Stephen Kwaku Asare

Internal Auditors' Evaluation of Fraud Factors in Planning an Audit: The Importance of Audit Committee Quality and Management Incentives

We examine internal auditors fraud risk decisions in response to variations in audit committee quality and management performance incentives. Using an experimental approach, we find that internal auditors serving in a either a self-assessment role or a due diligence role were sensitive to variations in management performance incentives, linked these variations to fraud risk assessments and altered their audit plans accordingly. With respect to audit committee quality, internal auditors in both roles were sensitive to variations in quality, but the responses to quality variations depended on whether they were in a due diligence or self-assessment role. With respect to the former, they linked the variation in quality to fraud risk, but did not alter the scope of their planned audit effort. With respect to the latter, they neither linked the variations in quality to fraud risk nor to planned scope.

Hypothesis revision strategies in conducting analytical procedures

Abstract A number of accounting tasks require an evaluation of competing hypotheses. For instance, a management accountant considers alternative reasons for a significant standard cost variance while an auditor must determine whether an unexpected fluctuation in a clients account balance was caused by an error, irregularity or a change in economic conditions. In spite of the prevalence of hypothesis evaluation in practice, little is known about the process. In this paper we provide evidence on two issues that could compromise effective and efficient hypothesis evaluation: (1) the revision of beliefs over competing hypotheses given diagnostic evidence; and (2) whether an eliminated hypothesis is subsequently resuscitated (i.e. reconsidered as plausible). To address these issues, 55 auditors were provided audit test results and were asked to evaluate five potential hypotheses that may have caused a material fluctuation in the gross margin ratio of a client. The findings indicate that, when presented with diagnostic evidence about a target hypothesis, auditors were prone to adjusting the likelihood of the target hypothesis but not revising the likelihoods of the competing hypotheses. This non-Bayesian revision strategy, which we label the “one-hypothesis syndrome”, appears to represent a trade-off reflecting competing forces of cognitive strain, efficiency and accountability. While our preliminary results indicate high performance (in identifying the actual cause), additional research in less controlled settings is needed to fully evaluate the effect of this trade-off on efficiency and effectiveness. Finally, contrary to anecdotal evidence from an SEC release, auditors were reluctant to eliminate hypotheses and those who did, did not regard their eliminations as permanent.

A Review of Audit Research Using the Belief-Adjustment Model

The basic audit process requires that the auditor search for and evaluate evidence related to an audit assertion (e.g., Cushing & Loebbecke, 1986; Felix & Kinney, 1982; Gibbins, 1984; Knechel & Messier, 1990). In evaluating an audit assertion (e.g., validity of accounts receivable balance), the auditor begins with an initial belief and then revises that belief upward or downward depending on whether each new piece of evidence is positive or negative, respectively. While this process has been modeled using Bayes rule (Kinney, 1975), a number of behavioral studies in auditing (e.g., Joyce & Biddle, 1981a, b; Kinney & Uecker, 1982; and others) indicate that Bayes rule is not a good descriptor of the auditor’s judgment process. In particular, the research results have indicated that an auditor’s judgment process is sensitive to normatively irrelevant variables such as hypothesis frame (Kida, 1984b), temporal sequence (Joyce & Biddle, 1981a), and more generally that auditors employ heuristics in their judgments of probability. These findings are consistent with similar research in psychology (e.g., Slovic & Lichtenstein, 1971; Tversky &Kahneman, 1974). Accordingly, decision theorists have recently focused on the effects of task variables on information-processing strategies.