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    Risk-Based Auditing, Strategic Prompts, and Auditor...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.06 Earnings Management, 08.0 Auditing Procedures – Nature, Timing and Extent 
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    Title:
    Risk-Based Auditing, Strategic Prompts, and Auditor Sensitivity to the Strategic Risk of Fraud
    Practical Implications:

    This study has implications for accounting firms as well as audit standard setters.  The results suggest that prompting auditors to consider how management might anticipate and exploit the auditor’s risk assessments and resource allocations may help decrease the number of undetected misstatements.  That is, prompting auditors to consider management’s strategic attempts to conceal fraud may direct the auditor’s attention to ostensibly low-risk accounts where fraud may have been intentionally concealed.  This research also suggests that improved audit effectiveness in terms of the increased detection of fraudulent reporting can be obtained without a corresponding loss in audit efficiency.

    For more information on this study, please contact Kendall Bowlin.
     

    Citation:

    Bowlin, K. 2011. Risk-Based Auditing, Strategic Prompts, and Auditor Sensitivity to the Strategic Risk of Fraud. The Accounting Review 86 (4): 1231-1253.

    Keywords:
    audit resource allocation; strategic reasoning; fraud risk; risk-based auditing; experimental economics.
    Purpose of the Study:

    Risk based auditing instructs the auditor to focus audit attention and resources on accounts that are deemed to be high-risk for a given audit engagement.  However, because fraud is strategic in nature and not random, management may intentionally target low-risk accounts for concealing fraudulent activity.  If auditors fail to consider the potential that management may intentionally target low-risk accounts for perpetrating fraud, the auditor may fail to detect the fraud due to a lack of audit procedures for the low-risk audit areas.
    This study uses an experiment to determine if:

    • Management is likely to act strategically by targeting low-risk accounts to conceal misstatements.
    • Auditors fail to detect misstatements in low-risk accounts because audit resources have been allocated to high-risk accounts.
    • If prompting auditors to consider management’s strategic concealment of fraud results in fewer undetected misstatements and changes in audit resource allocation.
       
    Design/Method/ Approach:

    132 accounting students enrolled in upper-division classes participated in a computer based simulation analogous to an audit engagement whereby students were paired such that one participant represented a manager and the other an auditor.  In the game, two buckets representing general ledger accounts were filled with 100 marbles (200 total) by a machine.  Participants were told that one of the buckets was susceptible to an odd-colored marble (representing a misstatement) being included by the machine during the filling process by chance.  The bucket with the chance misstatement occurrence represents a high-risk account existing during the audit process.  Additionally, the manager could override the machine filling either bucket to strategically and intentionally include an odd-colored marble in either of the buckets, representing fraud. 

    The auditor participant was provided a finite number of marbles they could pull from both buckets combined in search of the odd-colored (misstatement) marble.  This guessing distribution is analogous to the allocation of audit resources in an actual audit engagement.  One group of auditors had 101 guesses while another group of auditors could use up to 181 guesses.  After the manager had made their override decision and the auditor had made their resource allocation decisions, the computer informed the participants if a misstatement had been detected by the auditor. 

    In the game, the manager was rewarded for successfully having an undetected misstatement and auditors were penalized for failing to identify misstatements.  Additionally, auditors were incentivized to use few available resources when searching for misstatements.  Finally, some auditors were prompted to consider management’s strategic nature by reporting what they believed the manager assumed about the auditor’s resource allocation, and what the manager would likely do to in response to the anticipated allocation of audit resources.  The remaining auditors received no such prompt.
     

    Findings:
    • In the audit simulation game, managers anticipate that the auditor will allocate more resources to the high-risk account and override existing processes to intentionally include the misstatement in the low-risk account.
    • Auditors who were not prompted to consider how management might strategically anticipate the auditor’s resource allocation process used significantly fewer resources in searching for misstatements in the low risk account resulting in undetected misstatements.
    • Auditors who were prompted to state what they believed the manager assumed about the auditor’s resource allocation and what the manager would likely do to in response to the anticipated allocation of audit resources allocated more of their available, unused resources to the low-risk account but did not allocate more unused resources to the high-risk account.  This suggests that the prompt did not merely increase resource consumption in all audit areas, but only in the low-risk account.  This result held in both the low available resource group as well as the high available resource group.  The increased allocation of unused resources to the low-risk account resulted in fewer undetected misstatements.
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Fraud Risk Assessment