42 Pages Posted: 11 Jan 2010 Last revised: 23 Oct 2012
Date Written: August 8, 2012
Nonfinancial measures (NFMs), such as employee headcount and production space, are operational measures that are not included on the face of the financial statements but are often disclosed elsewhere in the annual report or 10-K (e.g., in Management’s Discussion and Analysis). Professional standards, auditing texts, and prior research suggest that external auditors can use NFMs to verify their clients’ reported financial information and, in turn, improve audit quality. In an initial experiment where auditors were asked to develop an expectation for a client’s sales balance, they generally failed to identify a seeded inconsistency between the client’s sales and related NFMs. In a second experiment, we find that auditors are more likely to react to the inconsistency (i.e., rely more on inconsistent NFMs / develop expectations that reflect the client’s current year decline in NFMs) when they are specifically prompted to consider the implications of NFMs and fraud risk is high (vs. low). Our results suggest that (1) a minority of auditors use NFMs as a source of information for testing and do not increase their reliance on NFMs when the NFMs point to a fraud red flag; (2) the presence of high fraud risk alone is insufficient to increase auditor consideration of inconsistent NFMs; (3) auditors are able to react appropriately to an inconsistency if they are effectively prompted; and (4) even a prompt that explicitly highlights an inconsistency is unlikely to improve auditor performance unless the prompt is processed in a high fraud risk setting.
Keywords: analytical procedures, auditor, fraud, non-financial measures
JEL Classification: M40, M41
Suggested Citation: Suggested Citation
Brazel, Joseph F. and Jones, Keith L. and Prawitt, Douglas F., Auditors' Reactions to Inconsistencies between Financial and Nonfinancial Measures (August 8, 2012). Available at SSRN: https://ssrn.com/abstract=1534778 or http://dx.doi.org/10.2139/ssrn.1534778