Audit quality in practice: how is audit quality conceived by practitioners in non-financial auditing?

Amsterdam Business School

Audit quality in practice: how is audit quality conceived by

practitioners in non-financial auditing?

‘’ Accountants will save the world’’

(Peter Bakker, president World Business Council for Sustainable Development)

Name: Wilmar Burgman Student number: 10835164

Thesis supervisor: Prof. Dr. Brendan O’Dwyer Date: 19 June 2016

Word count: 24920

MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam

Statement of Originality

This document is written by student Wilmar Burgman who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

Abstract

Since the development of non-financial reporting, accounting offices started to provide assurance services over this kind of reporting. The expanding of the services beyond the traditional financial audit statements however, raises a lot of unanswered questions. One of the questions DeFond and Zhang (2014) ask is what audit quality means in these settings. The concept of audit quality has been researched a lot, but the outcome of an audit is mostly unobservable. Most of the researchers therefore have tried to define the notion of audit quality as what it is not when it comes to audit outcomes. These studies mainly focused on the observable aspects of the financial report instead of the audit process itself. There is previous literature on how the notion of audit quality was conceived for financial auditors, however there is no previous literature on how non-financial assurors give meaning to the notion audit quality.

This thesis takes as it subject the manner in which non-financial auditors construct meanings for the concept of audit quality. It explores the way how non-financial assurors interpret and apply the concept and construct meaning that can influence the way in which the actual audit process has been conducted. Prior research concluded that auditors, users and preparers all view audit quality different and they failed to find consensus. The reality of audit quality for non-financial assurors is not just observable, but are hidden in the activities of the assurors. Therefore, the reality can be found by investigating how symbols are used internally by non-financial assurors and how they can give meaning to the concept of audit quality.

In this study eight assurors were interviewed that work for the sustainability department inside a Big Four audit firm. In this research there has been searched for symbols that financial assurors relate to audit quality. From analyzing the transcripts it became clear that non-financial assurors frame their notion of audit quality around three core codes: professional behavior, quality of the reports and their inner beliefs. These codes have an equal contribution to the quality of the audit in practice.

These findings have relevance for assurors of non-financial information, and other parties that are engaged with sustainability and integrated reporting. However, the meaning non-financial assurors give to the notion of audit quality in practice can change in time as it is subjected to social, regulatory and economic pressures.

Contents

1 Introduction ... 6

2 Literature Review ... 9

2.1 Sustainability reporting and integrated reporting ... 9

2.2 Assurance over sustainability reports ... 11

2.2.1 Assurance standards ... 12

2.2.2 Sustainability assurance in practice ... 13

3 Perspectives on Audit Quality ... 15

3.1 Introduction ... 15

3.2 Research approaches to audit quality ... 15

3.2.1 The classic definition of Audit Quality ... 16

3.2.2 Inputs and outcomes related to Audit Quality ... 17

3.2.3 Audit processes ... 18

3.2.4 Perception of audit quality ... 18

3.2.5 Summary... 18

3.3 Practitioners perspective on Audit Quality ... 19

3.3.1 ICAEW perspective on audit quality... 19

3.3.2 PWC’s perspective on audit quality ... 20

3.4 Regulatory perspectives on Audit Quality ... 22

3.4.1 IAASB’s perspective on audit quality ... 23

3.4.2 PCAOB’s perspective on audit quality... 24

3.4.3 Summary... 25

3.5 Summary ... 25

4 Theoretical framework ... 26

5.2 Collection of Data and Analysis of Semi-structured interviews ... 30

6 Case Context ... 32

7 Case analysis... 33

7.1 Meaning of audit quality in practice ... 33

7.1.1 Professional behavior ... 33

7.1.2 Quality of reports ... 41

7.1.3 Inner beliefs ... 43

7.2 Conflicts in practice ... 45

8 Discussion ... 47

8.1 Meaning of audit quality... 47

8.2 Summary ... 51

9 Conclusion ... 52

9.1 Conclusion ... 52

9.2 Contribution to the literature ... 55

Appendix A: Interview details ... 57

Appendix B: List of themes per interviewee ... 58

Appendix C: IAASB’s framework for Audit Quality ... 64

Appendix D: PCAOB’s framework for Audit Quality ... 65

1 Introduction

In recent decades demand for external assurance in other domains than financial audit has been increased (Andon et al., 2014, 2015; Andon and Free, 2012; Power, 1996, 1997A). This has led to the emergence of sustainability assurance (O’Dwyer et al., 2011) and assurance over integrated reports. Since the publication of the first environmental report in the late 1980’s, more and more companies have started to publish information on environmental, social and sustainability issues. KPMGS’s (2015A) survey reports that 90% of the world’s largest 250 companies are using Corporate Responsibility Reporting. To increase credibility over these Corporate Responsibility Reporting assurance is needed from an external party. KPMG’s (2015A) survey of Corporate Responsibility Reporting indicates that of the G250 companies publishing a Corporate Responsibility Report, 67% invests in external assurance statements, compared with 46% from 2011. The survey also reports that major accountancy firms dominate the market to provide assurance over Corporate Responsibility Reporting. The expanding of assurance services beyond traditional financial audit statements, raises a lot of unanswered questions according to DeFond and Zhang (2014). Such as whether auditors incentives and competences transfer to non-financial settings, whether assurance of non-financial information adds value, and what audit quality means in these settings (DeFond and Zhang, 2014).

Audits are required by the auditing standards to obtain reasonable assurance about whether the financial statements are free of material misstatements (PCAOB, 2010). The auditors express an opinion about how fair the financial statements are presented (PCAOB, 2010). The quality of the audit performed determines the degree to which financial statement users can rely on the audit opinion that is given. The scandals and economic events in the last decades have highlighted the importance of audit quality and its role to maintain the stability of financial markets (Christensen et al., 2015; Knechel, 2009). The Public Company Accounting Oversight Board (PCAOB) and International Auditing and Assurance Standards Board (IAASB) have started projects that seeks to define, measure and evaluate audit quality. These projects however are still in the early development stage.

The recent financial scandals, like Enron and similar cases, have heightened the interest of regulators and the public at large concerning auditing, corporate governance practices and financial reporting (Sulaiman, 2011). The scandals have made the notion of audit quality a hot topic for regulators, management, audit committees and auditors. Historically, management and audit committees assumed that the audit quality was fine unless told otherwise (KPMG, 2015B). But nowadays non-executives and audit committees can be held personally responsible for the

outcome. Therefore they want to know more about the processes and alternatives that auditors consider, and how auditors reached their conclusions. Furthermore, KPMG (2015C) argues that auditors cannot drive audit quality alone, audit firms need to be independent and while they also have to collaborate with the clients. Furthermore, clients need to be open and transparent to the auditors and provide them access to their information and systems. As a result that management and audit committees have a crucial role in conceiving audit quality. The different stakeholders (regulators, stakeholders, audit committees and executives) involved in the auditing process all have different needs and expectations (KPMG, 2015D). Therefore they have different viewpoints on how to define and measure audit quality, which makes it difficult to get to a consensus. Furthermore KPMG states that audit quality is constantly changing as audit firms improve what and how they deliver, and expectations from other stakeholders shifts as well. Regulators, for example, define audit quality as comply with a set of auditing standards. In practice, however, every company and sector has their complexities.

The concept of audit quality has been researched extensively, despite that the outcome of an audit is mostly unobservable. Therefore researchers have tried to define the notion of audit quality as what it is not when it comes to audit outcomes, but they predominantly used indirect but measurable proxies for audit outcomes (Redmayne, 2013). Sulaiman (2011) states that most research studies that examined audit quality have linked the observable signals of auditor quality (i.e. audit firm size) with the indicators of financial reporting quality (i.e. the quality of reported earnings). However, Humphrey et al. (2007) argues that in these studies the concept of audit quality narrowed down to specific characteristics or decisions and the indicators quality of the audit is restricted to the observable aspects of the financial report instead of the audit process itself. As a result, less is known about how auditors conceptualize the meaning of audit quality and what behavior and attributes auditors associate with audit quality. Power (2003) also point out that there is limited research that addresses auditing practice in context. Therefore, this thesis is based on an interpretive approach research method with semi-structured interviews to enhance understanding concerning the meaning of audit quality of non-financial auditors in a Big Four audit firm. There has been no extensive in-depth research that explores the practical meaning of audit quality from the perspectives of non-financial auditors.

This thesis takes as it subject the manner in which non-financial auditors construct meanings for the concept of audit quality. This thesis explores the way how non-financial assurors interpret and apply the concept and construct meaning that can influence the way in which the actual audit process has been conducted. Furthermore we will have a look how the notion of audit quality to be enacted different between financial and non-financial auditing.

Power and Gendron (2015) argues that the legitimacy and relevance of knowledge of quantitative methods could be enhanced by getting learning to understand the work experiences realities as they are experienced from practitioners in the field. Furthermore they argue that there is not a clear understanding on what auditors do in their everyday environment. Power and Gendron (2015) think that there is not much qualitative research because of the lack of willingness of the researchers and auditors to embark field research using real situations. Chapman (2012) and Gendron (2013) argue that an understanding of an object of study never can be achieved from a single perspective. For example audit quality can be examined via an archival study focusing on earnings management, but via fieldwork researchers can examine how auditors come to a shared belief if their work performed is of sufficient quality. Gephart (2004) states that qualitative research complements quantitative research and provides unique, socially important and theoretically meaningful contributions to the research fields.

2 Literature Review

This section provides an overview of the existing literature about the rise of sustainability reporting and the development of regulation and guidelines. Assuring a sustainability report is totally different then auditing the financial statements. Sustainability reports consists of different information, and sustainability reporting and assurance are not mandatory. Therefore the notion of audit quality can have a different meaning for non-financial assurors.

The first section provides an overview of the existing standards for sustainability and integrated reporting. The second section provides literature that describes why companies should assure their sustainability report, what assurance standards they can use and what issues there are for sustainability assurance in practice.

2.1 Sustainability reporting and integrated reporting Sustainability Reporting

There is an increasing number of companies and organizations that want to make their operations sustainable, and there is an increased expectation that long-term profitability should go hand-in-hand with social justice and protecting the environment (GRI, 2013A). Sustainability reporting, according to the GRI (2013A), helps organizations to set targets, measure performance, and manage change to make their operations more sustainable. A sustainability report consists of the organizations most critical impacts, as well positive as negative, on the environment, society and economy (GRI, 2013A).

Unerman and O’Dwyer (2007) demonstrate that increased regulation that is designed to protect the social and environmental interests of a range of stakeholders can serve to enhance the economic performance and the value for stakeholders. They furthermore state that regulation regime could enhance the credibility of the report, which is good for stakeholders decision making. Sustainability reporting guidelines must be developed and audit practices need to be standardized according to Adams (2004), because this will improve the completeness of reporting and reduce the audit expectation gap between the stakeholders expectations of the sustainability report and the information that an organizations discloses. Hubbard (2011), however, observed that the quality of sustainability reporting is shortcoming because the reported information is often not related to material issues. The quality of disclosures must therefore be improved to provide useful information to users (Hubbard, 2011).

In order to communicate the impact of business on material sustainability issues, some standards for sustainability were created. One of the major standard developers is the Global Reporting Iniative (GRI), which is an independent non-profit organization. The GRI planned and developed different standards during the years, where the G4 standard is the most recent standard that is published. The G4 standard was created to make sustainability reports accessible and more comparable. By developing and communicating about the connection between sustainability and business, the company can increase its value, improve and innovate, and measure changes (GRI, 2013A). Another standard that is well known and can be used for sustainability reporting is AccountAbility, however, both of these standards are not mandatory. An absence of environmental reporting standards causes significant different sustainability reports, and reduces the comparability (Beets and Souther, 1999).

Integrated Reporting

Another new audit space that emerges is the assurance on Integrated reporting (IR). The long-term vision of the International Integrated Reporting Council (IIRC) envisages that Integrated Reporting will eventually become the international corporate reporting norm. Just three years after the IIRC’s formation there was a framework for IR launched. The speed of this framework development testifies to the dramatic rise of IR and the escalating global significance and visibility of the IIRC (Humphrey et al., 2014). Integrated Reporting (IR) explains, according to the IIRC (2013), to financial capital providers how an organization creates value over time. It is a concise communication about how an organization’s strategy, governance, performance and prospects lead to the creation of value over the short, medium and long term (IIRC, 2013). The IIRC (2013) created a principle-based International IR framework which should be used when preparing an Integrated Report. However, this framework is not mandatory.

The IIRC (2015) states that IR is relatively new and still evolving, and assurance on Integrated Reporting will need to evolve alongside the practice of reporting itself. They also argue that there are risks in moving too quickly to assure IR. For example that assurance than would become a compliance exercise (e.g. preparers only report matters on which external assurance can be obtained, rather than focusing on the completeness of the information). Furthermore the internal systems that are being used for IR are far less mature than the internal systems for financial information (IIRC, 2015). The systems are often ad hoc, and in some cases do not exist at all. And at the moment it is still difficult to assess the total costs and benefits of assurance, however it is likely that assurance will become more cost effective as time goes by.

Relation between integrated and sustainability reporting

The notions of sustainability and integrated reporting seem to be very different, but according to the GRI (2013) there are also relations between both ways of reporting. They state that integrated reporters build their integrated reports on sustainability reporting foundation and disclosures. The integrated report is not a combination of the annual financial statements and the sustainability report, but interacts with other reports by making references to additional detailed information that is provided separately (GRI, 2013A).

2.2 Assurance over sustainability reports

Since the publication of the first environmental report in the late 1980’s, more companies have started to publish information on environmental, social and sustainability issues. The main drivers to have a sustainability report assured are according to KPMG (2015A) that assurance would improve the quality of reported information, improved reporting processes and reinforced credibility among stakeholders. KPMGS’s (2015A) survey reports that 90% of the world’s largest 250 companies are using Corporate Responsibility Reporting from which 67% does invest in external assurance statements.

An assurance engagement is defined by the International Audit Assurance Standards Board (IAASB, 2011) as ‘‘an engagement in which a practitioner aims to obtain sufficient evidence in order to express a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria’’. The GRI (2013B) recommends the sustainability reports to be externally assured. External assurance of sustainability reporting and financial reporting share similarities, but there are also important differences (GRI, 2013B). One of those differences is that sustainability reporting covers diverse topics, and the issues that are most critical to manage, measure and disclose vary for each company (GRI, 2013B). According to Deegan et al. (2006) and Kolk (2008) both assurance statements and audit assignments vary a lot, as do sustainability reports. Furthermore, the GRI (2013B) states that sustainability reports often involve a mix of quantitative and qualitative information.

Many investors and other stakeholders may use the information that is published in environmental reports and based on this information investors make their investing decision (Beets and Souther, 1999). As a consequence, the information in the environmental reports needs to be comprehensive, accurate and reliable. Beets and Souther (1999) furthermore state that the credibility of environmental reporting is being questioned, because they are not being

verified by independent third parties. To enhance reliability and credibility of sustainability reports, organizations can voluntary include external independent assurance in their sustainability report. O’Dwyer and Owen (2005) state that assurance can be seen as a central element in holding entities accountable to their stakeholders. Furthermore the external verification will benefit the investing public by providing assurance on a new form of disclosure in an complex investment marketplace (Beets and Souther, 1999). Besides that assurance contributes to the users of the report, it can provide important benefits for organizations concerning the quality of processes and disclosures (ACCA, 2009).

The assurance of sustainability reports is not regulated in the majority of countries, as a result there are different kind of organizations providing assurance services using different methodologies, scopes and assurance statements (Junior et al., 2014). Assurance can be provided by an external auditor. But where accountants have sophisticated measurements, control systems, standards and well established processes for financial auditing, the assurance of sustainability reporting is still developing and is mostly voluntary. One of the challenges external auditors have, according to ACCA (2010), is that they are often not able to deal with all sustainability information and the interdependence of social, environmental and economic issues, nor do accounting methods support this kind of approach.

2.2.1 Assurance standards

As discussed before, there are no generally accepted standards for assurance of sustainability reports. There are two well-known standards that auditors can use for assurance services around the world (WGEA, 2013). The first one is the AA1000 Assurance Standard that is developed by AccountAbility, which provides a specific framework for sustainability assurance and it is also used by non-accountants. AA1000 provides conclusions and findings on the progress of an organizations sustainability performance and encourages continuous improvements. AA1000 provides two levels of assurance: ‘‘type 1’’ and ‘‘type 2’’. Type 1 assurance evaluates the organizations materiality, responsiveness and participation with stakeholders. Type 2 assurance extents the type 1 assurance by also evaluating the reliability of sustainability information. Another standard, is ISAE3000 (Assurance Engagements Other than Audits or Reviews of Historical Financial Information) which is created by the IAASB and is used by many accountants to assure sustainability reports. ISAE3000 has been written for accountants in practice and provides two levels of assurance: ‘‘limited’’ and ‘‘reasonable’’.

Junior et al. (2014) state that the ISAE 3000 and AA1000 standards have been used by different groups of assurers, the accounting professionals and non-accounting professionals.

One of the differences between those groups of assurers is that, according to Hodge et al. (2009), non-accountants appear to focus more on completeness, fairness and overall balance in the opinion statements. Perego (2009) provides evidence that Big Four accounting firms provide a higher quality assurance in terms of reporting format and procedures and non-accounting assurance providers provide a higher of recommendations and opinions in a sustainability assurance statement. A comparison of the AA1000 with the ISAE3000 shows that the ISAE3000 provides rigorous guidance about how an assurance engagement should be undertaken. The AA1000 standards are more focused on the relevance of the reported information for stakeholders, they also go further in stakeholder involvement in determine the subject matter as well as suitable criteria for the assurance engagement and the report. KPMG (2005) argues that assurance based on the combined use of AA1000 and ISAE 3000 will result in a better approach, credibility, methodology and conclusion.

There are also other possibilities for providing assurance. The GRI G4 gives users the opportunity to self-declare to which extent the guidelines have been applied in their sustainability report (GRI, 2013C). The GRI recognizes that sustainability reporting is not one-size-fits-all, and therefore organizations can choose between two ‘‘in accordance’’ options: the ‘‘Core’’ and ‘‘Comprehensive’’ option. The Core option contains the essential elements of a sustainability report. Furthermore under the Core option the organization needs to report for all identified material aspects at least one indicator. The Comprehensive option, however, builds on the Core option and requires a number of additional disclosures about the organizations governance, ethics, integrity, strategy and analysis. Under the comprehensive option, an organization needs to report all indicators for all identified material aspects. The WGEA (2013) argues that some companies use experts or stakeholders to review the completeness of their sustainability report in addition to other assurance processes. The purpose of this panel is to ensure that all key aspects are not left out of the report. This can be very important because the sustainability frameworks allow flexibility of sustainability reporting. This flexibility might enhance the temptation to leave some essential information out of the report with the purpose to make it look better. These panels can provide an opinion on whether the organization has really implement the things they report and on the organizations reporting.

2.2.2 Sustainability assurance in practice

KPMGS’s (2015A) survey reports that more than 90% of the world’s largest 250 companies are using Corporate Responsibility Reporting from which 67% utilized formal assurance statements by an independent professional assurance provider. By contrast, only 1 of

the 10 organizations produces an integrated report. It is likely, according to Kolk (2011) that assurance over sustainability reporting will become more common, although some companies have stopped with the assurance they had done earlier.

Kolk and Perego (2010) state that the highest number of verified sustainability reports are located in Europe and Japan. The sectors that use the highest number of verified sustainability reports are the environmentally sensitive manufacturing industries and the banking and insurance sector (Kolk and Perego, 2010). Many studies conclude that assurance statements vary a lot in terms of content and the types of assurance. Deegan et al. (2006) argues that many of the organizations restrict themselves to assurance on specific data sets or information, and fewer organizations cover the full sustainability report. KPMG (2015A) states that third party assurance among G250 companies is dominantly provided by major accountancy firms. Kolk (2010), however, suggest that organizations shift away from the major accounting firms to consulting firms that are specialized in sustainability matters. The assurance statements vary a lot according to Kolk and Perego (2010), which makes it difficult to compare them.

The auditor states an opinion for the financial statements report in which he states if the accounts are ‘‘true and fairly’’ presented within the scope and constraints outlined (Wallage, 2000). But according to Wallage, it is nearly impossible to provide a high level of quality assurance on a sustainability report. The reason for this is, according to Wallage, that there is no generally accepted standards for sustainability reporting to consider when the assurors evaluates whether the environmental and social data satisfy this criteria. It might be very complex to develop generally accepted standards for sustainability reporting because of the infinite number of sustainability issues and the many stakeholders. The lack of standards is also a threat for auditors, because without an authorative guidance on auditing a sustainability report, and the associated degree of assurance, this may lead to an expectation gap. The opinion can have different levels of assurance for different parts of the reports.

3 Perspectives on Audit Quality

3.1 Introduction

Audit quality is of clear importance to regulators and are therefore of interest to academic researchers. As from the beginning it has been a challenge for regulators, investors, practitioners and academics to define and conceptualize audit quality. But last years there has been an increased focus around the notion and measures of audit quality. Investors define high quality audits as an audit in which the auditor provides an informative audit opinion (DeFond and Zhang, 2014). However, the other stakeholders have a different view on the exact definition of audit quality and how it could be measured best. In this chapter the different viewpoint on audit quality are discussed. In paragraph 3.2 the definitions and measures of audit quality from the researchers perspective are discussed. Paragraph 3.3 discusses the practitioners perspective on the notion and measurement of audit quality. Paragraph 3.4 discusses the regulators perspective on audit quality. In paragraph 3.5 a short summary will be provided of this chapter.

3.2 Research approaches to audit quality

The purpose of an audit is, according to the IAASB (2013), to enhance the degree of confidence of intended users in the financial statements. Auditors are responsible for gathering sufficient audit evidence to express an opinion on whether the financial statements are prepared in accordance with the applicable financial reporting framework and are presented in all material respects with a true an fair view of the entity’s financial position. The opinion about the financial statements could be misleading if auditors perform a poor audit, which could affect the economic decisions the users make over the financial statement.

The recent financial scandals have highlighted the importance of high-quality, credible financial reporting in all sectors of the world economy (IAASB, 2013). These circumstances have reinforced the need, in the public interest, to continuously improve the audit quality (IAASB, 2013). One of the developments is that congress made, as part of the Sarbanes-Oxley Act (SOX), audit committees responsible for the appointment, compensation and oversight of the external auditor (PWC, 2015A). These audit committees are important in ensuring auditor independence and enhancing audit quality (PWC, 2015A).

Power (1997b) states that audit quality is not immediately or directly observable and it is difficult to measure. Moreover, Sutton (1993) argues that audit market participants have conflicting roles and different expectations of audit quality which will lead to different

interpretations. Organizations and regulators have sought to define audit quality in the past years, but there was little consensus (PCAOB, 2013). Various academic research approaches have sought to define and measure audit quality in a number of ways which can be separated in inputs, outputs, processes and perceptions related to audit quality.

3.2.1 The classic definition of Audit Quality

The classic definition of audit quality is cited by DeAngelo (1981). She defines audit quality as: ‘‘the market-assessed joint probability that a given auditor will both (i) discover a breach in the client’s accounting system and (ii) report the breach’’. This definition highlights two aspects of audit quality: (1) the competence of the auditor in discovering a misstatement and (2) the independence of the auditor in reporting a misstatement. Knechel (2009) argues that the definition of DeAngelo is trying to define the unobservable, because users need to assess the competence and the independence of the auditors. To evaluate the competence users need to examine the audit working papers and compare if the work is done according to the auditing standards and guidelines (Sulaiman, 2011). It is, however, impossible for users to examine the audit working papers. Furthermore Sulaiman argues that it is even more difficult to evaluate the independence of auditors because independence in mind is an abstract notion and related to the ethical and moral beliefs of the individual auditors. Independence in appearance, however, is more observable and can be related to certain aspects that reflect the relationship between the auditor and client, such as auditor tenure.

DeFond and Zhang (2014) state that the definition of DeAngelo understates the benefits of high audit quality. They expect high quality auditors not only to consider if the client’s accounting choices comply with the regulation, but also if the financial statements reflect the firms underlying economics faithfully. They state that audit quality is determined by client demand and auditor supply. Client incentives, such as agency costs and regulation, create the demand for audit quality according to DeFond and Zhang. The auditor incentives for independence, such as reputation, litigation and regulatory concerns, create the supply of audit quality. Furthermore they state that the client needs competences to meet the demand (i.e. audit committee, and internal audit function) and the auditors needs competences to supply audit quality (i.e. expertise, and engagement-level inputs to the audit process).

Both the elements of audit quality (competence and independence) that are used in DeAngelo’s definition are unobservable (ACCA, 2014). Therefore, prior archival studies used a variety of proxies or surrogates to measure audit quality (Christensen et al., 2015). Proxies frequently being used include audit firm size, audit partner’s tenure, audit fees, financial

statement restatements, going-concern opinions, level of abnormal accruals, lawsuits filed against auditors and SEC enforcement actions (e.g., Carcello and Nagy, 2004; Carey and Simnett, 2006; Francis et al., 1999; Francis and Michas, 2012; Lambert et al., 2014; Lennox, 1999; Palmrose, 1998; Rusmin, 2010; Stanley and DeZoort, 2007) The variety of proxies used indicates that researchers have a diverse view on how audit quality can be measured reliably (Christensen et al., 2015). DeFond and Zhang (2014) state that there is no consensus on which measures are best, and it is difficult to compare one proxy to another. Despite that there is development of studies that try to understand audit practice in its context, little attention has been given to exploring how non-financial auditors give meaning to the concept of audit quality and how they construct it in practice. In other words, what does audit quality mean to those who carry out the non-financial audit engagements.

3.2.2 Inputs and outcomes related to Audit Quality

Researchers have tried to build on DeAngelo’s definition of audit quality, where the main theme of research considers the relationship between measures of output quality and various input related variables (Sulaiman, 2011). Sulaiman states that the input includes (i) characteristics of the audit firm including the size, audit fees, non-audit services and audit tenure and (ii) characteristics of auditors including the professional attributes and professional values. The output related to audit quality consists of the (i) financial reporting quality including quality of earnings, accurate financial information, restatements of financial statements, accurate audit opinion, regulatory sanctions and (ii) audit failure cases including litigation.

Overall, Sulaiman reviewed research papers that focused on the input and output factors. In general she concludes that this research has been conducted under the assumption that the proxies of audit quality, in particular audit firm size, are equal to high audit quality, but have produced mixed results. The banking crisis and the collapse of Arthur Anderson have ensured that this assumption needs to be revisited. Furthermore she highlights that the usefulness of the proxy audit firm size is limited, and that there is no difference in quality between the size of the audit firm. Sulaiman (2011) argues that despite that this kind of research enhances our understanding of audit quality from the perspective of the correlation between the proxies of audit quality and financial statements, it only provides limited information about audit practices that contribute to high audit quality. This suggest that additional research is needed that focuses beyond the association between the proxies of audit quality and related outcomes.

3.2.3 Audit processes

Other approaches that are relevant to audit quality is the research that is done on audit processes. Prior literature based on the audit process can be categorized into (i) research on audit procedures (what auditors do), (ii) research on the nature of the auditors judgment and decision making and (iii) research investigating the prevalence of behaviors which may undermine audit quality. Sulaiman (2011) has analyzed different kinds of researches that focused on the audit process and concludes that it is worth looking at audit quality beyond simple looking at competence and independence, or measures of audit quality in relation to inputs and outputs. Furthermore Sulaiman (2011) concludes that the literature provides evidence that audit quality can be influenced by contextual factors.

3.2.4 Perception of audit quality

Research on perceptions can be divided into the (i) perceptions of users and preparers of audit quality and (ii) research on the audit expectation gap. Prior research that focused on the perceptions of users and preparers of audit quality conclude that auditors, users and preparers view audit quality different (Schroeder et al., 1986; Knapp, 1991; Carcello et al., 1992; Behn et al., 1997; Chen et al., 2001; Duff, 2004). Sulaiman (2011) has analyzed different kinds of research focused on this topics and concludes that a few things are evident in this area of research. The first problem is that preparers, users and auditors don’t have a consensus on the meaning of audit quality and all have different views on the notion. Second, audit quality is a subjective topic and the notion and depends on the perception and expectation of various parties concerning audit services. Furthermore Sulaiman (2011) summarizes the research that is done on the audit expectation gap and finds that there are a few gaps and conflicts that exist in the auditing environment. The gaps relate to: to whom the auditor should be accountable, the degree to which the auditors are independent, what role effect the commercial interest has on the activities and the role of the external auditor. Although audit quality has been researched frequently and have revealed a considerable amount about the threats to achieve quality and the importance of audit quality, these studies only provide limited insights into the actual audit practices of auditors (Sulaiman, 2011).

3.2.5 Summary

Researchers have tried to define and conceptualize the notion of audit quality. Multiple measures have been used in the audit quality literature (Francis, 2004). DeFond and Zhang (2014) note that archival studies predominantly have measured audit quality by inputs to the

audit process and outputs of the audit process. Experimental studies, however, have placed greater emphasis on the process-based measures (DeFond and Zhang, 2014).

3.3 Practitioners perspective on Audit Quality

Audit quality already has been examined from a more practitioners perspective. Cook (1987), Aldhizer et al. (1995), McConell and Banks (1998), Tie (1999), and Krishnan and Schauer (2001) have examined audit quality by testing the degree to which the audit is conform the applicable auditing standard. The study of Krishnan and Schauer (2001), for example, find a positive association between the size of an audit firm and the compliance with the generally accepted accounting principles (GAAP) disclosure.

3.3.1 ICAEW perspective on audit quality

Practitioner approaches to audit quality try to place the emphasis on the process around the audit and within which professional judgment is exercised (Sulaiman, 2011). The ICAEW (2002) states that audit quality depends on a number of critical factors: people and their training, audit firms and their processes, clients and corporate governance. Furthermore the ICAEW explains that at its heart, audit quality is about delivering an appropriate professional opinion supported by the necessary evidence and objective judgments (ICAEW, 2010). Factors that contribute to the audit quality include good leadership, experienced judgment, technical competence, ethical values and appropriate client relationships, proper working practices and effective quality control and monitoring review processes (ICAEW, 2002). This explaining from the ICAEW suggests that quality consist of the auditors professional judgment, which is supported by the auditors, people who command and oversee it, and systems of quality control that monitor it, and the firm’s values that uphold it. The quality of the audit judgments, however, cannot be directly measured. Therefore audit quality ,that highlights the profession, can be seen as the quality of the audit process that supports their professional judgment.

The ICAEW has proposed a practical construct of audit quality which can be categorized into three main elements. The first element is the governance and the control of the firm, which includes working practices and monitoring the quality processes and client relationship. Good working practices are argued to influence the audit quality. Therefore, it is important for the audit firm to clearly define the roles and responsibilities of their employees. Other factors that influence good working practices are an adequate audit planning and the characteristics of the people that are executing the plan and the people that are reviewing the practices. Monitoring quality processes is another important aspect of the governance and control of the audit firm.

Monitoring procedures, including control reviews, training and learning and audit reviews are set up to assess the quality of audits.

The second element of audit quality are the people in the firm. The ICAEW (2002) notes that audits are performed by people, which means that the quality of the audit depends on the quality of the people. The people emphasize the importance of experience, expertise, skills and values to the quality of audits.

The third element of audit quality is the culture of the audit firm (ICAEW, 2002). Leaders working at the top of a firm are responsible to set the tone in an audit firm. They develop, and are responsible for the policies and procedures that promote audit quality. For example, procedures such as recruitment, training and rewards should reflect quality as important features. The ICAEW (2002) states that no matter how the firm defines audit quality, audit quality can only be achieved if it is translated to the firms strategy and objectives and will be set into practical actions.

In sum, the ICAEW has proposed a practical construction that emphasizes a wider view of audit quality. This construction of audit quality recognizes the influence of interaction within and between the firm. Furthermore it recognizes various internal and external factors in the auditing environment to audit quality.

3.3.2 PWC’s perspective on audit quality

PWC (2015B) recently released their 2015 focus on audit quality with the purpose to increase their transparency and providing their stakeholders a clearer look on how PWC commits quality in their assurance practice. In this report PWC discusses factors that have an impact on audit quality. These factors consist of: culture and values, people, approach, technology, monitoring and stakeholder engagement. PWC’s notion of a quality audit means that they comply with auditing standards; apply a deep and broad understanding of their clients businesses and the financial environment in which they operate; use their expertise to raise and resolve issues; and exercise professional skeptism in all aspects of their world (PWC, 2015B).

In the factor Culture, PWC describes how culture could enhance the audit quality. Here PWC states that a high audit quality only can be delivered when they focus on each of their quality control systems, including leadership, ethics and independence programs, human capital strategies, learning and development, audit methodology, resource management and monitoring programs. PWC states that trust is the vital element for auditors that translates the work auditors do into confidence in the capital markets. Trust and accountability go hand-in-hand according to

PWC. To be accountable PWC has adopted a system of accountability for the staff as a key component of audit quality, and provide their employees with a guidance with the firm’s expectations that communicates the responsibilities and accountability for every professional for providing a high quality audit. To provide a culture which enhances a quality audit, PWC ensures that employees are assessed with the PWC professional framework with the goal to meet the firm’s quality objectives. Furthermore PWC has a code of conduct which explains the behavior that is expected of the partners and staff. Another key characteristic of the auditor is that he or she has to be independent in fact and in appearance. PWC describes that they use various technology-based tools to support and maintain the auditors independence. PWC’s practices and systems also make sure that the practice leaders manage their partner rotation, which helps to identify timely when to rotate and helps to transit the responsibilities to another successor partner who has the skills to maintain the audit quality at that client. And at last PWC considers carefully whether to accept new clients or to continue with an existing client. PWC’s processes require to identify potential risks. Furthermore they need to assess whether their PWC has the right skills, experience, resources and industry knowledge to provide a high quality audit.

The second factor PWC explains in their report that contribute to a quality audit are the people. To make this factor a success PWC has created a people’s strategy which includes how talents are recruited and deployed, shows how to develop the employees skills and identify diverse professional experiences, and provides coaching and feedback. This people’s strategy ensures that PWC’s quality objectives are achieved.

PWC’s approach is the third factor that contributes to a high quality audit. Here PWC is trying to standardize, automate and simplify the audit procedures, and that PWC is continuing to improve their methodology and training programs to comply with new accounting and auditing standards. The assessment of risk is one of the key elements of PWC’s methodology. Furthermore PWC tries to alleviate the busy seasons for their people by enhancing the efficiency of processes and trying to apply more technologies to the processes. Another element of PWC’s approach are the Chief Auditor Network which provides direct and immediate support to the auditors in the field. These people have a deep understanding of auditing standards, firm policy and audit methodology and may also review certain aspects of an audit engagement before the audit is completed. And at last the PWC’s approach include a Quality Review Partner, which are involved in the most important aspects of the audit, consider the firm’s independence, review the audit plan and discuss the risks that are identified by the auditors and how the auditors did respond to those risks.

The fourth factor PWC mentions in his report is technology. They state that technology aims to provide audit teams with the best tools to support them. These tools can help auditors identifying and issuing risks earlier in the audit process and make the execution of the audit more consistent. Furthermore technology could improve the project management and phasing of the auditors work.

Monitoring is the fifth factor that enhances the audit quality. Monitoring makes it able for PWC to identify opportunities for improvement and quickly respond to them. And based on the conclusions of the comments from inspection, PWC tries to develop actions that could enhance the quality. For example guidance could be expanded, tools could be enhanced or additional trainings could be implemented.

In sum PWC has released a report in which they state how a high quality audit could be perceived. In this report PWC state that a few factors determine the quality of the audit. These factors are culture and values, people, approach, technology and monitoring. Gaynor et al. (2016) think that audit firms define a higher audit quality as those completed and comply to the firm’s policies and procedures or those that can be effectively defended.

3.4 Regulatory perspectives on Audit Quality

The events involving Enron-Anderson and other cases have heightened the interest of regulators and the public at large in topics of corporate governance practices, financial reporting and auditing. This cases have resulted in raised concerns in the areas that relate to the integrity of the financial statements, the quality of the audit performance, and how effective audit committees can oversee the financial reporting process and external audit function (Sulaiman, 2011). In respond to these events, changes have been made to the regulatory regime for auditing and governance practices in the US and Europe. One of the developments to strengthen the the legal regulations was by implementing the Sarbanes Oxley Act (SOX) in the US in 2002. And in Europe the Eight Directive was revised. This regulation provided changes in the areas of governance, reporting, auditing and independence. Furthermore this regulation ensured that independent inspections of listed companies became mandatory and there audit and non-audit services needed to be separated.

Several recent academic papers have provided theoretical frameworks that discuss the components of audit quality (e.g., Bedard et al., 2010; DeFond and Zhang, 2014; Francis, 2011; Knechel et al., 2012). In general, according to Christensen et al. (2015), these frameworks define the notion of quality in terms of audit inputs (i.e. expertise), audit processes (i.e. auditor

judgments and work performed), outputs and opinions (i.e. restatements), and audit contexts (i.e. auditor tenure). In addition to these academic frameworks, the Public Company Accounting Oversight Board (PCAOB) and International Auditing and Assurance Standards Board (IAASB) have started projects that seeks to define, measure and evaluate audit quality and created their own audit quality framework.

3.4.1 IAASB’s perspective on audit quality

The IAASB is an independent standards body that develops high quality auditing and assurance standards (IAASB, 2013). The IAASB’s framework is intended to raise awareness of the key elements of audit quality (inputs, outputs and interaction) and want to encourage key stakeholders to explore ways to improve audit quality. The IAASB (2013) argues that audit quality is a complex subject and therefore there is no definition or analysis that has achieved universal recognition of audit quality. A quality audit is likely to be achieved, according to the IAASB (2013), when the auditors opinion on the financial statements can be relied upon as it was based on sufficient appropriate audit evidence obtained by an engagement team that: exhibited appropriate values, ethics and attitudes; was sufficiently knowledgeable and experienced and had enough time allocated to perform the audit work; applied a rigorous audit process and quality control procedures; provided valuable and timely reports; and interacted appropriately with a variety of different stakeholders. An audit failure occurs according to Francis (2011) when the auditor is not independent in fact, or when the auditor issues a clean audit report incorrectly due to collecting not sufficient evidence required by auditing standards.

The IAASB (2013) developed a framework aiming to contribute in the public interest to improve audit quality. The IAASB (2013) states that a number of factors (inputs, outputs, interactions and contextual factors) can contribute to enhance audit quality within jurisdiction, and increase the likelihood of quality audits being consistently performed. The factors that enhance audit quality are displayed in exhibit C. With the framework the IAASB wants to raise awareness of the key elements of audit quality (inputs, outputs and interaction) and want to encourage key stakeholders to explore ways to improve the audit quality.

The input consists of the values, ethics and attitudes of auditors, the knowledge and experience of auditors and the effectiveness of the audit process. The different input categories are also analyzed in the framework at audit engagement level, audit firm level, and national level. The output of the audit is often determined by the context, including the legislative requirements. The outputs that arise from the auditing process primary consist of reports and information that are formally prepared and presented by one party to another party. However,

not all information in the output from the audit process is visible for people outside the audited organization. Furthermore the framework describes that every stakeholder in the financial reporting supply chain plays an important role in producing high-quality financial reporting. The people in the financial reporting supply chain are the people that are involved in the preparation, approval, audit, analysis and use of the financial report. The way in which these stakeholders interact can have a particular impact on audit quality. At last, the framework gives a number of contextual factors that have influence on financial reporting quality, these factors include legislative and regulatory requirements, corporate governance and the applicable financial reporting framework. To conceive quality audits, auditors need to apply rigorous processes and quality control procedures that comply with law, regulation and standards (IAASB, 2015).

In sum, the IAASB has a framework to be in the public’s interest and tries to accomplish to contribute to improve audit quality. In the IAASB’s framework they discuss a number of factors (inputs, outputs, interaction and contextual factors) that contribute to a more consistent and improved quality audits. Furthermore the IAASB tries to encourage accounting firms to challenge themselves and see if there is more they can do to increase the quality of the audit.

3.4.2 PCAOB’s perspective on audit quality

The Public Company Accounting Oversight Board (PCAOB) oversees the audits over public companies to protect the interests of the investor. The PCAOB initiated its own project in which they want to define and measure audit quality (PCAOB, 2013). They developed a discussion paper in which they present a framework for thinking about audit quality and they provide examples to measure audit quality. The PCAOB defines audit quality as meeting the investors needs for independent and reliable audits and robust audit committee communications on: financial statements; assurance over internal control; going concern warnings. The audit framework that is developed is based on previous studies and existing standards. They focus in the framework on three segments: inputs, processes and audit results. The framework can also be seen in Appendix D.

The PCAOB also searched for ways to measure and enhance audit quality. In 2008 the Advisory Committee on the Auditing Profession recommended in their report that the PCAOB should consider whether key indicators of audit quality could be developed and require auditing firms to publicly disclose these indicators. In July 2015, the PCAOB issued a concept release on Audit Quality Indicators (PCAOB, 2015) in which they describe 28 potential indicators that provide insight into audit quality. The Audit Quality Indicators measure elements of the audit quality framework, this subsequently gives insight into the audit quality. The 28 indicators fall

into three categories: audit professionals, audit process, and audit results. The first category, audit professionals, includes measures dealing with the availability, competence, and focus of those that are performing the audit. The second category, audit process, includes measures about an audit firm’s tone at the top, incentives, independence, and infrastructure. The last category, the audit results, includes measures relating to financial statements, internal control, going concern reporting, and auditor communication. The PCAOB’s framework does not discuss external pressures, they only focus on the Audit Quality Indicators. Furthermore their framework depicts that quality activities and results occur at different levels, including the engagement team, office or region, affiliate firm and global firm levels.

3.4.3 Summary

Regulators, such as the IAASB and PCAOB assess audit quality based on audit inputs, processes and audit outcomes. These regulators think that a high quality audit is achieved when sufficient appropriate evidence is obtained (Gaynor et al., 2016). In example, even if the audit opinion that is provided by the accountant is the correct one, the audit still can be of low quality if the audit procedures that were applied to determine the audit opinion were insufficient (Gaynor et al., 2016).

3.5 Summary

This chapter shows how various stakeholders have different views on the definition of audit quality. One element that all perspectives share is that they all focus on high quality audit inputs and processes and high quality outcomes. Furthermore, because of the different perspectives of the stakeholders there is, according to Gaynor et al. (2016), no one-size-fits-all audit quality measure. This chapter shows that there are still limitations in the research to audit quality. For example, there has been limited progress in research to our understanding of audit quality beyond the independence of auditors and their technical competence (Sulaiman, 2011). Furthermore there is limited research on how the employees that are involved in the audit process structure the notion of audit quality, and there is no research available that studies the non-financial practitioners construct the meaning of audit quality. This study seeks to investigate how non-financial practitioners give practical meaning to the concept of audit quality. It explores the way in which non-financial auditors interpret and apply the concept of audit quality and how they construct meanings that can influence the audit process.

4 Theoretical framework

The objective of this paper is to get an understanding about how the notion of audit quality is constructed by non-financial auditors. The research will be conducted using the symbolic interactionism theory. Symbolic interactionism is, according to Dennis & Smith (2015), a durable and distinctive sociological perspective that stresses the importance of the meanings people give to their activities. Furthermore Dennis & Smith state that humans make meaning by using symbols to interpret the actions of other humans, and subsequently he or she reacts on the basis of this interpretation.

George H. Mead and Herbert Blumer developed the central ideas of symbolic interactionism. According to Charon (2007), they tried to understand the process of making meaning of a social reality. In other words, with symbolic interactionism researchers try to understand how meanings are constructed based on the interaction between people and their environment (Sulaiman, 2011). Blumer (1969) asserted that there are three principles that are underlying the symbolic interactionism theory: (1) People act towards things based of the meanings that the things have for them (including everything a human being may observe in his world); (2) These meanings arise in social interaction; and (3) these meanings change and are being modified which means that people have to define and interpret in different situations.

Thus, the meaning of a human being is formed in the context of social interaction with other people and the thinking of human being and is used by these human beings in their actions (Sulaiman, 2011). Therefore the meaning of the humans can be seen as a social object. According to Charon (2007) is a social object any object that can be used in different situations by the human being. Furthermore Charon explains that the meaning of a social object is signified, communicated and created through the use of symbols. These symbols can be used in words, objects and acts that people use to express their meanings not only to others but also to themselves. To quote Charon:

“Social objects and therefore symbols are socially established and understood. This means that symbols are defined in interaction, not established in nature. People make them, people discuss them, people agree on what they shall stand for. Symbols are conventional, a socially established use for the purpose of representations. Conventional means that the symbol is arbitrarily and purposely developed to refer to something” (Charon, 2007, p.48-49).

This quote enlightens that symbols are important for human beings to define the meaning of the social object for themselves, and for others where they interact with. Dolch (2003) states

that symbols also can be used to manage the impressions of other people and subsequently influence other people’s definition of specific situations.

The reality of audit quality for non-financial assurors is not just observable, but are hidden in the activities of the assurors. Therefore, the reality can be found by investigating how symbols are used internally by non-financial auditors and how they can give meaning to the concept of audit quality. Therefore, in this study, audit quality for non-financial assurors is the symbolic representation of the reality that the non-financial assurors use to arrive at a certain degree of comfort and confidence in the work they have done (the audit).

Meltzer et al. (1975) state that people are self-reflective, and that their act and perception are influenced by forces within themselves (for example: their needs and instincts), by external factors (for example: political or social system) and also what lies in between. In the case of non-financial assurance, this is voluntary disclosing, but there are still legal and political structures that may influence the auditor’s work performance.

The symbolic interactionist perspective suggests, according to Sulaiman (2011) that the meaning of a social object can be understood by looking at the process of self-interaction. The process of self-interaction focuses on the individual’s perception, communication and conceptions with themselves influencing the meaning and actions. Symbolic interactionism emphasizes, according to Sulaiman, that the perception of people that are concerned with the meaning of a social object can be better understood through three important concepts. Those concepts are: (1) self-interaction, which influences the construction of the meaning of a social object; (2) the meaning of a social object is influenced by interaction with others in different environments and different situations; and (3) the way somebody acts and objects can be seen as symbols to communicate and represent what the meaning of a social object is to others and to themselves. These concepts will be applied to this thesis. To understand the meanings and symbols non-financial auditors share, communicate and manipulate via interactions, semi-structured interviews will be held among the non-financial assurors. In this study audit quality can be seen as a social object, and auditing practice as the socially constructed activity.

However, it should be noted that symbolic interactionists suffer criticism. Athens (1984), for example, states that interactionist researchers don’t rely on the use of scientific methods in their investigation. Blumer (1969), however, states that the interactionist perspective focuses on understanding social reality from the individual perspective. Furthermore, Blumer argues that the strengths and value of this individual perspective lies in the direct examination of people being studied and how they interpret the empirical social world. Charon (2007) explains the central

principle of symbolic interactionism and argues that it includes the understanding of what the individuals themselves believe about the world. For that reason it isn’t possible to capture the perspective of the individual actors by testing the hypotheses and defining variables and by testing the relationship between them.

5 Research methodology

The objective of this paper is to get an understanding about how the notion of audit quality is constructed by non-financial auditors. This thesis explores the way in which non-financial auditors interpret and apply the concept and construct meaning that can influence the way in which the actual audit process has been conducted. The data will be obtained through a qualitative research in which in-depth interviews will be held with practitioners that are working on the sustainability department within a Big Four accounting firm. The interviews will be held with accountants and non-accountants working on the sustainability department. The data that will be conceived can be used to analyze and explain how the practitioners on the sustainability department deal with the notion of audit quality.

A qualitative research gives researchers the opportunity to answer how and why questions in more depth and detail (Yin, 2009). Interviews can be used to study feelings, thoughts, knowledge and intentions interviewees have (Patton, 2002). Furthermore interviews can be used to get a better understanding of the process, in particular the meanings individuals bring to processes in real-life organizational settings (Cooper and Morgan, 2008).

5.1 Research methodology

Chua (1986) states that there are three methodological assumptions of accounting research that can expand research in the way of viewing and researching the world. The first research approach Chua (1986) mentions is the positivist/functionalist research approach, which believes that society is objective and external to the subject. The second research approach is the critical approach that researches how human beings have inner potentialities that are alienated though a restrictive mechanism. The third research approach Chua (1986) mentions is the interpretive approach, this approach is also applied in this thesis. This approach assumes that the nature of social reality is subjective. In contrast to the other two research approaches (positivist and critical approach), the interpretive approach focuses more on the individual meaning and the people’s perception of the reality (Hopper and Powell, 1985). In the case of audit quality practice there are also subjective dimensions. For example, auditing services involve activities that are undefined and the quality of its output is unobservable. The audit normally begins with a series of planning decisions that could be different for each client. In this stage auditors need, according to Sulaiman (2011), to use their professional judgment to make sure that the scope of the audit is appropriate and sufficient and to allow them to be reasonably satisfied that a high quality audit will be achieved and the annual report is free from material misstatements and is