Integration of Fraud Risk in the Risk of Material Misstatement and the Effect on Auditors' Planning Decisions

ABSTRACT Prior research finds that although auditors assess fraud risk accurately, they generally fail to adjust audit procedures appropriately. The most recent Public Company Accounting Oversight Board (PCAOB) inspections in 2016 still identify response to risks of material misstatement (RMM) as a major area of inspection focus and cite it as a recurring audit deficiency. In this study, participants assess RMM and make audit-planning judgments in a high/low fraud risk environment using either a traditional source-based representation of RMM (i.e., based on inherent, control, and fraud risk) or a newer type-based representation of RMM (i.e., based on error and fraud risk). The results indicate that while auditors in both groups show similar sensitivity to risk, the type-based group of auditors are better able modify their audit plans by using more procedures that are new to a standard audit program and assigning more experienced staff to address high fraud risk. Data Availability: Contact the author.

How Strategic Reasoning and Brainstorming Can Help Auditors Detect Fraud

SUMMARY Auditors often fail to effectively modify their standard audit procedures in response to fraud risk. Two audit interventions, strategic reasoning (i.e., considering how the audit client may be concealing a fraud from the auditor) and brainstorming in groups, have been suggested to help auditors design better fraud detection procedures. This paper summarizes a recent study (“Do Strategic Reasoning and Brainstorming Help Auditors Change Their Standard Audit Procedures in Response to Fraud Risk?” [Hoffman and Zimbelman 2009], The Accounting Review) in which an experiment was conducted in a high-fraud-risk setting to see whether these interventions helped audit managers design better fraud procedures. The study found that both interventions improved auditors' planning judgments, but that combining them was not more effective than either one alone. That is, once individual audit managers reasoned strategically, adding more audit managers to the process in a brainstorming group did not result in better judgments, and brainstorming groups did not obtain additional benefits from reasoning strategically together.

The Role of Incentives to Manage Earnings and Quantification in Auditors' Evaluations of Management-Provided Information

We conducted an experiment with 113 experienced auditors to examine the influence of two factors on the persuasiveness of a management-provided nonerror explanation for an unexpected fluctuation in revenue. We expected that auditors' evaluations of a management explanation would depend jointly on whether it is quantified (i.e., put into numbers) and the managers' incentives to manage earnings. Instead, we find that the persuasiveness of managers' explanations is determined solely by their incentives. Focus on managers' incentives is consistent with auditors attending to regulators ‘ recent concerns about earnings management. However, such a focus implies that when the likelihood of earnings management appears low, auditors fail to take into account information about sufficiency that is contained in the quantified explanation when they revise their planning judgments.

Audit-Planning Judgments and Client-Employee Compensation Contracts

This paper investigates, in a laboratory setting, the impact of different types of client-employee compensation contracts on auditors' audit-planning judgments. Self-interested client-executive actions (motivated by executive incentive pay) have been claimed to be at the core of a recent large public company failure and the associated demise of the company's global auditors (Byrne et al. 2002). However, we know relatively little about how client-employee compensation contracts affect the planning choices of auditors. Our main result is that audit-planning judgments are greater (i.e., audit risk is assessed higher and the level of evidence required to perform the audit is assessed higher) if the bonuses are based on financial performance measures rather than nonfinancial performance measures. We also find that audit-planning judgments are greater (i.e., audit risk is assessed higher, internal controls are assessed weaker, and more substantive evidence is required) if client-employee compensation comprises a fixed salary plus bonuses, based on either financial or nonfinancial performance measures, rather than comprises a fixed salary only; however, we find only partial support for the finding with respect to nonfinancial measures. An important implication of these findings is that audit firms may need to pay careful attention to how auditors are trained in strategic systems auditing approaches that rely more on understanding a client's nonfinancial performance measures and less on transaction-based testing.