Auditing Section Research Summaries Space

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  • The Auditing Section
    Auditor Risk Assessment; Insights from the Academic...
    research summary posted April 12, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.05 Assessing Risk of Material Misstatement, 06.08 SAS No. 99 Brainstorming – effectiveness 
    Title:
    Auditor Risk Assessment; Insights from the Academic Literature
    Practical Implications:

    This article provides a very informative summary of current research related to the risk assessment process that supports the audit.  By outlining both general audit risk insights as well as fraud risk insights, the authors provide a clear and informative summary that should be of use to any audit firm attempting to better understand the current theoretical and practical research related to this emerging area.  Finally, by utilizing the PCAOB questions, the discussion also provides insights directly relevant to the current regulatory process.

    Citation:

    Allen, R.D., D.R. Hermanson, T.M. Kozloski, and R.J. Ramsay. 2006.  Auditor Risk Assessment: Insights from the Academic Literature.  Accounting Horizons 20(2): 157-177.

    Keywords:
    Risk assessment; PCAOB risk assessment project; industry specialization, fraud risk assessment; audit risk model.
    Purpose of the Study:

    This paper summarizes insights from academic literature related to risk assessment in financial statement audits project.  Using the February 16, 2005 PCAOB Standing Advisory Group (SAG) briefing paper on risk assessments as the organizing framework, the authors provide a literature review of topics related to: business risk, inherent risk, control risk, fraud risk, linking risk assessment to subsequent testing, and the audit risk model. 

    Design/Method/ Approach:

    The authors organize the auditor risk assessment literature review around the PCAOB briefing paper’s ten questions.  While cknowledging that fraud risk is integral to the overall audit risk, the uthors separate audit risk and fraud risk in their responses to further acknowledge he special problems in identifying, assessing, and responding to fraud isk.  Therefore, for each question, the authors discuss general audit risk assessment issues first, followed by those ssues specific to fraud risk assessments.

    Findings:
    • While using a business process focus in assessing client risks appears to be an advantage in the audit, additional guidance for using this approach may be helpful to address the diverse approaches utilized by the firms.  Decision aids and analytical procedures may increase effectiveness.
    • Industry expertise and specialization are critical to effective risk assessment.
    • Considering fraud risks separately from misstatements due to error, brainstorming and strategic thinking about management’s efforts to commit and conceal fraud all enhance fraud risk assessment effectiveness.
    • Systems dynamics, a methodology for studying and managing complex feedback systems, may provide auditors a framework to assess potential risk.  Authors suggest further examination of this and models in other fields for use in the audit process would be beneficial.
    • Auditor fraud risk assessments may not be well calibrated to the presence of risk factors.  Evidence on the effectiveness of fraud risk decision aids is mixed.
    • Inherent risk assessments (a) often are not meaningfully applied to each assertion; (b) may be decreasing over time, possibly to promote audit efficiency; and, (c) sometimes are combined with control risk into one risk factor.
    • While auditors may respond to global factors (e.g., management integrity, corporate governance) during micro-level risk assessments, proper weighting of global factors is challenging in a fraud context.
    • Testing of and reliance on internal controls have increased markedly in recent years.
    • Limited research suggests subsequent audit testing is weakly positively related to assessed risks, thus supporting efforts to improve linkages.
    • While the audit risk model appears to be sound as a conceptual tool, there are some significant limitations as a mathematical equation. In particular, it does not consider the blurring of inherent risk and control risk, the risk of incorrect rejection, the quality of evidence, or inconsistencies that may exist with actual auditor judgments.

     

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Assessing Risk of Material Misstatement, SAS No. 99 Brainstorming – effectiveness
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  • Jennifer M Mueller-Phillips
    Auditors’ Reactions to Inconsistencies between Financial a...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.01 Substantive Analytical Review – Effectiveness 
    Title:
    Auditors’ Reactions to Inconsistencies between Financial and Nonfinancial Measures: The Interactive Effects of Fraud Risk Assessment and a Decision Prompt
    Practical Implications:

    The findings suggest that auditors need improvement in the use of NFMs when performing substantive analytical procedures. Also, the findings of this study suggest that a relatively simple and efficient prompt regarding the use of NFMs can improve auditor substantive testing in the important area of revenue recognition. The evidence suggests that auditors are more likely to respond appropriately to a prompt when fraud risk is assessed at high levels. This demonstrates that decision-makers should carefully assess the level of fraud risk that will result in the desired behavior from in-charge senior auditors.

    For more information on this study, please contact Joe Brazel (jfbrazel@ncsu.edu).

    Citation:

    Brazel, J. F., K. L. Jones, and D. F. Prawitt. 2014. Auditors' Reactions to Inconsistencies between Financial and Nonfinancial Measures: The Interactive Effects of Fraud Risk Assessment and a Decision Prompt. Behavioral Research in Accounting 26 (1): 131-156.

    Keywords:
    Analytical procedures, audit, fraud risk, nonfinancial measures
    Purpose of the Study:

    Professional standards, auditing texts, and prior research suggest that external auditors can use nonfinancial measures (NFMs) to verify their clients’ reported financial information. These sources also suggest that an inconsistency between a company’s financial performance and related NFMs represents a potential red flag for financial statement fraud. However, recent research indicates that auditors’ attention to NFMs is insufficient to detect inconsistencies between financial data and NFMs. This paper addresses this concern by investigating factors that affect auditors’ use of NFMs when auditing financial statement data. Specifically, the paper investigates whether auditors’ reliance on NFMs and development of revenue expectations are affected by the following factors:

    • The consistency/inconsistency of NFMs and related financial data
    • The use of a prompt to encourage auditors to use NFM to calculate a revenue expectation
    • The level of fraud risk assessed during planning

    The authors motivate their hypotheses using the Heuristic-Systematic Model from the psychology literature. This model suggests that the contextual features of a judgment affect how an individual processes information. The authors use this theory to suggest that auditors who are prompted to use NFMs might be more likely to use NFMs to set revenue expectations under high fraud risk compared to low fraud risk.

    Design/Method/ Approach:

    The research evidence used in this study was gathered in 2009. In this study, the authors use in-charge senior auditors from a Big 4 firm to complete two experimental tasks. In both experiments, the participants were given access to client information and were asked to develop an expectation for a client’s revenue balance.  The second experiment introduces an NFM prompt and manipulates fraud risk.

    Findings:
    • The authors find that a minority of auditors use NFMs as an information source for performing analytical procedures and report that auditors do not increase their reliance on NFMs when the NFMs point to a fraud red flag in revenue figures.
    • The authors find that the presence of high fraud risk alone does not affect the auditors’ NFM reliance or revenue expectations.
    • The authors find that auditors are more likely to rely on NFMs and question the client’s revenues balance when prompted about how NFMs can be used to develop a revenue expectation.
    • The influence of the prompt on auditor reliance on NFMs and account balance expectations is stronger when fraud risk is assessed as high.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Substantive Analytical Review – Effectiveness
  • Jennifer M Mueller-Phillips
    Broadening the Fraud Triangle: Instrumental Climate and...
    research summary posted November 15, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.02 Fraud Risk Models 
    Title:
    Broadening the Fraud Triangle: Instrumental Climate and Fraud
    Practical Implications:

    This paper incorporates important organizational theory into the fraud literature by reporting the presence of an instrumental climate when fraud is being perpetrated within an organization. Internal auditors and those charged with governance could adapt this climate measure as a red flag for potential fraud. 

    Citation:

    Murphy, P. R. and C. Free. 2016. Broadening the Fraud Triangle: Instrumental Climate and Fraud. Behavioral Research in Accounting 28 (1): 41-56.

    Keywords:
    organizational climate, instrumental climate, fraud, fraud triangle, rationalization
    Purpose of the Study:

    Many papers focus on investigating organizations in which management’s tone exemplifies high ethical standards, combined with a climate that support and encourages ethical behavior in an effort to examine if this organization is less vulnerable to fraud. However, this paper takes a different approach. It examines the “flip side” of organizations, those that are associated with fraud instead of those associated with preventing fraud. By doing this, the authors also hope to delve into the effectiveness of the fraud triangle. For years, the fraud triangle has been the dominant fraud framework but recently it has been called into question for its narrow interpretation and lack of comprehensiveness. Thus, the goal of this research is not only to identify an organizational climate that exists in the presence of fraud but also to broaden the interpretation of the fraud triangle by explicitly identifying fraud triangle elements related to such a climate. 

    Design/Method/ Approach:

    The authors created and administered a survey to three groups of individuals having fraud experience: (1) prisoners who are incarcerated for committing fraud within an organization, (2) individuals who audited or investigated fraud within an organization, and (3) individuals who witnessed fraud within their organization. 

    Findings:
    • The authors find that 39 percent of the respondents agreed or strongly agreed that an instrumental climate was present when fraud occurred within the organization.
    • The authors find that an instrumental climate is significantly associated with a malevolent work environment and social incentives and pressures.
    • The authors find that the use of externally oriented rationalizations are very common with instrumental climates, especially the claim of helping the company.
    • The authors find that an instrumental climate is not associated with conventional attitude variables (prior history of white-collar crime, character, ethical values of the perpetrator), internally oriented rationalizations (minimizing or ignoring the consequences of the fraud, or entitlement) or individual greed or need. 
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Fraud Risk Models
  • The Auditing Section
    CFO Intentions of Fraudulent Financial Reporting
    research summary posted April 13, 2012 by The Auditing Section, tagged 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.04 Management Integrity 
    Title:
    CFO Intentions of Fraudulent Financial Reporting
    Practical Implications:

    The results of this study call into question the legitimacy of compensation structure as a red flag for fraud risk and introduce company size as a new (and easily assessed) indicator of financial statement fraud. CFO attitude emerged as the most influential factor in the formation of intentions to misreport. This indicates that it is important that auditors attempt to assess client management’s attitude toward fraudulent financial reporting. Although directly assessing management’s attitude may not be possible, auditors can subjectively assess management attitude based on ongoing personal interactions with the client. More formal audit decision aids to assess management attitudes toward fraudulent financial reporting might also be valuable for successfully detecting fraud.

    Citation:

    Gillett, P.R. and N. Uddin. 2005. CFO Intentions of Fraudulent Financial Reporting. Auditing: A Journal of Practice and Theory 24 (1): 55-75.

    Keywords:
    Financial statement fraud, reasoned action model, company size, compensation
    Purpose of the Study:

    Many studies have examined whether the fraud risk factors or “red flags” listed in Statement on Auditing Standards (SAS) No. 99 are effective for predicting fraud. However, one limitation of this prior work is that it examines whether red flags were present after a fraud has already occurred. To address this limitation, this study identifies factors which influence the intentions of CFOs to report fraudulently and examines the predictive value of those factors. Thus, a CFO who expresses an intention to misreport will be more likely to actually do so. The following four factors are investigated to determine their respective influence on CFO intentions to fraudulently misreport: 

    •  Attitude: This refers to the CFO’s attitude toward fraudulent financial reporting. An attitude toward a behavior is formed based on the expected positive and negative consequences of the action. For example, if fraudulently overstating revenue will result in a management bonus, then the CFO’s attitude toward overstating revenue might be more positive.
    •  Subjective Norms: This refers to the CFO’s perception of the expectations of specific referents (e.g., coworkers, family, and friends) and the motivation to comply with those expectations. For example, a CFO who perceives that his/her coworkers, family and friends approve of fraudulent financial reporting will be more likely to misreport, especially if the CFO tends to comply with others’ expectations.
    •  Compensation Structure: When the compensation structure is highly contingent upon company performance, it is expected that managers are more likely to participate in fraudulent financial reporting. SAS No. 99 considers earnings-based compensation to be an incentive for fraud.
    •  Company Size: There is mixed evidence about the effect of company size on unethical or illegal activity. Therefore, the authors investigate whether company size influences CFO intentions of fraudulent financial reporting.
    Design/Method/ Approach:

    The authors collected their evidence by mailing surveys to the CFOs of domestic firms selected from the Compact Disclosure database as of July 1998. CFOs were provided with a fraud scenario, followed by questions measuring their intention to fraudulently misreport. The CFOs also answered questions measuring their attitude toward misreporting, subjective norms, their personal compensation structure, and the size of the firm for which they currently work. Once this data was collected, the authors used structural equation modeling (SEM) to determine the factors that influence CFO intentions of fraudulent financial reporting.

    Findings:
    • The authors find that a CFO’s attitude toward fraudulent financial reporting has the strongest influence on their intention to misreport. CFO attitudes toward fraudulent financial reporting appear to be driven primarily by the negative consequences expected if they misreport.
    • The authors find that larger firms are more likely to participate in fraudulent financial reporting.
    • Compensation structure and subjective norms did not influence CFO intentions to misreport in the manner expected by the authors. The finding that CFOs’ compensation structure does not influence intentions to misreport runs counter to SAS No. 99, which contends that earnings-based management compensation is a fraud red flag.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Management Integrity
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  • Jennifer M Mueller-Phillips
    Dividend Policy at Firms Accused of Accounting Fraud
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.06 Earnings Management 
    Title:
    Dividend Policy at Firms Accused of Accounting Fraud
    Practical Implications:

    The results of this study greatly contribute to the literature on the relation of earnings quality to dividends. Companies that report fraudulent financial statements have caused significant problems for financial markets and economies, and additional research in this are remains vital. The evidence found in this paper is consistent with the notion that dividend-paying firms are less likely to engage in fraud because they know they cannot maintain their same dividend policies if earnings are fraudulent. Fraud firms cannot keep pace with non-fraud firms in terms of dividend policy and fraud firms’ dividends are less related to earnings that are non-fraud firms.

    For more information on this study, please contact Judson Caskey.
     

    Citation:

    Caskey, J., and M. Hanlon. 2013. Dividend Policy at Firms Accused of Accounting Fraud. Contemporary Accounting Research 30 (2).

    Keywords:
    dividends; accounting fraud; earnings management; earnings manipulation
    Purpose of the Study:

    Recent studies and some policy experts have posited that dividends constrain financial misreporting. The premise behind this idea is that managers committing fraud cannot maintain the same dividend policy as managers of firms that achieve similar reported performance without manipulating earnings. Using this logic, managers at dividend paying firms would be less likely to commit fraud, and if management at a dividend-paying firm does commit fraud, the fraudulent reporting would alter dividend changes for that firm. This study attempts to investigate the relation between accounting fraud and firms’ dividend policies.

    Design/Method/ Approach:

    The authors examine the relationship between dividends and accounting fraud by comparing firms subject to an Accounting and Auditing Enforcement Release (AAER) from the SEC, to a matched sample of firms not accused of fraud and all firms in the same industries as the AAER firms. The primary sample was obtained from the 544 firms for which the SEC issued AAERs. The original sample was narrowed to 330 and tested with a conditional logit model. Descriptive statistics were also used to test the original hypotheses.

    Findings:
    • Dividend-paying status is negatively associated with fraud, which is consistent with dividends constraining fraud and indicating higher earnings quality.
    • Earnings-dividends relation is weaker for the fraud firms relative to the non-fraud firms during the fraud period.
    • Propensity score-matched tests indicate that the commission of fraud leads to the firm being 11 to 17 percent less likely to increase dividends. 
       
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Does Intent Modify Risk-Based Auditing?
    research summary posted July 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.02 Fraud Risk Models 
    Title:
    Does Intent Modify Risk-Based Auditing?
    Practical Implications:

    The findings suggest that such sensitization is not merely a main effect” that shifts the risk-to-resource mapping upward. Rather, human intent appears to exert an interactive effect that flattens the risk-to-resource mapping by changing the cognitive mindset of risk from a magnitude-based calculation. For audit practice, the interaction the authors detect relates to the PCAOB’s efforts to differentiate fraud risks from the more general logic that risks should be evaluated based on magnitudes and likelihoods. The study suggests that people are more comfortable conditioning audit resources on risk magnitudes for unintentional reporting risks than for the same risks arising from human intent.

    Citation:

    Kachelmeier, S. J., Majors, T., & Williamson, M. G. 2014. Does Intent Modify Risk-Based Auditing? Accounting Review 89 (6): 2181-2201.

    Keywords:
    experimental economics, fraud, intent, risk, risk-based auditing, scale insensitivity
    Purpose of the Study:

    Audit practitioners and regulators have embraced the concept of risk-based auditing, under which auditors expend more resources to address significant risks and fewer resources when risks are lower. In this study, the authors investigate why this reasoning might not apply equally to risks arising from intentional and unintentional sources. In particular, they apply the theory of valuation by feeling to develop the premise that people are more sensitive to the presence of risk than to the magnitude of risk when individuals sense that they could be cheated by others’ intentional actions. If so, risks stemming from willful intent could dampen the mapping from risk magnitudes to desired audit resources, ceteris paribus.

    The research premise speaks to the fundamental possibility that risks stemming from the willful intent of others can trigger a significant response independent of the magnitudes and consequences of such risks. That is, when facing a known intentional risk, valuation by feeling suggests that the desired level of audit resources is relatively invariant to the level of risk. The study seeks a deeper understanding of what risk-based auditing” means from a behavioral perspective. Specifically, if auditors react similarly to high and low levels of intent-based risks, then this propensity would suggest an incremental aversion to intent that goes beyond a strict cost-benefit interpretation of risk-based auditing.

    Design/Method/ Approach:

    The authors design a 2x4 factorial experiment with risk source as a between-participants factor (two levels) and risk magnitude as a within-participants factor (four levels). The authors recruit 83 undergraduate business student volunteers to participate in a one-shot experiment that they program using the ‘‘Z-tree’’ computer architecture for interactive experiments. The evidence was gathered prior to October 2011.

    Findings:

    The primary finding is that the mapping from the level of misreporting risk to the level of audit resources is steeper in the unintentional risk condition than in the intentional risk condition, meaning that auditor-participants are less inclined to back off as risks decline when those risks are from human reporters. Within the intentional risk condition, expenditures are similar to the unintentional risk condition when the level of risk is high, but do not decline as much when risks decline, resulting in a flatter mapping from risk levels to audit resources. At the lowest risk level, average investments in the intentional risk condition even exceed the total amount at risk.

    Within the controlled experiment setting, economically “irrational” behavior occurred, at least from a monetary perspective, insofar as participants expend different amounts to protect themselves from the same magnitudes and probabilities of monetary loss across the intentional and unintentional risk conditions. Accordingly, the findings suggest the possibility that heightened sensitivity to intent-based risks could be dysfunctional if fraud risks are truly low, leading auditors to do too much work. Real-world audit settings, however, cannot provide the strict control the experiment uses to hold the stated risk levels constant.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Fraud Risk Models
  • Jennifer M Mueller-Phillips
    Effects of Decomposition and Categorization on Fraud-Risk...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment 
    Title:
    Effects of Decomposition and Categorization on Fraud-Risk Assessments.
    Practical Implications:

    The results of the experiment show that auditors who decompose fraud assessments make overall and component fraud-risk assessments that are more appropriate in response to changes in opportunity and incentive cues than auditors who only categorize fraud-risk factors. This study also adds to the body of research that examined the linkage between judgment and decision; more specifically, in fraud judgment. The results of the experiment show that auditors who assess fraud with decomposition perceive a higher (or lower) need to revise audit plans and to increase (or decrease) the extent of testing than auditors who make categorical judgments prior to an overall assessment, in response to increase (or decrease) in fraud risk.

    Citation:

    Favere-Marchesi, M. 2013. Effects of Decomposition and Categorization on Fraud-Risk Assessments. Auditing: A Journal of Practice & Theory 32 (4): 201-219.

    Keywords:
    categorization, decomposition, fraud-risk assessments
    Purpose of the Study:

    Risk assessment is a fundamental part of the audit process. Public Company Accounting Oversight Board (PCAOB) standards highlight auditors’ responsibilities for considering the risk of fraud as a central part of this process. The current auditing standards categorize fraud factors along three dimensions: management’s attitude or character, opportunities, and incentives. Regulators, practitioners, and researchers have all expressed concerns that auditors rely heavily on their perception of management’s attitude when this perception suggests low fraud risk, not realizing the difficulty of accurately perceiving management’s attitude or not understanding the unreliable nature of such perceptions. The potential drawback is that when auditors perceive management’s attitude as indicative of low fraud risk, they may overlook incentive and/or opportunity risks indicative of high fraud risk in overall fraud-risk assessments.

    This study examines two issues related to the decomposition of fraud-risk assessments. First, it investigates whether there is a significant difference in the fraud-risk assessment of auditors who decompose the fraud judgment from that of auditors who merely categorize fraud-risk factors. Second, it examines whether the perceived need to modify the audit plan and the extent of testing in response to the fraud-risk assessment is significantly influenced by the decomposition of the fraud judgment.

    Design/Method/ Approach:

    A total of 60 managers from two of the Big 4 accounting firms in offices throughout Canada and the United States participated in this study. Managers were split evenly over the firms and, on average, had 8.4 years (standard deviation 2.2) of audit experience. The case, using modified WZ materials, was designed to simulate what audit managers review during the planning phase of an audit when assessing fraud risk. The evidence was gathered prior to June 2011.

    Findings:

    The results of this study indicate that auditors who decompose fraud-risk judgments have significantly different fraud-risk assessments than those of auditors who simply categorize fraud cues. When management’s attitude cues are indicative of a low fraud risk, decomposition auditors are significantly more sensitive to changes in incentive and opportunity cues than categorization auditors. Further, auditors who decompose fraud-risk assessments perceive a significantly higher need to revise audit plans and to increase the extent of audit testing.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Evaluating the Intentionality of Identified Misstatements:...
    research summary posted January 12, 2017 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment 
    Title:
    Evaluating the Intentionality of Identified Misstatements: How Perspective Can Help Auditors in Distinguishing Errors from Fraud
    Practical Implications:

    This study contributes by providing evidence regarding a type of reasoning process that appears to help auditors assess the risk that a misstatement identified during audit fieldwork was caused intentionally. In addition to considering fraud risks at the company level, auditors should also consider fraud risks that are specific to an operating location or individual manager. By considering a client manager’s perspective, auditors presumably gain insight into whether the manager perceived misstating to be personally beneficial and reasonably easy to perpetrate and conceal, assisting in the evaluation of the manager’s intentions. 

    Citation:

    Hamilton, E. L. 2016. Evaluating the Intentionality of Identified Misstatements: How Perspective Can Help Auditors in Distinguishing Errors from Fraud. Auditing: A Journal of Practice and Theory 35 (4): 57 – 78.

    Keywords:
    perspective taking, fraud risk, fraud detection, misstatement, and audit quality.
    Purpose of the Study:

    Although auditors are responsible for detecting misstatements arising from either error or fraud, the auditing standards require very different audit responses when a misstatement is believed to be the result of an intentional act. Specifically, auditors are instructed to perform additional audit procedures, reassess overall fraud risk and the integrity of management, and communicate potential concerns to the audit committee if they suspect intentional misstatement; thus, if the auditors fail to recognize and respond to information indicating a misstatement was caused intentionally, then audit quality may be impaired. The author uses this study to investigate whether auditors who consider the perspective of the manager responsible for a misstatement’s occurrence are more sensitive to circumstances indicating the misstatement was intentional. 

    Design/Method/ Approach:

     The author creates an experiment utilizing auditor participants at the manager level and above with a case describing an identified misstatement that resulted from the actions of a client manager and ask them to assess the likelihood that it was caused intentionally. 

    Findings:
    • The author finds that auditors who considered the client manager’s perspective, compared to those who did not, assessed the misstatement as significantly more likely to be intentional, but only when such increased skepticism was warranted.
    • The author finds that, while auditors who considered manager’s perspective assessed the misstatement’s intentionality higher in the high-fraud-risk condition than in the low-fraud-risk condition, auditors who did not consider the manager’s perspective assessed the misstatement’s intentionality the same regardless of whether the circumstances surrounding the misstatement were indicative of high or low fraud risk.
    • The author finds that auditors who consider management’s perspective respond to the identified misstatement more appropriately. 
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Financial Statement Fraud Detection: An Analysis of...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment 
    Title:
    Financial Statement Fraud Detection: An Analysis of Statistical and Machine Learning Algorithms
    Practical Implications:

    The results of this study are useful to practitioners as guidance when selecting and implementing the appropriate classification algorithms for constructing fraud detection models.  Improved fraud detection models will assist auditors in client selection, planning their audit, and performing analytical procedures.  Additionally, the SEC can use the results of this research to identify and target investigations of companies suspected of fraudulent reporting.

    For more information on this study, please contact John Perols
     

    Citation:

    Perols, J. 2011 Financial Statement Fraud Detection: An Analysis of Statistical and Machine Learning Algorithms. Auditing: A Journal of Practice and Theory 30 (2): 19-50.

    Keywords:
    Analytical auditing, financial statement fraud, fraud detection, fraud predictors, classification algorithms.
    Purpose of the Study:

    In an effort to increase the detection of fraudulent financial reporting recent research has tested the usefulness of various statistical and machine learning algorithms for predicting if fraud is present in a firm.  This study continues that research by evaluating the effectiveness of six commonly used machine learning and statistical models for detecting fraudulent financial reporting using different assumptions of the ratio of fraud firms to non-fraud firms in the sample data, and the costs associated with misclassifying a fraud firm or non-fraud firm.  Specifically, the author seeks to examine the following questions with this study:

    What classification algorithms are the most useful for predicting fraud under different assumptions about (a) the probability that a given firm is a fraud firm, and (b) the cost of misclassifying a firm as a fraud firm or a non-fraud firm?
    What probability of being a fraud firm and what cost of misclassifying a firm as a fraud firm or non-fraud firm should be used when training the classifier algorithms?
    What predictors of fraud are useful for the classification algorithms?  That is, what indicators do the algorithms use to predict if fraud is present in a given firm?
     

    Design/Method/ Approach:

    Six classification algorithms were selected from Weka, an open source data mining tool.  The six algorithms selected were: J48 (a decision tree learner), SMO (a support vector machine, or SVM), MultilayerPerception (an artificial neural network, or ANN), Logistics, stacking, and bagging.  The probability that a given firm year was fraudulent was manipulated at three levels 0.006 (which is based on past research that indicates that around 0.6 percent of all firm years are fraudulent), 0.003 to represent a low condition, and 0.012 to represent a high condition. Since the cost of misidentifying a fraud firm as a non-fraud firm (false negative) is much greater than the cost of misidentifying a non-fraud firm as a fraud firm (false positive), the author also manipulated cost of misclassification by using different levels of the ratio between the cost of a false positive and the cost of a false negative identification when training the classification algorithms.  The dataset used in the analysis consisted of 51 fraud firms and 15,934 non-fraud firm year observations.  Data were primarily collected from the period between the fourth quarter of 1998 through the end of 2005.  Finally, the author evaluates 42 financial statement fraud indicators that past research has shown to be present in different fraud situations.  The predictors included items such as the accounts receivable to sales ratio, whether a big 4 auditor was used, the firm’s Altman Z score, etc.

    Findings:
    • Overall, logistic regressions as well as SVM algorithms appear to perform best relative to the other algorithms examined in this study when examined under assumption conditions thought to exist in practice.
    • Using logistic regression, 9 of the 42 fraud indicator variables were found to be good predictors: auditor turnover, Big 4 auditor, total discretionary accruals, accounts receivable, meeting or exceeding analyst forecasts, allowance for doubtful accounts, inventory to sales, value of a company’s issued securities to market value, and unexpected employee productivity.
    • Across all of the algorithms, only 6 predictors were used in three or more of the algorithms: Big 4 auditor, auditor turnover, accounts receivable, total discretionary accruals, unexpected employee productivity, and meeting or exceeding analyst forecasts.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Financial Statement Fraud: Insights from the Academic...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment 
    Title:
    Financial Statement Fraud: Insights from the Academic Literature.
    Practical Implications:

    The research summarized above will provide valuable input to the accounting profession and standard-setters, and there are several areas in which additional research is needed. Despite existing auditing standards and authoritative guidance on an auditor’s responsibility for discovering and reporting financial statement fraud, there remains an expectation gap between what investors believe the auditor’s responsibility should be in detecting financial fraud and what auditors are willing to assume as responsibility in this area.

    Citation:

    Hogan, C. E., Z. Rezaee, J. A. Riley, and U. K. Velury. 2008. Financial Statement Fraud: Insights from the Academic Literature. Auditing: A Journal of Practice & Theory 27 (2): 231-252.

    Keywords:
    audit planning, audit procedures, financial statement fraud, fraud detection, fraud triangle, high-risk audit areas
    Purpose of the Study:

    Over the past several decades, a significant amount of academic research has been focused on fraud in general and financial statement fraud in particular. These studies address the trends, determinants, and consequences of financial fraud, as well as the responsibility for preventing, detecting, and remediating that fraud. To facilitate the development of auditing standards and to inform regulators of insights from the academic auditing literature, the Auditing Section of the American Accounting Association (AAA) has decided to develop a series of literature syntheses for the Public Company Accounting Oversight Board (PCAOB). The authors summarize relevant academic research findings and to offer insights and conclusions relevant to academics, standard setters, and practitioners. They discuss the characteristics of firms committing financial statement fraud, as identified in the literature, and research related to the fraud triangle. The authors then discuss research related to the procedures and abilities of auditors to detect fraud, and how fraud risk assessments impact audit planning and testing. In addition, they discuss several “high risk” areas and other issues as identified by the PCAOB. 

    Design/Method/ Approach:

    Statement on Auditing Standards (SAS) No. 99, Consideration of Fraud in a Financial Statement Audit, states that three conditions are generally present when fraud occurs. These conditions collectively are known as the fraud triangle. The authors reviewed the academic findings related to the presence of these conditions in cases of financial statement fraud. This helps provide a basis for understanding the development of the questionnaires and checklists in SAS No. 82 and SAS No. 99.

    Findings:

    The primary conclusions from the review of the literature on fraudulent financial reporting are as follows.

    • There is a significant amount of literature on the characteristics of fraud firms, providing support for the fraud triangle classifications and the list of “red flags” used in both SAS No. 82 and SAS No. 99.
    • Evidence on the usefulness of checklists as a fraud detection tool is mixed. While there is some research that supports the use of checklists as a decision tool, there is more evidence that suggests the use of checklists is dysfunctional in that auditors fail to expand their thinking beyond the checklist.
    • Research supports a need by auditors to align management incentives to the types of risks that should be evaluated as high.
    • There is evidence that suggests auditors do not make significant adjustments to audit plans as a result of higher fraud risk assessments.
    • Research supports further exploration into the use of additional fraud detection tools such as regression analysis, the use of nonfinancial information, digital analysis, and neural network models.
    • Research supports the identification of revenue recognition, significant or unusual accruals, and related parties as areas with increased risk of fraudulent financial reporting activity.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment

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