The Impact of an Auditor's Initial Hypothesis on Subsequent Performance at Identifying Actual Errors*

Abstract. Previous work on hypothesis generation demonstrates that auditors tend to generate frequently occurring financial statement errors as their initial hypotheses to explain unexpected fluctuations. However, such work does not examine how the initially generated hypothesis affects subsequent performance at identifying an actual error. We hypothesized that the initially generated hypothesis would interfere with an auditor's ability to subsequently switch to a different hypothesis. Thus, if the initial hypothesis were incorrect, auditors would find it difficult to switch hypotheses in order to identify an actual error. Moreover, initially generating a frequent error would exacerbate this difficulty. Auditor-subjects were asked to generate an initial error hypothesis after seeing a pattern of fluctuations in which sales and accounts receivable were overstated. After they generated their initial hypothesis, half of the subjects were provided with additional information that was consistent with a very frequent error (sales cutoff) and the other half were provided with information consistent with an infrequent error (sales recorded twice). As expected, we found that initially generating the very frequent error (i.e., sales cutoff) versus some other less frequent error affected auditors' subsequent performance at identifying actual errors. Specifically, auditors who generated the very frequent error as their initial hypothesis performed best when it was the actual error, but performed worst when the infrequent error was the actual error. In contrast, auditors who generated a less frequent error as their initial hypothesis performed moderately well (i.e., between best and worst) both when the actual error was frequent and when it was infrequent. The implications of these results for audit efficiency and effectiveness are discussed.     

Improving Auditors' Consideration of Evidence Contradicting Management's Estimate Assumptions

Auditors have difficulty evaluating the assumptions underlying management's estimates. One source of these problems is that auditors appear to dismiss evidence contradicting management's assumptions because their initial preference to support management's accounting biases their preliminary conclusions and, thus, their interpretation of evidence. We experimentally examine whether auditors with a balanced focus (i.e., a focus on documenting evidence that supports and contradicts their preliminary conclusion) are less likely to dismiss evidence that contradicts management's assumptions than auditors with a supporting focus (i.e., a focus on documenting evidence that supports their preliminary conclusion). We expect and find that, compared with auditors with a supporting focus, auditors with a balanced focus create documentation that is less dismissive of evidence contradicting management's estimate. Importantly, a balanced focus changes auditors' cognition and affects how auditors interpret contradicting evidence rather than merely increasing their documentation of this evidence. The effects of reduced dismissiveness persist to improve auditors' evaluations of a biased estimate and subsequent actions, improving audit quality in an important and difficult area.     

How Does Intrinsic Motivation Improve Auditor Judgment in Complex Audit Tasks?

Intrinsic motivation is generally thought to be positively associated with performance on a variety of tasks. However, there is only sparse experimental evidence supporting this idea and we know little about the specific mechanisms behind any effect. We develop theory about how auditors’ intrinsic motivation for their jobs can improve their judgments about complex accounting estimates. We experimentally test whether a prompt to make auditors’ intrinsic motivation for their jobs salient improves the specific information processing behaviors necessary for high‐quality judgments in complex audit tasks. It does: Prompted auditors attend to a broader set of information, process information more deeply, and request more relevant additional evidence. Supplemental analyses show that these processing behaviors mediate between salient intrinsic motivation and an improved ability to identify a biased complex estimate. Our theory and analyses indicate that auditors’ intrinsic motivation for their work provides unique value for improving judgment quality, particularly in the context of performing complex audit tasks. Our study supports the view that high‐quality cognitive processing can improve auditors’ professional skepticism by providing a foundation for skeptical judgments.     

Using Cultural Mindsets to Reduce Cross-National Auditor Judgment Differences

In a globalized audit environment, regulators and researchers have expressed concerns about inconsistent audit quality across nations, with a particular emphasis on Chinese audit quality. Prior research suggests Chinese audit quality may be lower than U.S. audit quality due to a weaker institutional environment (e.g., lower litigation and inspection risk) or cultural value differences (e.g., greater deference to authority). In this study, we propose that lower Chinese audit quality could also be due to Chinese auditors' different cognitive processing styles (i.e., cultural mindsets). We find U.S. auditors are more likely to engage in an analytic mindset approach, focusing on a subset of disconfirming information, whereas Chinese auditors are more likely to take a holistic mindset approach, focusing on a balanced set of confirming and disconfirming information. As a result, Chinese auditors make less skeptical judgments compared to U.S. auditors. We then propose an intervention in which we explicitly instruct auditors to consider using both a holistic and an analytic mindset approach when evaluating evidence. We find this intervention minimizes differences between Chinese and U.S. auditors' judgments by shifting Chinese auditors' attention more towards disconfirming evidence, improving their professional skepticism, while not causing U.S. auditors to become less skeptical. Our study contributes to the auditing literature by identifying cultural mindset differences as a causal mechanism underlying lower professional skepticism levels among Chinese auditors compared to U.S. auditors and providing standard setters and firms with a potential solution that can be adapted to improve Chinese auditors' professional skepticism and reduce cross-national auditor judgment differences.     

Revising Audit Plans to Address Fraud Risk: A Case of “Do as I Advise,Not as I Do”?*

Prior research documents that auditors fail to revise audit plans to effectively address identified fraud cues. While auditors may understand what evidence would address such cues, we propose that auditors fail to apply this understanding because they use implemental mindsets when making decisions for themselves (i.e., deciding). However, we also propose that auditors use deliberative mindsets when advising. To test our predictions, we assign auditors to a decider or an advisor role in a realistic case that contains seeded fraud cues and asks them to consider revising last year's plan. We also manipulate whether the case prompts auditors to revise the plan unconventionally. Results indicate decider-condition auditors use implemental mindsets: Prompted deciders follow the unconventional plan without regard to underlying fraud risk and unprompted deciders stick with the same-as-last-year plan. Advisor-condition auditors use more deliberative mindsets: In the prompt and no prompt conditions, they identify plans that are strongly linked to their own fraud risk assessments and that better align with experts' recommended plan for effectively addressing the seeded fraud cues. Supplemental analyses suggest deciding and advising auditors both follow the experts' plan when they believe in its potential effectiveness but, after controlling for the influence of perceived effectiveness, deciding auditors follow it to a greater extent simply because they believe the PCAOB wants it. By contrast, advising auditors do not exhibit signs of excessive PCAOB influence. Our findings provide evidence that seeking informal advice (or thinking like an advisor) helps auditors to effectively revise audit plans in response to identified fraud risk—it helps when a prompt is present or not, suggesting it complements rather than merely substitutes for interventions meant to improve auditors' judgment and decision making.     

The Effect of Accountability and Time Budgets on Auditors' Testing Strategies*

This study investigates the joint effects of accountability and time budgets on auditors' testing strategies. The task studied, substantive analytical procedures, requires auditors to identify and test hypotheses when investigating the cause of unexpected fluctuations. Thus, auditors must determine the number of tests to conduct (i.e., extent), the number of potential hypotheses to directly test (i.e., breadth), the number of tests for each hypothesis (i.e., depth) and the number of potential error or non‐error hypotheses to test (i.e., focus). Testing strategies, which we define as choices made with respect to extent, focus, depth, and breadth of testing, have significant practical and theoretical implications. For example, reducing the breadth of testing may result in failure to test the correct hypothesis, potentially impairing audit effectiveness. In this study, auditors inherited five potential causes of an unexpected increase in the gross margin of a client. As in practice, their task was to conduct tests to investigate and identify the actual cause of the fluctuation. Auditors were randomly assigned to one of four conditions created by fully crossing accountability and time budgets. The results indicate that accountability leads to an increase in the extent and breadth of testing but does not affect the depth of testing. Further, accountability leads to an increase in the testing of errors but results in a decrease in the testing of non‐errors. The focus on breadth and error testing is consistent with the notion that accountability, to a superior with unspecified preferences, promotes more cautious behavior. The results also show that a time budget decreases the extent and depth of testing but does not affect the breadth of testing. There was no evidence that the two factors interactively affected testing strategies or performance. Finally, increased breadth of testing was the mechanism that led to better performance as measured by the identification of the actual cause of the unexpected fluctuation.     

Auditing Goodwill in the Post‐Amortization Era: Challenges for Auditors

The elimination of goodwill amortization in 2001 brought about significant change in how companies are required to account for goodwill. This change in accounting also brought with it new challenges for auditors, namely evaluating the reasonableness of management's assumptions related to goodwill valuation. In addition to introducing technical challenges, this task is particularly difficult given the misalignment in incentives it creates between managers who likely prefer to avoid recording an impairment and auditors who seek to minimize the bias in management's impairment testing. This study focuses on the consequences of the misaligned incentives that auditors face under the current goodwill assessment process. We find that the decision to record a goodwill impairment is associated with an increase in the probability of auditor dismissal. Consistent with the presence of significant friction with clients, our results also indicate that the likelihood of auditor dismissals is negatively related to the favorability of the impairment decision. Furthermore, we find that companies impairing goodwill prior to dismissing auditors subsequently employ auditors that are, on average, more favorable to clients in their impairment decisions.     

Sequential auditor decision making: Information search and evidence evaluation*

Abstract. This paper presents the results of an experiment that examined five hypotheses related to the information search and evidence evaluation that takes place as part of an auditor's sequential decision process. The results indicate the following. (1) When given a choice, auditors examined the most reliable type of evidence. (2) Auditors who stopped at intermediate stages in the sequential task had, on average, more extreme assessments of the outcome, although there were differential effects depending on whether the auditors based their decisions on positive or negative evidence. (3) Changes in the direction of the auditor's judgments were consistent with the signal in the audit evidence. (4) Negative evidence, in general, led to greater judgment revisions than positive evidence, and the most reliable negative evidence led to the greatest revisions. (5) Auditors searched for corroborating evidence, but their evaluation of that evidence did not impact the assessment of evidence received earlier in the sequential task. Résumé. Les auteurs présentent les résultats d'une expérience portant sur l'analyse de cinq hypothèses reliées à la recherche d'information et à l'évaluation de l'information probante qui s'inscrivent dans le processus de décision séquentiel du vérificateur. Les résultats obtenus indiquent ce qui suit: 1) lorsqu'ils ont le choix, les vérificateurs examinent l'information probante la plus fiable, 2) les vérificateurs qui s'arrêtent à des étapes intermédiaires de la tâche séquentielle produisent, en moyenne, des évaluations plus extrêmes des résultats, bien que l'on observe des incidences marginales selon que les vérificateurs ont fondé leurs décisions sur des informations probantes expresses ou tacites, 3) les modifications dans l'orientation des jugements posés par le verificateur sont conformes aux indications livrées par l'information probante, 4) l'information probante tacite mène, en général, à une révision plus importante des jugements que l'information expresse, et l'information tacite la plus fiable mène à la révision la plus approfondie, et 5) les vérificateurs cherchent à obtenir des preuves de corroboration mais leur évaluation de cette information probante n'a pas d'incidence sur lévaluation de l'information probante obtenue aux étapes antérieures de la tâche séquentielle.     

The Effects of Multitasking on Auditors’ Judgment Quality

Auditors must frequently multitask in order to complete their work efficiently. However, the potential impact of multitasking on auditors’ judgment quality is poorly understood. Using Ego Depletion Theory and a laboratory experiment, we predict and find that auditors become less able to identify seeded errors after multitasking, and that this effect is most prominent in the identification of conceptual, rather than mechanical, errors. These negative consequences of multitasking are mitigated when auditors are exposed to an intervention based on a theoretical countermeasure of replenishing depleted self‐control resources, in that multitasking auditors identify more seeded errors with the intervention than without. Given that multitasking is a pervasive feature of the current audit environment, these findings have direct implications for audit practice. Beyond identifying multitasking as a cause of impaired performance in auditing, this study's results provide initial evidence that such negative effects can be mitigated, resulting in improved audit quality and, by extension, improved financial statement quality.     

Independence Threats,Litigation Risk,and the Auditor's Decision Process*

This study examines the effect of independence threats and litigation risk on auditors' evaluation of information and subsequent reporting choices. Using a Web‐based experiment, I tracked auditors' information gathering and evaluation leading to a going‐concern reporting decision. Specifically, 48 audit managers assessed client survival likelihood, gathered additional information, and suggested audit report choices. I found that auditors facing high independence threats (fear of losing the client) evaluated information as more indicative of a surviving client and were more likely to suggest an unmodified audit report, consistent with client preferences. In contrast, auditors facing high litigation risk evaluated information as more indicative of a failing client and were more likely to suggest a modified audit report. In addition, the association between risk and report choice was fully mediated by final information evaluation. This suggests that it is unlikely that different reporting choices resulted from a conscious choice bias, but rather that motivated reasoning during evidence evaluation plays a key role in the effect of risk in auditor decision making.     

家族控制上市公司内部传承与绩效关系的实证研究

家族企业已经成为我国私营部门的生力军,其权力能否有效传承直接关系到企业的生存与发展。在传承方式的选择上,我国家族企业普遍倾向于内部传承。论文采用2012年694家家族控制上市公司的数据,运用样本均值比较分析、相关性分析和回归分析等实证分析方法,通过家族权力内部传承和外部传承与绩效关系的对比,揭示家族继承人继承权力对公司绩效有显著影响,内部传承方式有利于提升企业绩效。同时,进一步从家族内部传承所有权和管理权两个维度,分析其代理成本差异和与企业绩效的关系,结果显示家族继承人是否为指定管理层与托宾Q值显著相关,表明传承管理权更有助于提升企业绩效。     

Managing Perceptions of Technical Competence: How Well Do Auditors Know How Others View Them?*

We investigate factors that influence an auditor's accuracy in knowing how subordinates, peers, and superiors view his or her own technical competence (metaperception). Extant literature on reputation management in auditing contexts depicts preparers of audit workpapers as strategic agents (subordinates) who stylize workpapers and engage in behaviors that enhance their reputations with reviewers (superiors). These superiors, in turn, are represented as strategically engaging in coping behaviors in response to such stylization attempts. One of the necessary conditions for auditors to enhance their reputations on a sustainable basis is accurate metaperception. We report the results of an experiment that investigates determinants of auditors' metaperception accuracy. Our participants comprise teams of audit partners, managers, and seniors who work together in the field. Each auditor performs two tasks of varying complexity and then predicts whether other team members can accurately perform the task and how other team members assess his or her performance on the tasks. Results show that accuracy in knowing what others think of one's technical proficiency (metaperception) is generally high, particularly when the predictor auditors are partners and managers; however, metaperception accuracy is asymmetric and varies depending on the predictor auditor, the target auditor being predicted, and task complexity. Implications are discussed.     

Pricing of Initial Audit Engagements by Large and Small Audit Firms*

We investigate the extent to which auditors of U.S. companies reduce fees on initial audit engagements (“fee discounting”). We hypothesize that rivalries among sellers, in terms of client turnover and price competition, are more intense among small audit firms. The data support this hypothesis. New clients account for 34 percent of all clients for small audit firms, but only 9 percent of all clients for large audit firms. We theorize that differences in client turnover rates between large and small audit firms can be explained by the market structure of the audit industry, which consists of an oligopolistic segment dominated by a few large audit firms and an atomistic segment composed of many small audit firms. We further hypothesize and confirm that fee discounting is more extensive in the atomistic sector, and our results confirm this hypothesis. Our analysis of audit fee changes indicates that clients who switch auditors within the atomistic sector receive on average a discount of 24 percent over the prior auditor's fee. However, clients who switch auditors within the oligopolistic sector receive on average a discount of only 4 percent. Given that price competition is known to be less intense in oligopolistic markets than in atomistic markets, we believe that market structure theory can explain why fee discounting is lower when larger audit firms compete for clients.     

When Is the Averaging Effect Present in Auditor Judgments?

Auditing standards task auditors with collecting sufficient appropriate evidence to form audit judgments. Yet, cognitive psychology documents a robust finding in which people evaluate a bundle of relevant, directionally consistent evidence as though averaging the strength of the components. In consequence, a bundle of evidence may be viewed as weaker evidence than the bundle's strongest evidence item alone. We experimentally examine whether this averaging effect occurs in an audit context, and we test a potential moderator. In three independent mini-cases, we ask auditor participants to make judgments about going concern, internal controls, and fraud risk. We present auditors with unfavorable audit evidence relevant to each judgment, manipulating whether we present a single strong evidence item or bundle it with a weaker evidence item. We also manipulate the auditor's initial impression of the client's state. We find that experienced auditors succumb to the averaging effect, making more strongly unfavorable judgments in response to the single evidence item than the bundle, and that this bias is reduced when the observed evidence is inconsistent with the auditor's initial impression. We interpret our results as consistent with the dual-processing theory of cognition.     

Hierarchical Differences in Audit Workpaper Review Performance*

This paper investigates the performance of senior and staff auditors in the identification of conceptual and mechanical errors during workpaper review. In this study, we begin to examine the potential for effectiveness and efficiency gains by involving staff (assistant) auditors in the review process. We find that senior auditors were more accurate than staff auditors in identifying conceptual errors contained in a hypothetical set of workpapers just reviewed. However, staff auditors were more accurate than senior auditors in identifying mechanical errors. Highlighting the benefits of a hierarchical review, composite groups consisting of a staff auditor and a senior outperformed composite groups consisting of two seniors or two staff auditors. The study finds that the differences in review performance between managers and seniors found in Ramsay 1994 generalize to lower levels of experience. Considering our results in conjunction with Ramsay 1994, we show a progression to a more conceptual review template as the rank of the reviewer moves from staff to senior to manager. The paper provides some guidance to audit firms that are presently introducing major changes to the way in which the review process is carried out, including the inclusion of reviews by staff auditors.     

Auditor Face‐Work at the Annual General Meeting

This paper examines how auditors prepare for the annual general meeting (AGM) and how they report their work to the shareholders there. Prior literature has suggested—but not explicitly studied—that the endpoint of an audit is a state of comfort between the auditor and the management and audit committee members, but also is potentially fragile. The fragility can arise from a failure to relay trust to the investor community, which may initiate or increase doubts about the financial report and/or the auditor's independence. We build the case that an AGM is an event to study how the endpoint of an audit engagement is both a state of collective comfort and a fragile state. The analysis is based on ten interviews and three workshops with auditors as well as observations at 67 AGMs. To analyze the field material, the paper draws on Goffman's idea of face‐work, which requires backstage preparations, notably with management, and a front stage performance as an independent auditor to relay trust to the shareholders. The paper details how auditors at the AGM perform as independent verifiers of the management's financial report. Although we recorded that auditors were typically successful in preventing the backstage activities from becoming visible to the shareholders, we found incidents that challenged both the auditors' and the managements' face. In analyzing these incidents, we found that auditors reinforced their image as independent to regain both their own face and the management's face. The management did not take a similar collective responsibility for the auditor's face, which implies that auditors were asymmetrically committed to the management. As a take‐away, the paper discusses how governance mechanisms backstage are linked and can surface front stage at the AGM.     

Who Cares about Auditor Reputation?*

I provide evidence on the demand for auditor reputation by examining the defections of Arthur Andersen LLP's clients following the accounting scandals and criminal conviction marring the auditor's reputation in 2002. About 95 percent of clients in my sample did not switch auditors until after Andersen was indicted for criminal misconduct regarding its failed audit of Enron Corp. I test whether the timing of client defections and the choice of a new auditor are consistent with managers' incentives to mitigate potentially costly information and agency problems. I find that clients defected sooner, mostly to another Big 5 auditor, if they were more visible in the capital markets; such clients attracted more analysts and press coverage, had larger institutional ownership and share turnover, and raised more cash in recent security issues. However, my proxies for agency conflicts — managerial ownership and financial leverage — are not associated with the timing of defections or the choice of new auditor. Overall, my study suggests that firms more visible in the capital markets tend to be more concerned about engaging highly reputable auditors, consistent with such firms trying to build and preserve their own reputations for credible financial reporting.     

Effect of Concession‐Timing Strategies in Auditor–Client Negotiations: It Matters Who Is Using Them

In this study, we examine how norms about the use of negotiation strategies by different parties in an auditor–client negotiation influence the relative efficacies of these negotiation strategies. We conduct an experiment with experienced auditors/financial managers as participants, who enter into a negotiation on an income‐decreasing audit adjustment with a hypothetical client/auditor who uses a strategy where the same concessions are given either at the start, gradually, or the end of the negotiation. We find that the concession‐end strategy is more effective than the concession‐start strategy when used by auditors; however, the reverse is true when these same strategies are used by financial managers. The concession‐gradual strategy leads to superior outcomes when used by either auditors or clients. We also provide evidence that auditors’ and financial managers’ perceptions of the norms relating to the use of these strategies correspond to what we propose in our theory.     

Racial steering by real estate agents: Mechanisms and motives

Data from fair housing audits conducted in Cincinnati (1983–85) and Memphis (1985–87) are analyzed to discern whether and how racial steering occurs. The six real estate firms analyzed here engaged in some sort of steering during at least one-half of the audited transactions, on average. This steering did not limit the number of alternative areas shown to black auditors, nor their geographic concentration. Rarely were black auditors not shown dwellings in predominantly white areas, especially if they requested such. But of all the homes they saw, black auditors were shown significantly smaller fractions in predominantly white areas, and significantly larger fractions in mixed and predominantly black areas. These racial patterns persisted regardless of the geographic definition of area chosen: census block, census tract, school district, or community. In addition, blocks adjacent to the homes shown black auditors had higher percentages of black residents, on average, than those shown to white auditors. White auditors rarely were shown houses in racially mixed areas unless they requested them. Even then, after the requested home was shown the bulk of subsequent showings were located in predominantly white areas. This pattern of showings was buttressed by numerous favorable comments by agents about such predominantly white areas and school districts . . . comments that were rarely given to black auditors. The evidence was fully consistent with only one hypothesis about why real estate agents steer. They steer so as to perpetuate two segregated housing markets buffered by a zone of racially transitional neighborhoods, thereby maximizing housing turnover and agents’ commissions.     

Do Mutual Fund Investors Care About Auditor Quality?

We study the influence of perceived auditor quality on investment decisions by bond mutual fund investors. Audits of bond mutual funds require significant auditor expertise. Fund managers estimate daily the fair market values of holdings that are often opaque and illiquid. Managers can use their discretion to manipulate their fund's performance results. While it is known that investment flows into funds that report good past performance, little evidence exists about whether investors' confidence in the reliability of fund financial reports is influenced by auditor quality. Using hand‐collected data from SEC filings, we find that the positive association between reported performance and investment flows is stronger for funds with auditors who are industry specialists and are longer‐tenured, as well as for funds that pay higher audit fees. We do not find that auditor office size strengthens the association. We also find that the presence of industry‐specialist auditors, long‐tenured auditors, and higher audit fees lead to additional disclosure in the form of emphasis‐of‐matter. This study contributes to the streams of research investigating perceived audit quality, fund investment decisions, and auditing for financial services.