed to be reliable, we hypothesize that the external auditor will conduct more interim period work. This leads to Hypothesis 2:
H2: The higher the degree of reliance on an IAF, the greater portion
of audit effort committed to interim testing.


The extent of audit effort is the amount of work performed by the external auditor. While the IAF may not significantly affect the planned audit effort, the utilization of prior and concurrent work performed by the IAF may reduce the number of external auditor hours necessary to achieve the audit objectives. For example, the IAF may observe inventories at various locations throughout the year. If the IAF is deemed reliable, the external auditor may utilize this substantive evidence, reducing the number locations to which the external auditor must travel. This leads to Hypothesis 3:
H3: The higher the degree of reliance on an IAF, the fewer the total
number of audit testing hours required by the external auditor.


PROPRIETARY DATA, VARIABLE MEASUREMENT AND MODEL SPECIFICATION

Proprietary Data

The audit documentation used in this study is acquired from a Big 4 firm. The firm granted access to its archived audit working papers for a given practice office. Using a random number generator, sample audits were selected from the list of archived engagements containing audit files from 1996 to 1999. The firm provided audit data for 78 audit engagements all from different auditees. Within the sample, 66 auditees are publicly traded and 21 employ an IAF. The audit firm has been auditing these clients for an average of 7 years. The data set does not contain any first-year audits. All sampled engagements received unqualified opinions, and there has been no restatement or known allegation of audit failure for two years following the most recent observation date. The firm assisted in the coding of variables used in this study, and provided a subsequent multi-level review to facilitate consistent coding of the data. (4) Each of the 78 firm-year audit observations include the external auditor's documented revenue cycle inherent and control risk assessments, as well as the auditor's assessed level of reliance on the IAF, if one exists. Each observation includes an audit program for the entire year's engagement.

Measurements for the nature, timing and extent of audit procedures, as well as risk assessments used in this paper are taken from the revenue portion of the audit program. The data-granting firm considers revenue to be a "significant account." (5) Partners of the data-granting firm perceive the revenue portion of the audit to be a more risky audit area, warranting a higher degree of scrutiny. This perception is corroborated by the fact that 70% of recent Security Exchange Commission Accounting and Auditing Enforcement Releases reviewed surrounded revenue recognition issues (AICPA, 2000). Given these characteristics, revenue is a primary area in which risk assessment and related audit testing may be varied, and therefore provides a more powerful setting to study audit-planning decisions.

Model Specification and Variable Measurement

The external auditor may address specific auditee characteristics by adjusting the evidential plan. This can be accomplished by altering the nature of evidence collected, the timing of evidence collection, and the extent of audit procedures conducted. (6) To test Hypothesis 1-3, we examine the impact of an IAF on nature, timing and extent independently by employing the following equations:
[NATURE.sub.i] = [[beta].sub.0i] + [[beta].sub.1] [IA.sub.i] +
[[beta].sub.2] [MR.sub.i] + [[beta].sub.3] [TIMING.sub.i] +
[[beta].sub.4] [EXTENT.sub.i] + [[beta].sub.5] [REV.sub.i] +
[[beta].sub.6] [YA.sub.i] + [[beta].sub.7] [PUB.sub.i] +
[[beta].sub.8] [IND.sub.i] + [e.sub.i] [1]

[TIMING.sub.i] = [[beta].sub.0i] + [[beta].sub.1] [IA.sub.i] +
[[beta].sub.2] [MR.sub.i] + [[beta].sub.3] [NATURE.sub.i] +
[[beta].sub.4] [EXTENT.sub.i] + [[beta].sub.5] [REV.sub.i] +
[[beta].sub.6] [YA.sub.i] + [[beta].sub.7] [PUB.sub.i] + [[beta]
.sub.8] [IND.sub.i] + [e.sub.i] [2]

[EXTENT.sub.i] = [[beta].sub.0i] + [[beta].sub.1] [IA.sub.i] +
[[beta].sub.2] [MR.sub.i] + [[beta].sub.3] [NATURE.sub.i] +
[[beta].sub.4] [TIMING.sub.i] + [[beta].sub.5] [REV.sub.i] +
[[beta].sub.6] [YA.sub.i] + [[beta].sub.7] [PUB.sub.i] +
[[beta].sub.8] [IND.sub.i] + [e.sub.i] [3]


NATURE is measured by categorizing evidence as outside, outside/inside, and inside. Using these categories, we weight audit procedures listed in the revenue cycle of the audit program using a three-point scale (outside evidence equals 3, outside/inside equals 2, and inside equals 1). "Outside" evidence is obtained, inspected, or observed completely independent of management. This is considered to be the most persuasive form of evidence. An example of outside evidence is an accounts receivable confirmation sent directly from a client's customer to the auditor. "Outside/inside" evidence originated from a third party outside of the influence of management but has the potential to be manipulated by management. An example of outside/inside evidence is a customer purchase order sent by the customer to the client. This purchase order originated from the customer but passed through the hands of the auditee, and thus had some potential to be manipulated by the auditee. "Inside" evidence is obtained directly from the auditee. An example is a copy of a sales invoice prepared by the auditee. NATURE is the sum of the persuasiveness rankings for all procedures listed in the revenue cycle audit program. The higher the value of the variable, the more persuasive (independent) the total evidence collected. We acknowledge this metric is an approximation of this characterization of nature. Prior literature has measured the nature of audit evidence by looking at the use of specific tests and the total number of audit tests performed (e.g., Messier and Plumlee, 1987; Bedard and Wright, 1994; Mock and Wright, 1993, 1999). We believe the metric used in this study is likely to be a more effective measurement for capturing the nature characteristic since it reflects a measure of the variation in evidence strength. Where NATURE is the dependent variable, we expect the coefficient on IA to obtain a negative value, indicating the external auditor requires less persuasive evidence when reliance on the IAF is higher.

The dependent variable TIMING equals the proportion of revenue testing hours conducted at the auditee's fiscal year-end relative to total revenue testing hours. (7) If, for a given audit, 60 percent of audit hours are conducted at the auditee's fiscal year-end, and 40 percent during interim work, then the observation receives a TIMING score of 60. When TIMING is the dependent variable we expect the coefficient on IA to obtain a negative value, indicating the external auditor conducts more interim testing when reliance on the IAF is higher.

The dependent variable EXTENT equals total revenue cycle audit hours. When EXTENT is the dependent variable we expect the coefficient on IA to obtain a negative value, indicating the external auditor requires less evidential effort when reliance on the IAF is higher.

IA is our experimental variable, and represents an aggregated reliance assessment made by the auditor and is taken directly from the working papers. IA is a summary of the external auditor's assessment of the competence, work performance and objectivity of the IAF measured on a continuous scale from 0 to 100. (8)

We include misstatement risk (MR) as a control for firm characteristics captured in preliminary risk assessments. According to SAS 47, risk assessments should influence EP decisions. As discussed above, the IAF may indirectly affect EP decisions via MR. The inclusion of this variable may bias us away from finding significant results on our test variable, IA. MR is the multiplicative combination of ranked external auditor-assessed inherent and control risks (SAS 47). The data-granting firm measures and documents inherent and control risk assessments as "low," "medium," or "high." The risks are coded 1 for low, 2 for medium, or 3 for high, resulting in MR values of 1, 2, 3, 4, 6, and 9. We expect higher levels of assessed risk to be associated with more persuasive, year-end, overall evidence.

To control for auditee size, we include the natural log of total auditee revenue (REV) for the year under audit. Prior literature has shown that the relationship between auditor effort and client size is nonlinear (O'Keefe, Simunic & Stein, 1994). For this reason, we utilize the natural log of revenue. While larger firms may have greater oversight, leading to potentially lower misstatement risk assessments and audit effort, they may have more complex control structures and greater decentralization, potentially increasing assessed risk and effort. It is unclear how these effects will aggregate and affect the relationship between evidential effort and REV. Accordingly, we do not have an expectation of the sign on REV.

Prior literature has noted that the length of the auditor-auditee relationship may affect risk assessments and audit effort due to learning over time (O'Keefe et al., 1994; Ashton, 1991). We control for this effect by including the number of years the external auditor has been auditing the auditee (YA). As the relationship between the external auditor and auditee continues over time (higher values of YA), we expect the external auditor to require less persuasive evidence, more effort at interim, and less overall evidence.

Prior research suggests the external auditor is more likely to be sued if the auditee is publicly held (e.g., St. Pierre and Anderson, 1982). Additionally, incentives to overstate financial standing and results of operations are suggested to be greater for managers of public firms due to market driven compensation packages (O'Keefe et al., 1994). We control for these two factors by including an indicator variable (PUB), which we expect to exhibit a positive association with audit effort. To control for potential systematic differences in the manner in which audits are conducted between industry groups as identified by the data-granting firm we include IND. IND is an indicator variable representing the two industry categories in our sample (biotech and high-tech). Because we do not have any evidence concerning major changes in audit approach by the data-granting firm between industry groups, there is no expectation for the coefficient on IND.

To address the potential tradeoffs between nature, timing and extent decisions, we include the other evidential planning decisions as control variables (i.e., when NATURE is the dependent variable, TIMING and EXTENT are independent variables). The residuals from Equations 1-3 may be correlated due to the possibility that omitted variables may simultaneously influence nature, timing and extent decisions. In light of this, we use SUR analysis to improve the efficiency of the coefficient estimation. (9)

RESULTS

Table 1 presents descriptive statistics for the dependent and independent variables used to test Hypotheses 1 through 3.

Table 2 presents the results from the Seemingly Unrelated Regression analysis (Equations 1-3).

These results indicate that IA is significantly related to TIMING (-0.2154, p=0.0687) but not NATURE (0.0101, p=0.4433) (10) and EXTENT (0.2295, p=0.4300). The significant, negative coefficient on IA in Equation 2 provides evidence to support Hypothesis 2, inferring that when the IAF is relied upon, more interim work is conducted. The adjusted R2 of over seventy percent indicates that this equation explains a significant amount of the variation in TIMING. By using SUR analysis, and including the other evidential planning decisions as control variables, these results appear to be robust to the effects of possible trade-offs between the three evidential effort decisions. (11)

When considering the findings for H2 and H3 in conjunction, the indication is that evidential effort is shifted from year-end to interim periods. This supposition is drawn because there is a significant change in the timing of evidence collection without a change in the overall extent of audit effort. In Table 3 we examine the apparent shift of audit effort by partitioning EXTENT into year-end hours and interim hours.

This partitioning is accomplished by interacting TIMING and EXTENT. Specifically, we calculate TIMING*EXTENT to obtain a metric for the extent of year-end audit testing (YEAREND), and EXTENT-(TIMING*EXTENT) for interim testing (INTERIM). These two variables (INTERIM and YEAREND) are used as dependent variables in the following equations:
[INTERIM.sub.i] = [[beta].sub.0i] + [[beta].sub.1] [IA.sub.i] +
[[beta].sub.2] [MR.sub.i] + [[beta].sub.3] [NATURE.sub.i] +
[[beta].sub.4] [REV.sub.i] + [[beta].sub.5] [YA.sub.i] +
[[beta].sub.6] [PUB.sub.i] + [[beta].sub.7] [IND.sub.i] + [e.sub.i] [4]

[YEAREND.sub.i] = [[beta].sub.0i] + [[beta].sub.1] [IA.sub.i] +
[[beta].sub.2] [MR.sub.i] + [[beta].sub.3] [NATURE.sub.i] +
[[beta].sub.4] [REV.sub.i] + [[beta].sub.5] [YA.sub.i] + [[beta].sub.6]
[PUB.sub.i] + [[beta].sub.7] [IND.sub.i] + [e.sub.i] [5]


Equation 4 (INTERIM) shown in Table 4 obtains a positive coefficient on IA (2.6873, p=0.0555) while Equation 5 (YEAREND) obtains a negative coefficient on IA (-1.3241, p=0.0035), indicating a greater reliance on the IAF is associated with a shift in effort from year-end to interim periods. NATURE is included as a control variable because TIMING and EXTENT are interacted to obtain the dependent variable. These results strengthen the notion that the external auditor increases interim audit effort and decreases year-end effort as reliance on the IAF becomes stronger.

Sensitivity Analysis

Due to the ordinal, categorical nature of the MR measurement, we utilize a different measurement for misstatement risk to test the robustness of our results. The following exhibit documents the ranking scheme employed.
 IR

 Low Medium High

 Low 1 2 3
CR Medium 2 3 4
 High 3 4 5


The results of this scheme provide a measurement of misstatement risk (MR2) that include values of 1, 2, 3, 4 and 5. Table 4 presents the results from replication of Equations 1-3 using the new risk measure.

The results shown indicate the previous tests are robust to a different measure of the risk control variable. Similar sensitivity analyses were conducted by including measures for profitability and the year of observation as control variables. The results remained unchanged. Results are also robust to the use of the log of total client assets as the control variable for size.

CONCLUSIONS

This study extends earlier evidential planning research by examining the influence of an IAF on the nature, timing and extent of audit effort. Prior literature has documented that the IAF has a significant affect on the external auditor, but has been limited in its ability to examine the influence the IAF has on the evidential mix (i.e., Felix, Gramling and Maletta, 2001). Our analysis utilizes data taken directly from the revenue cycle audit program workpapers, including direct measures of the persuasiveness of audit evidence and timing of audit procedures previously unavailable due to the proprietary nature of audit documentation. The degree of reliance placed on the IAF by the external auditor was found to significantly influence the timing of audit procedures after controlling for assessed misstatement risk. Further examination revealed this change in timing represented a shift of effort from year-end procedures to interim procedures. The results in this study are robust to different measurements of persuasiveness and misstatement risk, and provide controls for potential trade-offs between nature, timing and extent decisions.

It is important to recognize the potential limitations in the generalizability of these findings. The data utilized in this study comes from a single Big 4 practice office. While the single source may limit generalizability, it also reduces noise which could be introduced from inter-firm and intra-industry observations. While the focus on one cycle of the audit program may bias us away from finding results, it reinforces the significance of finding an effect for timing.

The results of this study have implications to future research regarding the relationship between auditee characteristics and audit effort. The results of this study may indicate that auditee characteristics are not sufficiently captured in preliminary risk assessments as they are used in evidential planning decisions. In the face of a reliable IAF a "reliance approach" to auditing seems to be followed (i.e., relying on controls and thus, performing fewer substantive tests). This approach would seem to allow the auditor to contend with typical year-end human resource constraint issues. Future research should consider the importance of an IAF in the revisions of the Audit Risk Model.

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William L. Felix, Jr., University of Arizona

Tim Kizirian, California State University, Chico

L. Dwight Sneathen, Jr., Mississippi State University

ENDNOTES

(1) The ARM is an audit planning metaphor for a risk-focused approach to evidential planning that assists auditors in the implementation of the opinion formulation process.

(2) Standards for the Professional Practice of Internal Auditing (Altamonte Springs, FL: Institute of Internal Auditors, 1980, pp. 3-4).

(3) SAS's 55 and 78 direct the external auditor to obtain an understanding of the design of internal controls relevant to the financial statements, and, when reliance on controls is planned, determine whether these controls are operating effectively via compliance tests.

(4) We did not perform any tests for inter-coder reliability. Instead we relied on the firm's assistance in coding the variables to insure they measure accurately the constructs we examine.

(5) The data-granting firm considers an account or cycle to be significant if it is critical to the prevention of audit failure, or if its examination will significantly decrease audit firm risk. Several sources corroborate the perceived higher risk of errors and irregularities within the revenue cycle of the audit (e.g., COSO Report, 1999).

(6) A forth variable ['staffing'] may also be affected [see Bedard, Mock and Wright, 1999].

(7) The data set does not contain audits that changed the proximity of the year-end engagement relative to the auditee's fiscal year-end. The proprietary nature of audit documentation especially limits the analysis of the timing of audit procedures in the extant literature (e.g., Srinidhi & Vasarhelyi, 1986).

(8) Extant literature normally considers auditor risk judgment in a categorical setting (i.e., "low," "medium," and "high"), which may not require a high degree of accuracy (Waller, 1993).

(9) For a description of this approach, see Zellner (1962).

(10) These findings are robust to the use of a different measure of nature. When the number of audit procedures is used as a proxy for nature (Mock and Wright, 1993, 1999) we obtain similar results.

(11) These findings do not support H1 and H3, however the authors acknowledge that potential limitations of the data (a focus on the revenue cycle, a comparatively small sample size as well as a sample drawn from one firm) preclude us from drawing a significant conclusion from the lack of statistical results found in Equations 1 and 3. Considering these limitations, the authors feel the findings in Equation 2 are all the more significant as they have not been shown in previous field based studies.
Table 1: Descriptive Statistics

N=78

 Quartiles
 MEAN STD DEV 3 2 1

IA Reliance (IA) 4.6795 9.44360 5 0 0
IA Existence (IA2) 0.2692 0.44643 1 0 0
Misstatement
 Risk (IR*CR=MR) 2.5128 2.23167 4 1 1
Misstatement
 Risk (MR2) 1.9487 1.26796 3 1 1
NATURE 12.2706 6.25237 14.7 10.7 7.5
TIMING 83.5000 14.35790 98 85 70
EXTENT 74.8333 112.29696 62 31.5 20

Variable Definitions:

IA equals the external auditor-documented general level of
 reliance on the IAF.

IA2 is an indicator variable that takes on the value of 1 for a
 firm that has an IAF, and zero otherwise.

MR equals Inherent Risk * Control Risk for the revenue cycle.

MR2 is based on an inherent and control risk combination heuristic
 resulting in values ranging from 1 to 5.

NATURE is the sum of the persuasiveness rankings for all procedures
 listed in the revenue cycle audit program. Persuasiveness is
 ranked using a three level scale: 3 for outside information,
 2 for outside/inside information, and 1 for inside
 information.

TIMING is the percentage of audit testing conducted at the end of the
 fiscal year of the client.

EXTEN is the total hours spent performing test of controls and
 substantive testing in the revenue cycle during the audit.

Table 2: SUR Regression Analysis
N=78

Test of H1: [NATURE.sub.i] = [IA.sub.i] + [1]
 [MR.sub.i] + [TIMING.sub.i] +
 [EXTENT.sub.i] + [REV.sub.i] +
 [YA.sub.i] + [PUB.sub.i] +
 [IND.sub.i] + [e.sub.i]

Test of H2: [TIMING.sub.i] = [IA.sub.i] + [2]
 [MR.sub.i] + [NATURE.sub.i] +
 [EXTENT.sub.i] + [REV.sub.i] +
 [YA.sub.i] + [PUB.sub.i] +
 [IND.sub.i] + [e.sub.i]

Test of H3: [EXTENT.sub.i] = [IA.sub.i] + [3]
 [MR.sub.i] + [NATURE.sub.i] +
 [TIMING.sub.i] + [REV.sub.i] +
 [YA.sub.i] + [PUB.sub.i] +
 [IND.sub.i] + [e.sub.i]

 Dependent Variables

Independent NATURE TIMING
Variables and
Expected Signs

Intercept -20.7969# 105.0482#
 0.0088# <0.0001#
IA Reliance (IA) - 0.0101 - -0.2154#
 0.4433 0.0687#
Misstatement
 Risk (MR) + -0.2874 + 1.7880#
 0.1719 0.0037#
NATURE ? 1.0427#
 <0.0001#
TIMING ? 0.2440#
 <0.0001#
EXTENT ? 0.0506# ? -0.0451#
 <0.0001# 0.0009#
Revenue (REV) ? 0.3806 - -1.5559#
 0.1140 0.0110#
Years as
Auditor (YA) - 0.1889 - -0.8724#
 0.1155 0.0031#
Public/
 Private (PUB) + 1.4808 + -2.3198
 0.1286 0.1958
Industry (IND) ? 1.3539 ? -1.7497
 0.1712 0.3973
Adjusted
 R squared 63.66% ([dagger]) 70.56% ([dagger])

 Dependent Variables

Independent EXTENT
Variables and
Expected Signs

Intercept 233.3340
 0.1151
IA Reliance (IA) - 0.2295
 0.4300
Misstatement
 Risk (MR) + 6.1805
 0.1340
NATURE ? 17.1595#
 <0.0001#
TIMING ? -3.5834#
 0.0009#
EXTENT

Revenue (REV) + -1.9355
 0.3705
Years as
 Auditor (YA) - -3.5010
 0.1132
Public/
 Private (PUB) + -24.5385
 0.1545
Industry (IND) ? -20.9996
 0.2529
Adjusted
 R squared 61.81% ([dagger])

Variable Definitions:

NATURE is the sum of the persuasiveness rankings for all procedures
 listed in the revenue cycle audit program. Persuasiveness is
 ranked using a three level scale: 3 for outside information,
 2 for outside/inside information, and 1 for inside information.

TIMING is the percentage of audit testing conducted at the end of the
 fiscal year of the client.

EXTENT is the total hours spent performing test of controls and
 substantive testing in the revenue cycle during the audit.

IA equals the external auditor-documented general level of
 reliance on the IAF.

MR equals Inherent Risk * Control Risk for the revenue cycle.

The control variables include: the natural log of revenue (REV), Years
as Auditor (YA), public or private ownership (PUB), and industry
categorization (IND).

Coefficients with p-values less than .10 are shown in bold.

([dagger]) Adjusted R-squared is based on OLS regression,
as opposed to the SUR weighted R-squared.

Note: Coefficients with p-values less than .10 is indicated with #.

Table 3: OLS Analysis of Interim vs. Year End Effort
N=78

[INTERIM.sub.i] = [IA.sub.i] + [MR.sub.i] + [NATURE].sub.i] [4]
[REV.sub.i] + [YA.sub.i] + [PUB.sub.i] + [IND.sub.i] +
[e.sub.i]

[YEAREND.sub.i] = [IA.sub.i] + [MR.sub.i] + [NATURE].sub.i] [5]
[REV.sub.i] + [YA.sub.i] + [PUB.sub.i] + [IND.sub.i] +
[e.sub.i]

 Dependent Variables

Independent INTERIM YEAREND
Variables and
Expected Signs

Intercept -289.0890# 51.3744
 0.0192# 0.1418
IA Reliance (IA) + 2.6873# - -1.3241#
 0.0555# 0.0035
Misstatement Risk (MR) + 3.6775 + 0.8897
 0.2991 0.3282
NATURE ? 14.6272# ? -2.5142#
 <.0001# <.0001#
Revenue (REV) ? 12.9380# ? -2.5512
 0.0916# 0.2433
Years as Auditor (YA) - -2.6386 - 0.7330
 0.2329 0.2398
Public/Private (PUB) + -20.3460 + 6.1770
 0.5199 0.2578
Industry (IND) ? -11.2482 ? 1.7635
 0.6413 0.7988
Adjusted R squared 59.60% 46.61%

Variable Definitions:

INTERIM is the total hours spent performing test of controls and
 substantive testing for the revenue cycle prior to the
 balance sheet date.

YEAREND is the total hours spent performing test of controls and
 substantive testing for the revenue cycle after the balance
 sheet date.

IA equals the external auditor-documented general level of
 reliance on the IAF.

MR equals Inherent Risk * Control Risk for the revenue cycle.

NATURE is the sum of the persuasiveness rankings for all procedures
 listed in the revenue cycle audit program. Persuasiveness is
 ranked using a three level scale: 3 for outside information,
 2 for outside/inside information, and 1 for inside
 information.

The control variables include: the natural og of revenue (REV), Years
as Auditor (YA), public or private ownership (PUB), and industry
categorization (IND).

Coefficients with p-values less than .10 are shown in bold.

Note: Coefficients with p-values less than .10 is indicated with #.

Table 4: Sensitivity Analysis Using MR2
N=78

Test of H1 (SUR): [NATURE.sub.i] = [IA.sub.i] + [MR2.sub.i] + [6]
 [TIMING.sub.i] + [EXTENT.sub.i] +
 [REV.sub.i] + [YA.sub.i] + [PUB.sub.i] +
 [IND.sub.i] + [e.sub.i]

Test of H2 (SUR): [TIMING.sub.i] = [IA.sub.i] + [MR2.sub.i] + [7]
 [NATURE.sub.i] + [EXTENT.sub.i] +
 [REV.sub.i] + [YA.sub.i] + [PUB.sub.i] +
 [IND.sub.i] + [e.sub.i]

Test of H3 (SUR): [EXTENT.sub.i] = [IA.sub.i] + [MR2.sub.i] + [8]
 [NATURE.sub.i] + [TIMING.sub.i] +
 [REV.sub.i] + [YA.sub.i] + [PUB.sub.i] +
 [IND.sub.i] + [e.sub.i]

Independent
Variables and Dependent Variables
Expected Signs

Intercept NATURE TIMING

 -18.2559# 94.3081#
 0.0204# <0.0001#
IA Reliance (IA) - -0.0009 - -0.2171#
 0.4946 0.0579#
Misstatement
 Risk (MR2) + -0.2303 + 4.2996#
 0.3480 0.0001#
NATURE ? ? 0.8393#
 0.0005#
TIMING ? 0.2101# ?
 0.0005#

EXTENT ? 0.0496# ? -0.0428#
 <0.0001# 0.0010#
Revenue (REV) ? 0.4055 - -1.0488
 0.1991 0.1161
Years as
 Auditor (YA) - 0.1575 - -0.8949
 0.1567 0.0016
Public?
 Private (PUB) + 1.4117 + -1.7232
 0.1367 0.2527
Industry (IND) ? 1.3168 ? -1.2688
 0.1768 0.5200
Adjusted
 R squared 64.50% 73.11%
 ([dagger]) ([dagger])

Independent
Variables and Dependent Variables
Expected Signs

Intercept EXTENT

 245.8053#
 0.0971#
IA Reliance (IA) - 0.2567
 0.4215
Misstatement
 Risk (MR2) + 10.7146
 0.1658
NATURE ? 17.1946#
 <0.0001#
TIMING ? -3.7139#
 0.0010#
EXTENT ?

Revenue (REV) + -2.3855
 0.6891
Years as
 Auditor (YA) - -3.6903
 0.1014
Public?
 Private (PUB) + -23.5787
 0.1638
Industry (IND) ? -20.2362
 0.2692
Adjusted
 R squared 61.86% ([dagger])

Variable Definitions:

NATURE is the sum of the persuasiveness rankings for all procedures
 listed in the revenue cycle audit program. Persuasiveness is
 ranked using a three level scale: 3 for outside information,
 2 for outside/inside information, and 1 for inside
 information.

TIMING is the percentage of audit testing conducted at the end of the
 fiscal year of the client.

EXTENT is the total hours spent performing test of controls and
 substantive testing in the revenue cycle during the audit.

IA equals the external auditor-documented general level of
 reliance on the IAF.

MR2 is based on an inherent and control risk combination
 heuristic resulting in values ranging from 1 to 5.

The control variables include: the natural log of revenue (REV), Years
as Auditor (YA), public or private ownership (PUB), and industry
categorization (IND).

Coefficients with p-values less than .10 are shown in bold.

([dagger]) Adjusted R-squared

Note: Coefficients with p-values less than .10 is indicated with #.
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Author:Felix, William L., Jr.; Kizirian, Tim; Sneathen, L. Dwight, Jr.
Publication:Academy of Accounting and Financial Studies Journal
Date:Jan 1, 2005
Words:7192
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