Academic journal article Auditing: A Journal of Practice & Theory

Auditors' Consideration of Corporate Governance and Management Control Philosophy in Preplanning and Planning Judgments

Academic journal article Auditing: A Journal of Practice & Theory

Auditors' Consideration of Corporate Governance and Management Control Philosophy in Preplanning and Planning Judgments

Article excerpt

SUMMARY

The professional literature (e.g., COSO 1992, POB 1993), recent auditing standards (e.g., SAS Nos. 78 and 82), and prior research (e.g., Beasley 1996; Beasley et al. 1999; Dechow et al. 1996) highlight the importance of corporate governance and management control philosophy in ensuring the integrity of the financial-reporting process. We examine the link between these two macro-level factors and both preplanning (e.g., client acceptance, business risk judgments) and planning judgments (e.g., extent and timing of testing).

Ninety-six auditors evaluated a hypothetical client with corporate governance and management control philosophy characteristics that were either strong or weak. More experienced auditors performed preplanning (client acceptance) judgments, while the remaining auditors performed planning judgments related to the extent and timing of substantive testing. As predicted, management control philosophy and the governance structure did affect the preplanning and planning judgments, with a stronger effect observed for management control philosophy. While the results for judgments related to the extent of testing were consistent with professional guidance, auditors lacked consensus in judging the effect on the timing of tests. The results provide insight into the effect of two important elements of the control environment on preplanning and planning judgments and could prove useful in the development of work papers and risk assessment models.

Key Words: Corporate governance, Management control philosophy, Client acceptance, Audit planning.

Data availability: Data used in this study are available upon request from the authors.

Financial-reporting problems of companies (e.g., BCCI, Phar-Mor, Bankers Trust, Barings Bank, Centennial Technologies, Rite-Aid) are often attributable to weak corporate governance and/or weaknesses in management control philosophy (Beasley 1996; Beasley et al. 1999). For example, Dechow et al. (1996) note that the likelihood of earnings manipulation is systematically related to poor governance structures and weaknesses in management oversight. The importance of these characteristics in ensuring the relevance and reliability of financial information has been addressed in several reports issued by various stakeholders in the financial reporting process. For example, the Public Oversight Board (POB 1994, 30) notes that independent auditors, the board of directors, and the audit committee should be natural allies in protecting shareholder interests. Further, Chair of the Securities and Exchange Commission (SEC) Levitt (1999) argues that there needs to be more attention paid to the link between corporate governance mechanisms and the financial-reporting system.

This study investigates the impact of the quality of corporate governance and management control philosophy on preplanning (judgments related to the client-acceptance process) and audit-planning judgments. Both corporate governance and management control philosophy relate to the sharing of power among stakeholders and the protection of shareholders' interests. However, the professional literature (e.g., POB 1993; Committee of Sponsoring Organizations of the Treadway Commission [COSO] 1992) identifies distinct activities that relate specifically to either corporate governance or management control philosophy. Corporate governance includes those oversight activities undertaken by the board of directors and audit committee to ensure the integrity of the financial-reporting process (POB 1993). Management control philosophy includes the activities and attitudes of management related to controls, and the actions taken to convey their importance throughout the organization (COSO 1992).

The increased recognition of the importance of these issues in the financial-reporting process has led to several recent changes in auditing standards (e.g., Statements on Auditing Standards No. …

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