Error management at audit firms

"An open climate significantly increased auditors’ willingness to report an error."

Door Anna Gold

Companies issue annual financial statements to provide information about their financial position and results. Many stakeholders in society, such as shareholders, investors, bankers, governmental bodies and NGOs, rely on financial statements during their decision-making related to investments, credit-granting or giving subsidies. As the credibility of financial information is vital, there is a need for assurance on the reliability of the financial statements. Such assurance is provided by a qualified and independent external party, called a financial statement auditor (registeraccountant in Dutch). The law typically requires a financial statement audit to enforce a fair and transparent functioning of the financial markets by reducing the cost of capital. Hence, auditors fulfill an important societal role.

The auditing profession is in the spotlights. In times of major scandals − think of Enron, Ahold, Econcern, and Imtech − audit firms are frequently being blamed for failing to detect questionable accounting practices and fraud (e.g., Sikka, 2009; Jones, 2011; SOBI, 2014). Only recently, the Dutch regulator of the audit profession (the AFM) confirmed that audit quality at the "Big 4" audit firms (Deloitte, EY, KPMG and PwC) is currently unacceptably low (AFM, 2014). More specifically, AFM inspections in 2013-2014 revealed a multitude of deficiencies in the course of the audit, suggesting almost 50 percent of the reviewed audit engagements are inadequate, and implying that the auditor failed to perform relevant audit procedures. At the extreme, such deficiencies could result in a situation where the auditor issues a clean audit opinion for a client’s financial statements where this would be unwarranted. This situation would be a clear sign of low audit quality.

What is the cause for audit deficiencies? While one may be tempted to jump to conclusions about bad auditor intentions, it is more reasonable to assume that the majority of deficiencies is instead rooted in unintentional errors. Furthermore, even though audit firms have adopted mechanisms to prevent errors, total elimination of errors is impossible, given the complexity and unpredictability of processes and the audit environment and the simple fact that auditors are just human beings. As a result, alongside prevention mechanisms, considerable attention needs to be paid to the manner in which how errors are being managed, to make sure that (1) immediate negative error consequences are reduced, and (2) auditors and audit firms learn from their errors to reduce their occurrence in the future. Aviation and healthcare are two similarly complex professional environments, with human errors representing a substantial threat to primary outcomes (in this case, passenger and patient safety). One key lesson learned from research in these areas is that excessive error prevention may reduce the extent to which organizational members share their error experiences, hence reducing or even eliminating the potential for properly managing negative error consequences and learning from errors.

I have embarked on a research program that focuses on the manner in which auditors, audit firms and audit regulators deal with unintentional errors, how varying audit firm climates affect error reporting behavior, and whether and how auditors learn from errors. In a recent interview study with Dutch auditors (Gold, Huijsman & Wallage, 2015), we observed that auditors generally view errors as something inherently negative that should be prevented or avoided at all costs. Related to this, auditors experience a high level of fear that admitting to an error may not only negatively affect one’s reputation, but also have adverse career-related consequences. Anticipation of AFM inspections similarly creates a culture of fear. As a result, even though auditors in our study display awareness of the benefits of open communication, the extent to which errors are actually shared openly appears to be very limited, probably due to auditors’ fear of potential repercussions such as sanctions. As a consequence, even though audit firms are clearly devoted to life-long learning (by means of courses, trainings, and coaching programs), learning from concrete errors only rarely occurs.

What can be done about such resistance to sharing errors? In an experimental setting (Gold, Gronewold & Salterio, 2014), we studied the effects of an audit firm’s error management climate on auditors' willingness to report discovered errors in audit work papers. Amongst other variables, we manipulated the description of the audit firm climate. In one condition, participating auditors were asked to assume that they work at an audit firm which is noted for a “getting it right the first time” mentality, where errors are seen as signs of incompetence and where auditors committing an error are generally sanctioned (a "blame" climate). In the other condition, the audit firm climate was described as an “open for improvement” mentality, where errors are seen as a natural part of learning, and (unless repeated) errors will not be documented in performance evaluations (an "open" climate). We found that, overall, an open climate significantly increased auditors’ willingness to report an error to his/her superior, compared to a "blame" climate.

In the coming years, my research team and I will further examine issues surrounding auditor errors. First, we will establish a taxonomy of auditor errors, which will aid audit firms to conduct adequate root-cause analyses (as required by the regulator). Then we will analyze the role of external oversight (AFM in the Netherlands) and audit firms’ own policies in potentially hindering or facilitating the development of constructive error management. Finally, we will examine how behavioral change can be instigated to improve the error management climate in audit practice, with the ultimate goal of increasing audit quality.

Gold, A.
Anna Gold is hoogleraar bij de afdeling Accounting.

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