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Abstract:
This study examines whether auditors can effectively use nonfinancial measures to assess the reasonableness of financial performance and, thereby, help detect financial statement fraud (hereafter, fraud). If auditors or other interested parties (e.g., directors, lenders, investors, or regulators) can identify nonfinancial measures (e.g., facilities growth) that are correlated with financial measures (e.g., revenue growth), inconsistent patterns between the nonfinancial and financial measures can be used to detect firms with high fraud risk. We find that the difference between financial and nonfinancial performance is significantly greater for firms that committed fraud than for their non-fraud competitors. We also find that this difference is a significant fraud indicator when included in a model containing variables that have previously been linked to the likelihood of fraud. Overall, our results provide empirical evidence suggesting that nonfinancial measures can be effectively used to assess the likelihood of fraud.

analytical procedures, fraud, nonfinancial measures

Abstract:
This study examines whether auditors can effectively use nonfinancial measures to assess the reasonableness of financial performance and, thereby, help detect financial statement fraud (hereafter, fraud). If auditors or other interested parties (e.g., directors, lenders, investors, or regulators) can identify nonfinancial measures (e.g., facilities growth) that are correlated with financial measures (e.g., revenue growth), inconsistent patterns between the nonfinancial and financial measures can be used to detect firms with high fraud risk. We find that the difference between financial and nonfinancial performance is significantly greater for firms that committed fraud than for their non-fraud competitors. We also find that this difference is a significant fraud indicator when included in a model containing variables that have previously been linked to the likelihood of fraud. Overall, our results provide empirical evidence suggesting that nonfinancial measures can be effectively used to assess the likelihood of fraud.

analytical procedures, earnings management, fraud, nonfinancial measures

Abstract:
Practitioners and regulators are concerned that when auditors perceive management's attitude or character as indicative of low fraud risk, they are not sufficiently sensitive to high levels of incentive or opportunity risks in their overall fraud risk assessments. In this study, we examine whether a fraud-triangle decomposition of fraud risk assessments (i.e., separately assessing attitude, opportunity, and incentive risks prior to assessing overall fraud risk) increases auditors' sensitivity to opportunity and incentive cues when perceptions of management's attitude suggest low fraud risk. In an experiment with 52 practicing audit managers, we find that auditors who decompose fraud risk assessments are more sensitive to opportunity and incentive cues when making their overall assessments than auditors who simply make an overall fraud risk assessment. However, this increased sensitivity to opportunity and incentive cues appears to happen only when those cues suggest low fraud risk. When opportunity and incentive cues suggest high fraud risk, auditors are equally sensitive to those cues whether they use a decomposition or a holistic approach. We discuss and examine potential explanations for this finding.

Attribution, decomposition, fraud, risk assessment

Abstract:
Practitioners and regulators are concerned that when auditors perceive management's attitude or character as indicative of low fraud risk, they are not sufficiently sensitive to high levels of incentive or opportunity risks in their overall fraud risk assessments. In this study, we examine whether a fraud-triangle decomposition of fraud risk assessments (i.e., separately assessing attitude, opportunity, and incentive risks prior to assessing overall fraud risk) increases auditors' sensitivity to opportunity and incentive cues when perceptions of management's attitude suggest low fraud risk. In an experiment with 52 practicing audit managers, we find that auditors who decompose fraud risk assessments are more sensitive to opportunity and incentive cues when making their overall assessments than auditors who simply make an overall fraud risk assessment. However, this increased sensitivity to opportunity and incentive cues appears to happen only when those cues suggest low fraud risk. When opportunity and incentive cues suggest high fraud risk, auditors are equally sensitive to those cues whether they use a decomposition or a holistic approach. We discuss and examine potential explanations for this finding.

Attribution, decomposition, fraud, risk assessment

Abstract:
The Public Company Accounting Oversight Board recently reported that its inspections show that auditors fail to effectively modify their standard audit procedures in response to fraud risk. Prior academic research is consistent with this finding. Our study examines the effects of two interventions on auditors' planning decisions in a high-fraud-risk setting: strategic reasoning and brainstorming in groups. Both interventions were predicted to lead auditors to more effectively modifiy their planned audit procedures. we use a panel of fraud experts to identify effective modifications to the audit plan of a specific fraud case. The experts' recommendations were then used to evaluate the effectiveness of practicing auditors' audit plans with and without the two interventions. We predict and find that each intervention leads to more effective modifications to the standard audit procedures and that the combination of the interventions is not significantly more effective than either intervention alone.

audit planning, fraud risk, nature of audit procedures, strategic reasoning, brainstorming

Abstract:
This commentary examines academic research for insights regarding the detection and prevention of fraudulent financial reporting. We review theoretical and empirical research from game theory, social psychology, judgment and decision making, and auditing to identify improvements in audit practice and promising areas for future research. This review focuses on the strategic fraud setting and suggests modifications in auditing standards that should facilitate auditors' use of strategic reasoning in this setting. We emphasize three critical audit tasks - fraud risk assessment, audit planning, and audit plan implementation - and recommend changes to current auditing standards and identify potential research questions for each task.

Audit judgment, audit planning, fraud, game theory, risk assessment, strategic reasoning

Abstract:
This study experimentally investigates the interaction between auditors and auditees in a strategic setting. Auditee subjects asserted an asset value, given knowledge of the true value. Auditor subjects selected a costly sample of the assets and decided whether to accept or reject an auditee's asserted value. The experiment included between-subjects manipulations of auditee pay for undetected overstatements and ambiguity facing auditors. We investigate whether auditees anticipate the effect of auditors' ambiguity aversion on their decisions to sample and reject the reported balance. Results indicate that sampling increased with increases in either auditors' ambiguity or auditees' incentive to misstate. Also, controlling for sample size, auditors tended to reject the asserted value given a stronger incentive to misstate, but were unaffected by ambiguity. Auditees' misstatement rate was higher given a stronger incentive to misstate, and lower given more ambiguity facing auditors. Further, we document a strategic effect of ambiguity as the effect of auditors' ambiguity in reducing auditees' tendency to misstate was larger given a weaker incentive to misstate.

Abstract:
A computerized test instrument was used to investigate the effects of requiring experienced auditors to separately assess fraud risk on their attention to fraud risk factors and audit planning decisions. Computer software randomly manipulated, between subjects, the type of risk assessment required and indicators of fraud risk in an audit case. A model is developed linking risk assessment policy to knowledge use, attention to risk factors, risk assessments, and audit planning decisions. 108 auditors were monitored by the software as they read about a hypothetical audit client and provided risk assessments, budgeted hours, and audit procedure selections. Results indicate that auditors who separately assessed fraud risk, as required by SAS No. 82, spent more time attending to red-flag cues and significantly increased their budgeted hours at both risk levels. Mixed results are reported for the prediction that auditors' budgeted hours exhibit increased sensitivity to fraud risk when they separately assess fraud risk. Finally, variability in planned audit tests was not systematically related to fraud risk for either group of auditors. In sum, these results suggest that SAS No. 82 can be expected to direct auditors' attention to fraud cues and lead to changes in budgeted hours but the nature of audit plans will not likely be affected.