CURRENT ISSUES IN AUDITING American Accounting Association
Vol. 11, No. 2 DOI: 10.2308/ciia-51851
Fall 2017
pp. P1–P8
PRACTITIONER SUMMARY
Managing Risk in a Poor Economy: The
Association between Economic Conditions
and Risk Tolerance and Its Implications for
Practice
Penelope L. Bagley
Appalachian State University
Jack W. Dorminey
West Virginia University
Tracy N. Reed
Appalachian State University
SUMMARY: An academic study by Bagley, Dorminey, McSwain, and Reed (2016)
regarding the association between economic activity and an auditor’s response to risk was
recently published, highlighting auditors’ willingness to accept higher levels of risk to retain
clients in challenging economic times without an appropriate adjustment to audit fees.
Given that business cycles are a fact, auditors need to understand how they respond to
increases in risk during a poor economy in ways other than increasing fees or resigning
from audit engagements, neither of which is necessarily optimal to do during economic
downturns. This paper summarizes Bagley et al. (2016) and provides alternative strategies
firms can utilize to mitigate risk, regardless of economic conditions.
Keywords: risk management; economy; auditor fees; auditor resignations.
INTRODUCTION
T
his article summarizes a recently published academic study, ‘‘Managing Risk in a Poor
Economy: The Association between Economic Activity and Auditor Response to Risk’’
(Bagley, Dorminey, McSwain, and Reed 2016). In this paper, we review the motivation,
We thank Dwayne McSwain, two anonymous reviewers, and J. Gregory Jenkins (editor) for their invaluable assistance.
Editor’s note: Accepted by J. Gregory Jenkins.
Submitted: January 2017
Accepted: June 2017
Published Online: July 2017
P1
Bagley, Dorminey, and Reed P2
method, and findings of the article. The findings indicate that auditors are willing to accept higher
levels of risk to retain clients in challenging economic times with insufficient adjustments to audit
fees. In this paper we discuss the implications of these findings and provide several strategies,
other than resignation, that firms can utilize to mitigate risk, regardless of the economic climate.
MOTIVATION
The issue of engagement risk is and has always been a major concern for the auditing
profession. Each year, auditors give careful consideration to the level of engagement risk clients
represent and evaluate whether retaining the client is worth the risk. Academic research has
consistently shown that auditor resignations are more likely to occur for clients who are considered
to be high risk (e.g., Bockus and Gigler 1998; J. Krishnan and J. Krishnan 1997; Zhan Shu 2000;
Elder, Zhang, J. Zhou, and N. Zhou 2009; Landsman, Nelson, and Rountree 2009).
An audit firm, like any other for-profit organization, seeks to maximize profit within the confines
of a tolerance for certain risks. The most definitive risk moderating/avoidance strategy for an audit
firm is to simply resign from an engagement that no longer fits with the firm’s preferred risk-return
horizon. Each resignation, however, is not costless; it also means a loss of revenue. In times of
poor economic conditions, firms will likely suffer a loss of revenue due to client bankruptcy and the
clients’ own cost-cutting initiatives. The loss of further revenue due to voluntary resignations from
risky clients may not be as appealing to audit firms during an economic downturn. In Bagley et al.
(2016), we examined whether the need to retain client revenue causes auditors to retain clients
who have increased risk factors, measured, for the purpose of this study, as those clients who
receive adverse internal control over financial reporting (ICFR) opinions, more so than they would
in good economic conditions.1
While retaining risky clients can certainly increase an auditors’ engagement risk, retaining
revenue streams during difficult economic times is necessary for a firm’s long-term viability. We
predicted that the long-term viability concerns during a weak economy would cause firms to retain
clients who would otherwise be dropped, in particular, those clients who had an adverse ICFR
opinion, with the hopes that such clients would become less risky in time (i.e., remedy internal
control problems). Therefore, we proposed the following hypothesis:
H1: Auditors are less likely to resign following an adverse ICFR opinion when the economy is
weak.
An alternative way audit firms can mitigate risk is to increase the audit fees associated with
risky clients, thereby affording the firm an appropriate premium for the risk they are absorbing and
compensation for the incremental audit procedures that will likely need to be performed. Prior
research finds that internal control deficiencies in particular are associated with an increase in
audit fees (Canada, Sutton, and Kuhn 2009; R. Hoitash, U. Hoitash, and Bedard 2008; Hogan and
1
Firms reporting material weaknesses (MWs) in internal controls are more likely to be smaller, younger,
financially weaker, undergoing restructuring, or experiencing more rapid growth than those not reporting MWs
(Doyle, Ge, and McVay 2007). Furthermore, firms reporting internal control MWs are more likely to have
complex operations, recent organizational changes, and more accounting risk than firms that do not report a
MW in internal controls (Ashbaugh-Skaife, Collins, and Kinney 2007). Research indicates that auditors are
more likely to dismiss clients when their internal control effectiveness is weak and that as the number of
weaknesses increase, the likelihood auditors will resign also increases (Johnstone and Bedard 2004; Thevenot
and Hall 2011). These findings support the use of adverse ICFR opinions as our measure for identifying clients
with increased risk factors.
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Bagley, Dorminey, and Reed P3
Wilkins 2008; Raghunandan and Rama 2006). Increased audit fees, regardless of the reasoning,
can lead to auditor dismissals (Ettredge, Scholz, and Li 2007). Again, during difficult economic
times, audit firms may not be in a position to afford such loss of revenue, thus they may limit or
even eliminate any fee increase that might normally occur for risky clients. We therefore examined
the relationship between audit fee increases and increased risk; i.e., risk premiums during poor
economic times. We predicted that firms would limit risk premiums when the economy is weak.
More formally, we tested the following hypothesis:
H2: Risk premiums assessed on adverse ICFR opinions are lower when the economy is
weak.
Regardless of economic conditions, there are times when the client engagement risk is too
high to tolerate and therefore audit firms will resign. Incoming auditors willing to take on these
clients, arguably the most risky clients, will likely charge a significant premium to perform the audit
in an effort to offset the increased risk. However, during an economic downturn, where the need for
revenue retention and income for an audit firm may be higher than normal, we questioned whether
this would influence the amount of risk premium an incoming auditor would be willing to charge.
Therefore we also proposed and tested the following research question:
RQ1: Will the premium assessed by incoming audit firms following a resignation after an
adverse ICFR opinion be impacted by the economy?
METHOD
The models used to test our hypotheses are based on prior research that explores auditor
resignations and dismissals in association with litigation risk factors. Our data consist of 28,282
observations from 5,546 registrants between November 15, 2004 and January 5, 2012 as
reported by Audit Analytics.2 A total of 295 of the observations represent auditor resignations.
We test the association of the presence of internal control weaknesses (ICWEAK),3 economic
condition (ECON), and the interaction between the two (ICWEAK ECON) with our two
dependent variables auditor resignation (RES) and audit fees (FEE).4 Our inclusion of the
interaction term ICWEAK ECON permits us to evaluate the effect that economic conditions
have on the importance of internal control weaknesses on the likelihood of resignation and the
level of assessed audit fees.
In testing our first hypothesis, we code RES ¼ 1 if there is an auditor resignation during the
fiscal year. Observations where RES ¼ 0 indicate that there was either no change in auditor or that
the auditor change was the result of a dismissal. Our second dependent variable, FEE, is the fees
assessed by auditors and is used as the dependent variable in testing our second hypothesis.
ICWEAK is coded 1 if the incumbent auditor issues an adverse ICFR report, and 0 otherwise. Our
variable ECON is the Leading Index for the United States provided by the Federal Reserve Bank of
Philadelphia.5 The Leading Index utilizes multiple economic inputs (e.g., housing permits,
2
During our sample period, the U.S. economy suffered from a recession beginning in December 2007 and ending
in June 2009 (U.S. Bureau of Labor Statistics 2012).
3
A total of 2,384 of our observations have at least one material weakness in internal controls.
4
Consistent with Ettredge, Heintz, Li, and Scholz (2011), we define our variable FEE as the natural log of audit
fees.
5
The Leading Index provided by the Federal Reserve Bank of Philadelphia is readily available at: https://fred.
stlouisfed.org/.
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Bagley, Dorminey, and Reed P4
unemployment claims, manufacturing, and interest rates) to provide one composite index to
capture economic trends. The design of the index has a smoothed effect that avoids much of the
volatility reflected in individual components used in its construction. A higher index value reflects a
healthier economic outlook (ECON). Consistent with prior work, we included several control
variables, further discussed in Bagley et al. (2016).
RESULTS
In our model to test H1, we find that ICWEAK ECON is a significant (p ¼ 0.003) and positive
predictor of auditor resignations. The positive sign on the ICWEAK ECON variable indicates that
an auditor is less likely to resign from an audit engagement where an adverse ICFR opinion has
been issued when the economy is weak and more likely to resign when the economy is strong,
thus supporting H1. In our model to test H2, we find that ICWEAK is a significant (p , 0.001)
positive predictor of audit fees, indicating that, for clients who have received an adverse ICFR
opinion in a prior period, the continuing auditor will charge a risk premium related to audit fees. We
also find that ICWEAK ECON is a significant (p ¼ 0.002) positive predictor of audit fees. Our
results indicate that during a strong economy, the auditor will charge higher risk premiums for
clients who have received an adverse ICFR in the prior period. Thereby, during poor economic
conditions, the auditor will charge lower risk premiums, thus supporting H2. For arguably the
riskiest clients, those of whom auditors do choose to resign from during a poor economy, we find
that economic factors do not influence risk premiums.6 Thus, subsequent auditors appear to price
risk appropriately regardless of the economy when clients are very risky.
The findings related to both hypotheses indicate that, when the economy is poor, the risk
tolerance of auditors shifts and the auditor is willing to accept a level of risk that they are not willing
to accept when the economy is strong. They will also charge a smaller risk premium for the
additional risk assumed during a weaker economy. The graphics in Figure 1 and Figure 2 (adapted
from Cefaratti, Lin, Dorminey, and Reed [2013]) illustrate a shift in risk tolerance in relation to
economic conditions. In both figures, there is a range of risk tolerance that is a function of the
likelihood of an event occurring, which in this case would be litigation, and the impact of that event.
Ideally, if a client’s assessed engagement risk fell within this range, then the risk could be mitigated
and appropriate risk pricing achieved. If a client’s assessed engagement risk were outside of this
range, in particular if it were to the right of the range, then the firm would be subjecting itself to
higher risk than tolerable and should therefore avoid or resign from the client. Figure 1 displays a
steady environment. The dot represents a client’s assessed engagement risk. In a steady
environment, the client would be considered too risky and therefore the firm should forgo the
engagement. Figure 2 illustrates an environment where some outside factor, such as a weak
economy or any other event that might create a strong need for income to the firm, has caused the
risk tolerance range to shift, where firms are more willing to accept or retain higher-risk clients. In
this environment, the client who would otherwise be avoided is now within the acceptable level of
risk for the firm. It is in situations like this when methods for more aggressively managing risk
become of the utmost importance.
6
We examine the three-way interaction of economic condition, internal control MW, and resignation (ECON
ICWEAK RES) on audit fees to provide insight into our research question. The three-way interaction is not
significant ( p ¼ 0.680).
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FIGURE 1
Initial Assessment of a Risk Profile of a Given Event
Adapted from Cefaratti et al. (2013).
IMPLICATIONS FOR PRACTICE
Auditors can find assistance and guidance for managing risk in many different places,
including audit standards and various publications. As previously mentioned, the best, although
least preferred, action toward minimizing risk is to let go of very risky clients or to charge a risk
premium and increase the audit procedures and/or quality of audit personnel to cover the cost of
mitigating that risk. However, when firms are pressed for revenues, they may marginally shift their
risk tolerance levels in an effort to retain the income provided by such high-risk clients. We provide
various suggestions for how audit firms can minimize their risk when resigning or increasing audit
fees is not an option. These suggestions are not limited to entities with specific increased risk
associated with a material weakness; they are meant to broadly address a number of more risky
scenarios.
1. Assign more experienced staff (Perry 2011; D’Aquila, Capriotti, Boylan, and O’Keefe 2010;
Ethridge, Marsh, and Revelt 2007) and be sure they know what they are doing. The
highest-quality work will come from a team with more experience and knowledge. More
experience with the audit process in general, more experience and knowledge of the
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FIGURE 2
Subsequent Assessment of a Risk Profile of a Given Event
Adapted from Cefaratti et al. (2013).
industry, and, in particular, more experience and knowledge of specialized issues related to
the client are the best ways to assure that misstatements will be detected.
2. Provide more supervision (D’Aquila et al. 2010). For those on the engagement team who
may not have much experience, provide them with a supervisor who has experience with
that client or industry and will give them the guidance they need to learn.
3. Emphasize the importance of professional skepticism (Perry 2011; D’Aquila et al.
2010). Staff must rely on the client to obtain the information they need to complete the
audit, therefore it is important to establish a relationship with the client. Too strong a
relationship or familiarity with the client can cloud one’s judgement. Exhaustion, time
pressure, and various other aspects of the audit environment can also compromise
professional skepticism. Train (and remind) employees to maintain a questioning mind
and to verify information obtained from the client with high-quality evidence when
possible.
4. Change up the audit by forgoing standard approaches and adding an element of
unpredictability (Perry 2011; D’Aquila et al. 2010; Ethridge et al. 2007). Avoid using a
standard approach to an audit when dealing with higher-risk clients. Varying the nature,
extent, and timing of the procedures performed will keep clients on their toes and add a
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level of unpredictability. For example, related to the nature of audit procedures, if in the
prior year the auditor tested an area using a combination of inquiry and observation, then
perhaps they could test that same area this year using a more reliable method such as
reperformance or recalculation. Similarly, if in prior years an area was always tested only at
year-end, then the auditor could change the timing of testing to include a portion at an
interim period, as well as at year-end. Finally, if in prior years the auditor tested a selection
of 25 accounts receivables when performing confirmations, then the auditor could increase
the extent of the testing to include 40 accounts selected using a stratification method. This
could lead to a more effective audit.
5. Document thoroughly. Risk assessments, responses to risk assessments, and risk
assessment procedures all need to be documented thoroughly. Be sure the engagement
team provides all the relevant information to support what they did, why they did it, what
they found, and any conclusions made. Worst-case scenario, should the threat of litigation
come to fruition, the work papers are evidence that a high-quality audit in compliance with
the applicable auditing standards was performed.
6. Integrate more quality control policies and procedures in the audit (Perry 2011). All firms
should have quality control policies and procedures in place to assure they comply with
professional standards and any legal or regulatory requirements related to the client and to
further aid the issuance of the appropriate report given the circumstances. Quality control
procedures should be purposefully integrated in high-risk engagements. Doing so will help
assure compliance with audit standards.
7. Recognize the importance of the engagement quality review (D’Aquila et al. 2010) and
ensure that the partner doing this review is aware of the increased risk involved with this
client. The engagement quality review, also known as the concurring partner review,
provides a fresh, experienced set of eyes to examine the evidence and determine if the
conclusions made during the audit are reasonable. The reviewer should have knowledge of
the client and the industry, including any particular relevant risks. During the review, the
reviewer should pay particular attention to areas that involve significant judgment, such as
materiality judgments and risk assessments, as well as the responses to the increased risk.
Emphasizing the increased risk associated with a particular client to the concurring partner
will further indicate to him/her the importance of performing a thorough review of the
engagement.
8. Allocate greater resources to brainstorming sessions required by the PCAOB (AS 2110.52-
53, PCAOB 2012) and AICPA (AU-C 240.15, AICPA 2016) standards when the client is
considered more risky (Dennis and Johnstone 2016). This would include utilizing partners
who are considered industry experts, managers who have more client-specific experience,
decreasing the use of checklists—which can lead to dysfunctional performance in fraud
detection—increasing the use of open discussion, and including team members who self-
evaluate their professional skepticism as high. These factors lead to higher brainstorming
quality (Dennis and Johnstone 2016), which in turn can lead to better audit planning and
higher overall audit quality.
Along with the strategies noted above, auditors should engage in a vigilant revisit of the
assessment of risk over time and be aware of a potential shift in risk tolerance, particularly when
the shift is inadvertent or unintentional, when economic and environmental activities change and
when firm profitability changes.
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