Regulatory standards vs audit quality: Bridging a persistent gap
Audit firms struggle to meet regulatory audit standards, despite evidence of improving audit quality – exposing a persistent industry-regulator gap
The gap between regulatory expectations and audit firm performance has become a pressing issue in the financial sector, highlighting significant challenges for both industry players and oversight bodies. This divide has far-reaching implications for market integrity, investor confidence, and the overall stability of the financial system.
At the heart of this issue lies a paradox: while various metrics indicate improving audit quality, regulatory inspections continue to reveal high error rates. In Australia, regulators such as the Australian Securities and Investments Commission (ASIC) have been at the forefront of efforts to enhance audit quality and financial reporting standards. However, their expectations often seem misaligned with the realities faced by audit firms, leading to growing tensions between regulators and the auditing profession.
This discrepancy has sparked intense debate within the industry and raised questions about the effectiveness of current regulatory frameworks. It has contributed to a growing public focus on accounting and auditing entities’ work. Questions about audit quality were a partial driver of a 2019 parliamentary inquiry into the regulation of auditing in Australia, and this culminated in a call for ASIC to be split in two.
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This mismatch between audit quality and inspection results, without a better understanding of its causes, can cause audit firms to make bad strategic decisions. For example, audit firms may erroneously choose to discontinue programs directed at improving audit quality because these programs do not improve the outcome of inspection reports.
Investigating the regulator-audit inspection mismatch
So, why do public oversight bodies find the same (high) error rates from audit firms year after year when all other metrics continually point to improving audit quality? This question piqued the interest of Dr Greg Richins, a lecturer in the School of Accounting, Auditing and Taxation at UNSW Business School. According to Dr Richins, the increased scrutiny stems from a conundrum that has preoccupied experts for as long as the public oversight bodies have been around and tracking auditors’ data.
“There is this ongoing puzzle in the auditing literature, where we have all kinds of measures of audit quality, all of which are imperfect, but they all pretty much go in the same direction: they say audit quality is getting better. If you talk with companies’ boards of directors, they think audit quality is good and improving,” he explained. “Basically, the only group going against that is in the inspection process, which is pretty static every year; about the same percentage of audits are found to be deficient by ASIC in Australia, the PCAOB in the US and, really, every country.”
A possible (kinder) explanation
Teaming up with UNSW Business School Scientia Professor Ken Trotman and Senior Lecturer Dr Di Yang, Dr Richins sought to explain the mismatch, and he thought he could do it using a theory from psychology research called prevalence-induced concept change.
According to this theory, as the prevalence of an underlying concept changes, people will subconsciously redefine the concept and thus their standards for evaluating it. If audit quality has been steadily improving, with audit inspectors seeing fewer low-quality audits, prevalence-induced concept change might explain why they keep finding the same rate of inadequate audits.
The resulting research paper, The effects of prevalence induced concept change on audit scepticism judgements, published in the Accounting & Finance Journal, may help explain the tension between the auditors and the public servants auditing them. As Dr Richins explained, the findings provide a new way of viewing this tension as the result of a subconscious psychological phenomenon rather than a symptom of something more sinister.
“What we argue in the paper is that the people who are really paying attention to this – the parliamentary inquiries and the boards of directors who oversee audits, the groups that are really on top of this – they generally have the impression that audit quality is good in Australia and is improving. The thing we bring to the debate is that, sometimes, both the audit firms and the regulatory inspectors, in Australia’s case ASIC, aren’t necessarily that generous in the way they interpret each other’s actions,” he said. “We offer an explanation for these static results that doesn’t put either the auditors or the inspectors in a particularly negative light.”
Defining the problem
Dr Richins said he usually starts with a problem and then goes “digging around in psychology or economics to look at it”. This time, he began with a theory and went looking for a problem to solve. “This is the only paper where we’ve gone in the other direction,” he said, explaining that he first got the idea for the project after a friend shared the 2018 psychology paper, Prevalence-induced concept change in human judgment, that would ultimately undergird the team’s research.
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“I went to talk with Ken Trotman because he’s a superstar – he’s published more auditing research than just about anyone” Dr Richins said. “He’s like, ‘You know, I think that’s really good and would work, but I’ve got a better setting for it.’ He’s done a lot of work on the actual problem that we ended up talking about.”
The team first confirmed that, despite empirical evidence that inspections by public oversight bodies have caused audit quality to improve, the rate of deficiencies found in audits is not decreasing. “For instance, in 2022, ASIC found that in 32% of key audit areas reviewed for the largest six audit firms, auditors did not obtain sufficient appropriate evidence that the financial statements were free of material misstatements, which is similar to the prior year, with similarly high figures found in US and UK jurisdictions,” according to the research paper.
Prior research has attempted to explain this discrepancy in various ways, including that it stems from the differing incentives of auditors and regulators. Inspectors “have an incentive to find these [quality] issues – that’s literally their job – and so the fact that they are finding them maybe shouldn’t be surprising,” as Dr Richins portrayed this position. “It’s easy to write it off that way, but doing so feels a little bit cynical to me.”
He added that he had spent time working for the PCAOB (The Public Company Accounting Oversight Board, a non-profit corporation that oversees the audits of US-listed public companies), which also influenced his thinking. “Yes, there are these incentive issues that have been talked about in the prior research, but I have a hard time believing that’s the sole driving force because all the people I worked with at the PCAOB were public servants making a good-faith effort at doing their best,” he said. “So I find it hard to believe that this problem could be entirely explained away just by saying, they’re very cynically finding problems just to find problems.”
From coloured dots to trained judgments
This belief in good-faith inspectors is why the theory of prevalence-induced concept change appealed to Dr Richins – it offered an “entirely subconscious” explanation of the problem.
The authors of the 2018 paper, including David E. Levari, introduced this phenomenon through a study in which participants were shown dots ranging in colour from clearly blue to clearly purple. When the researchers decreased the prevalence of ‘blueness’ in the dots over time, they discovered that participants expanded their concept of ‘blue’ to include dots they would have previously considered purple. In other words, each participant had an “inflection point” for when a dot tipped into blueness – but that inflection point shifted when the prevalence of actual blueness changed.
“Once the phenomenon was established with a concept as discretely definable as colour, the authors then conducted experiments showing that it happens with fuzzier concepts such as aggressive appearance and ethicality via experiments wherein participants would rate previously non-threatening faces as a threat and previously ethical research proposals as unethical in response to changes in underlying prevalence,” Dr Richins and his co-authors explained in their paper.
Levari also acknowledged that, in real-world applications, context will heavily affect whether prevalence-induced concept change is problematic and to what extent.
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As the 2018 paper stated: “When yellow bananas become less prevalent, a shopper’s concept of ‘ripe’ should expand to include speckled ones, but when violent crimes become less prevalent, a police officer’s concept of ‘assault’ should not expand to include jaywalking. What counts as a ripe fruit should depend on the other fruits one can see, but what counts as a felony, a field goal, or a tumour should not, and when these things are absent, police officers, referees, and radiologists should not expand their concepts and find them anyway.”
According to Dr Richins, he and his colleagues wanted to explore this “explicit assertion” about “referees and police officers and radiologists, all people who are making judgments about the thing they’re explicitly trained to make a judgment about”, to see if prevalence-induced concept change was in fact an issue among such trained decision makers.
Evaluating scepticism
The research team presented participants with more than 100 vignettes describing issues auditors faced and the actions they took in response. The vignettes covered three levels of “scepticism” demonstrated in the given audit, showing high, medium and low scepticism by the auditor.
As participants were shown vignettes, the researchers decreased the prevalence of low-scepticism audit vignettes and correspondingly increased high-scepticism vignettes for one group but kept them stable in a second group. “We found, exactly in line with Levari, that when you change the scepticism, their idea of what is and is not sceptical begins to change as well,” Dr Richins explained. “This could be at least part of the explanation for this ongoing puzzlement.”
By exploring the possible psychological phenomena and bias questions in the audit context, Dr Richins noted that the team hoped to clarify the relationship between audit quality and inspection results and help audit firms avoid bad decision-making. “Some people would argue that these inspections are one of the best proxies for audit quality, and so if there’s a bias that makes them less reliable, that can lead to bad outcomes where they are giving an inaccurate signal of audit quality,” he explained. The audit firm might then make harmful changes to its strategy based on the poor signal.
Young theory, broad implications
Dr Richins said the research could have implications far beyond the setting in which the UNSW team explored this emerging theory. “One of our goals was not just to solve this problem but also to introduce prevalence-induced concept change to the accounting literature,” he said. “I’m really hopeful that someone in management accounting, financial accounting and tax will run with it in their domains. We think it has really broad implications in a lot of different scenarios.”
Understanding the theory could also be critical for ASIC and other oversight bodies because there are emerging ideas about debiasing prevalence-induced concept change. However, they are still “very, very new in the psychology literature”, Dr Richins stressed. “One of the things that seems to help with this is that, because of the way prevalence-induced concept change works, it’s a comparison-based phenomenon, and so you can potentially de-bias it,” he explained.
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“Preliminary research suggests that if I give you a really extreme example of whatever it is you’re looking at, you’ll recalibrate on those endpoints, and you won’t be as susceptible to prevalence-induced concept change,” he said. For example, Levari et al. found that periodically exposing participants to a ‘truly’ blue dot helped them re-establish their concept of blueness as its prevalence changed.
For ASIC or PCAOB inspectors, Dr Richins said, recalibration could involve ongoing training involving “a sort of highlight reel of the best and the worst: ‘This is what a really good audit looks like, just so you know; and this is an example of what a substandard audit looks like.’”