Audit Risk Management and Audit Effort in Small and Medium Audit Firms

Abstract

The purpose of this paper is to analyze audit planning decisions of small and medium-sized Spanish audit firms about risk evaluation and audit effort. Prior research examining audit risk overwhelmingly focuses on the 4 large audit firms, and little is known about how audit planning decisions influence audit risk in smaller firms; a significant part of the audit profession. Thus, it is important to examine the planning judgments in small and medium-sized audit firms and the link between planning risk assessments and the extent of the effort made to achieve an acceptable level of audit risk. Using specific audit engagement data derived from publicly available databases and survey data, this study investigates the factors which explain the risk evaluation of client material misstatement and whether the effort made to execute the audit effectively responds to that risk. We find a significant statistical relationship between audit risk and audit effort, which provides empirical evidence that auditors modify the extent of audit effort based on perceived audit risk and makes the work of the small firms debatable. Additional analysis shows that audit effort (i.e., hours) is significantly influenced by the tenure and the timing of the audit (i.e., peak audit season). However, audit engagements with longer tenure do not adjust their audit effort in response to low management integrity or weak internal controls, which suggests familiarity, that is, auditors may not be so skeptical of management incentives. This paper contributes to the debate on audit quality and whether the size of audit firms serves as an observable characteristic associated with higher audit quality.