Managing Risk in a Poor Economy: The Association between Economic Conditions and Risk Tolerance and Its Implications for Practice Free

This 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, 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.

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 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?

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 = 1 if there is an auditor resignation during the fiscal year. Observations where RES = 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, 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).

In our model to test H1, we find that ICWEAK ∗ ECON is a significant (p = 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 = 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.

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 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 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.