The Strength of an Accounting Firm's Ethical Environment and the Quality of

Auditors' Judgments (Martinov-bennie, Nonna; Pflugrath, Gary 2009)

ABSTRACT
This study examines the impact of the strength of an accounting firms ethical environment
(presence and reinforcement vis-a`-vis the presence of a code of conduct) on the quality of
auditor judgment, across different levels of audit expertise. Using a 2x2 full factorial between
subjects experimental design, with audit managers and audit seniors, the impact of different
levels of strength of the ethical environment on auditor judgments was assessed with a
realistic audit scenario, requiring participants to make judgments in respect of an inventory
writedown.
Based on prior research, and as hypothesized, participants possessing greater auditing
experience made higher quality technical judgments. While there were no significant
differences between the quality of audit judgments made by participants in the stronger
ethical environment, over-all results indicate that managers are more sensitive to differences
in the strength of the ethical environment than seniors. This is consistent with the
hypothesis, and with prior research which suggests that the impact of the code will only be
significant if it has been bilaterally internalized by individuals. This has important implications
for accounting firms and regulators, given that the International Standard on Quality Control
1, requires the communication and reinforcement of ethical principles as part of firms quality
control processes. It suggests that firms will need to carefully consider the means by which
they communicate and reinforce ethical principles, as it is possible to differentially impact
auditors of different rank.
High profile corporate collapses, such as Enron and WorldCom, have brought into question
the status and credibility of the accounting profession, and highlighted the point that auditors
need to be technical and ethical experts when auditing financial reports (Gaa, 1994). In order
to restore public confidence in the profession, regulators have embarked on a number of
measures, including the introduction of new quality control standards [e.g., International
Standard on Quality Control 1 (ISQC1) Quality Control for Firms that Perform Audits and
Reviews of Historical Financial Information, and Other Assurance and Related Services
Engagements] for accounting firms, which prescribe both ethical and technical requirements.
ISQC1 [and its Australian equivalent Australian and Professional Ethics Standard (APES)
320 Quality Control for Firms] aims to help firms to establish a system of quality control for
audits and reviews of historical financial information and other assurance engagements.The
standard applies to all members of the International Federation of Accountants (IFAC) and
requires all firms to have appropriate policies and processes in place.

HYPOTHESIS
Libby and Luft (1993) suggest that the audit environment is a determinant of decisionmaking performance. The ethical environment is a subset of the audit environment and
provides a specific context for auditors to operate in and within which to make decisions
(Booth and Schulz, 2004). According to Libby and Luft (1993), a stronger ethical
environment could either impose additional guidelines by which the auditors must abide, so
that their judgments are based on technical and ethical considerations or alternatively, a
stronger ethical environment may increase the effort auditors are willing to expend on
judgment-making due to concerns.
More specifically, a number of studies have found codes to have a positive effect on
individual ethical decision-making processes and judgments. Codes of conduct have been a
common proxy for the ethical environment in accounting and auditing literature, because
organizations, including accounting firms, and their employees consider them to be relevant
and important (Lamberton et al., 2005; Martinov, 2004) in making ethical values explicit,
putting employees on notice as to what is ethical, and shifting accountability for actions from
firms to individuals.
H1: Auditors in the stronger ethical environment (the presence and reinforcement of a code)
will elicit higher quality overall judgments than auditors in the weaker ethical environment
(presence only of a code).
Technical competency represents an individual ability and is considered to be an important
determinant of auditor judgment quality. Based on research to date, the common proxies for
technical competency are experience (general and task-specific) and knowledge. Depending
on the type of audit task, the degree to which auditing experience and knowledge will assist
in decision-making will vary (Abdolmohammadi and Wright, 1987; Bonner and Lewis, 1990;
Libby and Tan, 1994; Lin et al., 2003; Shelton, 1999).
General auditing experience has been found to be positively related to auditors judgment
performance when the audit task requires exercise of individual judgment. For lowcomplexity tasks with welldefined routine solutions (i.e., structured tasks) auditors need only
to exercise minimal judgment. Thus in Ashton and Kramer (1980),
H2: More experienced auditors (audit managers) will elicit higher quality technical judgments
than less experienced auditors (audit seniors).

Within the auditing context Libby and Luft (1993) suggest that a stronger ethical environment
imposes additional guidelines by which the auditors must abide, so that their judgments are
based on technical and ethical considerations. This argument assumes that auditors ethical
awareness will have an important impact on their judgments. An individuals ethical
awareness is an important factor in the cognitive process of decision-making because it is
related to his/ her ability to recognize the existence of an ethical issue. Karcher (1996)
investigated the ethical sensitivity of auditors in Big 6 firms. The study found that auditors
were more sensitive to two ethical scenarios covered by the professional code of conduct
than an ethical issue that was not discussed by the code.
Wotruba et al. (2001) and Noreen (1988) suggest that the impact of an ethical code of
conduct will be significant only if the code has been bilaterally internalized by individuals,
either consciously or subconsciously. Pflugrath et al. (2007) provides support for Wotruba et
al.s (2001) proposal, reporting a positive relationship between the strength of the ethical
environment (absence vis-a`-vis the presence of a code) and ethical judgments in
professional accountants exposed to codes of conduct within their organizational
environment, but not in student participants whose familiarity with actual organizational
context is none or very limited.
H3: A stronger ethical environment (the presence and reinforcement of a code) will have
greater impact on the judgments of more experienced auditors (audit managers) than less
experienced auditors (audit seniors).
H4: Subordinate auditors (audit seniors) judgments will conform to the expected judgments
of their superiors (audit managers).
H5: Subordinate auditors (audit seniors) expected judgments of their superiors will be well
aligned with the actual judgments of their superiors (audit managers).
SUMMARY
The aim of this study was to examine whether the strength of the ethical environment
(proxied by the presence only versus the presence and reinforcement of a code) has an
impact on audit quality. This was motivated by the recent introduction of the ISQC1, which
requires all accounting firms to implement policies and processes to ensure employees
technical and ethical competence. Audit seniors and managers (as proxies for auditing
experience) were asked to make a number of judgments in relation to an inventory
writedown task, with aggressive client preference already indicated. All participants were
highly likely to discuss the writedown issue under all conditions. This indicates that all

participants were aware of the significance of the audit issue (i.e., the inventory writedown)
addressed in the study, and thus enhances the validity of the results obtained.
Audit managers were sensitive to the presence and reinforcement (vis-a`-vis the presence
only) of a code, whereby the difference was significantly greater in the stronger ethical
environment. In contrast, seniors appear to be generally unaffected by the differences in the
strength of the ethical environment. These results provide support for previous research
(Noreen, 1988; Pflugrath et al., 2007; Wotruba et al., 2001), which suggests that the impact
of a difference in the strength of the ethical environment will be greater for more experienced
auditors who have bilaterally internalized the significance of a code. This can be explained
by the combined effect of the commitment that comes with having internalized the
significance of the code, and the differences in the accountability pressures experienced by
managers, vis-a`-vis seniors. Commitment is defined as the totality of internalized
normative pressures to act in a way that meets organizational interests (Wiener, 1982, p.
48). Therefore, given that commitment can be influenced by organizational intervention
(Wiener, 1982) and that the degree of commitment is heightened by the number of acts
performed by the subject (Kiesler, 1971), it is expected that requiring subjects to sign a
declaration in respect of having read the code and agreeing to abide by the code (relative to
those who merely receive a copy of the code) will heighten commitment. It also follows from
prior research that audit managers will be more committed to the organizational outcomes
under the reinforcement of the code condition, given their greater experience (and hence
greater internalization of the significance of the code).
Furthermore, given audit managers direct relationship with the clients, managers will
encounter greater accountability pressure than seniors, who are generally only directly
accountable to managers. While Peecher (1996) found evidence that auditors became more
skepticalwhen theywere held accountable to superiors, DeZoort et al. (2006) demonstrated
that different levels of accountability pressures lead to differences in auditors judgments.
They showed that auditors faced with higher levels of accountability pressures (e.g.,
justification) produced more conservative judgments than auditors under lower levels of
pressure (e.g., review). These two different levels of accountability pressure equate with the
pressures being faced by managers and seniors, respectively. While seniors are subject to
review pressure from theirmanagers (who review their decisions), managers are subject to
the higher level justification pressure as they are required to explain to, and negotiate with,
the client. Consequently, the managers, in the presence and reinforcement of the code, will
encounter both higher levels of accountability and have a heightened commitment to the
organizational interests, than subjects in the other three cells. Consistent with the result of
this study, it implies that managers, in the presence and reinforcement of the code of ethics,

will be more skeptical and make more conservative judgments. On average, the results of
this study suggest that audit managers make judgments that are more conservative in the
stronger ethical environment for each of the key decisions: (i) the technically correct amount
and (ii) the recommended amount; while the opposite is true for seniors. Additionally,
contrary to previous research (Buchman et al., 1996; Cuccia et al., 1995; Hackenbrack and
Nelson, 1996) that suggests that seniors judgments would align with the expectations of
managers; this study showed that seniors made judgments that were significantly different
from the judgments that they expected their audience (i.e., managers) to make. Seniors
were able to correctly identify what judgments the managers would make.

THE EFFECT OF THE TYPE AND NUMBER OF INTERNAL CONTROL WEAKNESSES

AND THEIR REMEDIATION ON AUDIT FEES (Keane, Matthew J; Elder, Randal J; Albring,
Susan M, 2012)
The implementation of compliance procedures associated with the Sarbanes-Oxley Act of
2002 came at a great cost to most publicly-traded firms, largely due to the internal control
disclosures required by Section 404 of the Act. The purpose of this paper is to contribute to
the inquiry on internal control effectiveness by examining the impact of the type (same or
different) and number of internal control weaknesses on audit fees. The paper also
examines whether firms that remediate continue to incur higher audit fees compared to firms
that never disclosed a weakness.
Prior research examines the effect of auditor and firm characteristics on audit fees (including
Simunic, 1980; OKeefe et al., 1994; Craswell et al., 1995; Houston et al., 1999; Carcello et
al., 2002; Abbott et al., 2003; Francis et al., 2005; Houston et al., 2005; Lowensohn et al.,
2007). Mitra (2009) examines audit fees for firms that remediate an internal control
weakness and firms that do not remediate and finds that fees decline for firms that
remediate. In contrast, we examine firms that disclose and do not disclose internal control
weaknesses. We find fees of remediating firms do not decline to the level of fees the firm
would have paid if they had never disclosed an internal control weakness. Thus, the firm
continues to pay for the weakness despite remediation efforts. We test several years after
remediation and find that fees remain higher for firms that disclosed an internal control
weakness. Our findings are consistent with the view that auditors build a risk premium into
the audit fee at the time of disclosure[2]. We analyze 9,122 firm-year observations covering
the years 2004 through 2007. We find that incremental material weaknesses identified have
a positive effect on audit fees. Though audit effort should not increase significantly due to a

disclosure in the second year, we find that firms that report the same or different material
weaknesses in consecutive years pay higher audit fees.
H1. Additional internal control weaknesses are associated with higher audit fees.
We examine the impact of remediation on audit fees two and three years after disclosure of
a material weakness. In the years following remediation, auditors would likely focus their
effort on testing the effective controls that remediated the weakness around a specific
process, in addition to gaining the opportunity to reduce risk assessments for the purpose of
the financial statement audit (Auditing Standard No. 5, 2007). Auditor effort related to a client
two (three) years after the disclosure of ineffective internal control should not be materially
different from a client that never disclosed ineffective internal controls. Thus, audit fees
should decrease two (three) years after remediation. However, if audit fees of a firm remain
high two or more years after remediation, a portion of the increase in fees is likely due to the
existence of a risk premium in response to the disclosure, rather than solely to an increase in
auditor effort. This leads to hypothesis two, stated as follows:
H2. Audit fees remain higher up to three years after the remediation of a material weakness.
Elder et al. (2009, p. 3) find that auditors price audit risk and client business risk into the
audit fee. A firm with disclosures of ineffective internal controls in consecutive years is
expected to have higher perceived client business risk. Hoitash et al. (2008) compare audit
fees for firms that disclose a material weakness during the last year of Section 302 to firms
that continue to disclose an internal control weakness in the first year of Section 404 and find
that audit fees remain high. We extend their analysis and examine the impact of consecutive
internal control weaknesses on audit fees within the Section 404 time period, when internal
control disclosures are audited. We differentiate between ineffective controls in consecutive
years by examining whetherfirms that report the same material weakness in consecutive
years have higher audit fees. Firms that report the same material weakness in the
subsequent year should have a higher level of audit fees because although the company
had the opportunity to remediate, the company either chose not to or was unable to
remediate, indicating a more substantial problem with their overall control environment. We
also examine whether firms that report different material weaknesses in consecutive years
have higher audit fees. A firm that reports a new internal control weakness should have
higher audit fees since a new risk needs to be addressed by the auditors. The third
hypothesis is stated as follows:
H3a. The disclosure of different ineffective controls in consecutive years is positively related
to audit fees.

H3b. The disclosure of the same ineffective controls in consecutive years is positively
related to audit fees.
This paper examines the impact of internal control weaknesses and their remediation on
audit fees and contributes to the literature examining the effect of a clients disclosure of
ineffective internal controls on fees. We analyze the impact of additional internal control
weaknesses on audit fees and find that there is a significant incremental impact for
additional disclosed material weaknesses. The results suggest that as the number of
weaknesses disclosed increases, auditors assess more risk, increase testing, and
subsequently increase fees. We also find that persistently ineffective internal controls have a
positive effect on audit fees, indicating that auditors may use disclosure in consecutive years
as a signal of client-related risk and price it into the audit fee. In addition, our results suggest
that firms that report the same material weakness in consecutive years pay higher audit fees
than firms that report different material weaknesses. Further, we find that firms that
remediate continue to pay higher audit fees in the year of remediation compared to firms that
did not report an internal control weakness. This finding suggests that the auditor is not able
to rely on the clients controls despite their effectiveness in the current disclosure year, and is
unable to reduce testing. We also find that audit fees continue to remain high two and three
years after remediation, despite the auditors ability to rely on controls and reduce testing.
The findings are consistent with the contention that a portion of the increase in fees in
response to the disclosure of ineffective internal controls is due to the existence of a risk
premium, rather than solely to an increase in auditor effort. An analysis of change in audit
fees provides further support that auditors do not reduce audit fees for clients that
remediate. Prior research finds that internal governance factors such as audit committee and
board structure are determinants of remediation; however, remediation is not associated with
external governance factors such as the nature of the auditor, analyst following or
institutional ownership (Li et al., 2011). Future studies can shed light on other determinants
of remediation. Future research can also examine whether the relationship between audit
fees and remediation differs for accelerated versus non-accelerated filers.

THE INFLUENCE OF INTERNAL CONTROL STRUCTURE ON AUDITOR RISK

ASSESSMENTS (August-Crook, Tamara A, 2008)
Previous studies of audit task structure and auditor knowledge structure have concluded that
judgment performance is improved when a match between structures exists. Auditing
Standard No. 5, An Audit of Internal Control Over Financial Reporting That is Integrated with
an Audit of Financial Statements (2007) (AS No. 5) establishes a top-down task structure on

the audit of internal control over financial reporting. The new AS No. 5 structure, unlike most
other internal control task structures, includes a hierarchical analysis of both schematically
and taxonomically organized information. Prior research suggests that auditor knowledge
structures of internal controls are organized both schematically by transaction flow and
taxonomically by audit objective. This study investigates how an auditing task characteristic
(task structure) interacts with decision maker characteristics (attention and knowledge
structure) to examine whether the new AS No. 5 task structure of internal control evaluation
affects governmental auditors' processing of internal controls in three audit tasks: control risk
assessment, analytic risk assessment, and pattern identification. Results indicate that
auditors were better able to sort internal controls according to a traditional internal control
task format as compared to the new AS No. 5 task format. However, results also suggest
that in a weak control environment, the task format of AS No. 5 affected auditor ability to
weight cues, as evidenced by control risk assessments and assessments of the probability
of misstatement, such that risk assessments were greater in the AS No. 5 treatment than
those of auditors using a categorical task structure. Finally, study findings support prior
literature that suggests that as task complexity increases, auditor problem-solving ability
correlates with improved decision performance.
REFERENCES
August-Crook, Tamara. 2008. The influence of internal control structure on auditor risk
assessments.
Ph.D.
diss.,
The
Florida
State
University,
http://search.proquest.com/docview/304641239?accountid=31434
(accessed
September 28, 2014).
Keane, Matthew J., Randal J. Elder, and Susan M. Albring. 2012. The effect of the type and
number of internal control weaknesses and their remediation on audit fees. Review
of
Accounting
&
Finance
11,
(4):
377-399,
http://search.proquest.com/docview/1115340729?accountid=31434
(accessed
September 28, 2014).
Martinov-bennie, Nonna, and Gary Pflugrath. 2009. The strength of an accounting firm's
ethical environment and the quality of auditors' judgments. Journal of Business
Ethics 87, (2) (06): 237-253, http://search.proquest.com/docview/198112785?
accountid=31434 (accessed September 28, 2014).