NRI RESEARCH PAPER SERIES

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1 NRI RESEARCH PAPER SERIES ACADEMIC THEORY THE DIFFERENCES BETWEEN AUDITORS AND FORENSIC ACCOUNTANTS WITH RESPECT TO THEIR ABILITY TO IDENTIFY EFFECTIVE ADDITIONAL PROCEDURES TO MITIGATE IDENTIFIED FRAUD RISKS I.G.F. Verwey November 2009 ~ no

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3 NRI RESEARCH PAPER SERIES The differences between auditors and forensic accountants with respect to their ability to identify effective additional procedures to mitigate identified fraud risks Drs. I.G.F. Verwey RA November 2009 NRI Research Paper no ISSN NRI The Nyenrode Research & Innovation Institute (NRI) is a research association consisting of researchers from Nyenrode Business Universiteit and Hogeschool INHOLLAND, within the domain of Management and Business Studies. Straatweg 25, 3621 BG Breukelen P.O. Box 130, 3620 AC Breukelen The Netherlands Tel: +31 (0) Fax: +31 (0) [email protected] NRI research papers can be downloaded at

4 Abstract Any decision an auditor takes concerning fraud is perceived as extremely sensitive. Several enormous financial scandals at the beginning of the 21 st century created doubt about the role of the auditors for these companies being questioned. Auditors were being blamed for having made mistakes with respect to fraud risks. It seems that in general auditors experience degrees of difficulties with respect to fraud risk assessment. The aim of this article is to introduce my research. It is a literature study outlining my research approach to the aforementioned problem of fraud risk assessment and the role auditors have in this. Because it is a preliminary study this article does not contain any empirical data. Over the course of the last few years there have been a substantial number of articles appearing in leading international accounting journals investigating the causes as to why auditors have difficulties with respect to fraud risk assessment. Former research indicates that forensic accountants might be better equipped than auditors to identify effective procedures to mitigate fraud risks. With my research I want to investigate why this is the case. Therefore I am identifying factors which influence the quality of the fraud risk assessment. By means of a combination of an experiment and a survey I want to investigate the (causal) relationships between these factors and an effective fraud risk assessment. Keywords Audit planning, Forensic auditing, Fraud risk assessments, Fraud risk factors Address for correspondence Drs. I.G.F. Verwey RA Nyenrode Business Universiteit Straatweg 25, 3621 BG, Breukelen P.O. Box 130, 3620 AC Breukelen Phone [email protected] 2 of 31

5 1. Introduction ISA 240 and SAS 99 dictate that auditors have a responsibility to act accordingly with respect to fraud. They are required to identify material fraud when performing an audit. International Standard on Auditing (ISA) 240 deals with the auditor s responsibility to consider fraud as part of the standard procedure in an audit, and to design and perform procedures to detect material misstatement due to fraud, in an audit of financial statements. The auditor is responsible for: ( ) obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error. According to ISA 240 during the audit, the auditor has to: (a) Consider fraud when identifying and assessing the risks of material misstatement of the Financial statements, by maintaining an attitude of professional skepticism and recognizing the possibility that a material misstatement due to fraud could exist; (b) Respond to the assessed risks of material misstatement of the financial statements due to fraud, including the risks of management override of controls, by designing and performing procedures to detect material misstatement due to fraud; and (c) Respond appropriately to identified or suspected fraud. During the audit, the auditor has to identify fraud risk factors. These factors are events or conditions that indicate an incentive or pressure to commit fraud or provide an opportunity to commit fraud. After identifying the fraud risks the auditor has to assess these risks by designing effective procedures to mitigate those fraud risks. This is called fraud risk assessment (hereafter: FRASK). Any decision an auditor takes concerning fraud is perceived as extremely sensitive. (Kennedy et al. 1997, Hackenbrack 1990). Any decision an auditor takes concerning fraud is perceived as extremely sensitive. Several enormous financial scandals at the beginning of the 21st century created doubt about the role of the auditors for these companies being questioned. Auditors were being blamed 3 of 31

6 for having made mistakes with respect to fraud risks. It seems that in general auditors experience degrees of difficulties with respect to fraud risk assessment. Research found that auditors are amply capable in adjusting an audit plan with effective procedures to mitigate fraud risks whereas forensic accountants are considered to be better equipped to define those effective procedures (Boritz et al., 2008). This article is about my research approach to study the aforementioned issues governing auditors and their ability to detect and mitigate risk. I will describe the research theory leading to my research model and research hypotheses as well as the research methods I will use to conduct the research. As this article is a preliminary study, it does not contain any empirical data. 4 of 31

7 2. Auditors and fraud risk assessment: research theory As judgment and decision making is inherent to nearly every phase of the audit process (Solomon and Shields 1995) - and is directly related to audit quality - I will first examine research that investigates decision and judgment making with respect to the audit of financial statements. Because of increased public scrutiny regarding audit quality, Nelson and Tan (2006) amplify the urgency surrounding investigations along this line of research. During the Eighties the first accounting research studies were published concerning an auditors judgment process (Gibbins 1984, Ashton 1985). Psychological research validated that during judgment and decision-making processes, like any other human being expert or not - an auditor is prone to biases, neglecting, self-serving judgment and ambiguity (Koch and Wustemann 2008, King 2002). Bazerman et al. (1997) state that the main problem with respect to audit failure is that auditors are vulnerable to unconscious biases, especially self-serving biases: ( ) We maintain that the oversights of an auditor are the natural results of the auditor-client relationship. ( ) it is psychologically impossible for auditors to maintain their objectivity: cases of audit oversight are in evitable, even with the most honest auditors. According to Bazerman et al. (1997) to be able to solve this problem it is necessary to eliminate those biases by implementing new policies to reduce auditor s interest in whether a client is satisfied with the results of an audit. Audit firms attempt to control audit failure and mitigate these negative aspects as much as possible by implementing decision aids and quality control procedures (Libby and Trotman 1993, Bedard and Graham 2002, Seow 2002). Therefore, consulting a forensic accountant is considered as a decision aid. Over the course of the last few years there have been a substantial number of articles appearing in leading international accounting journals investigating the causes as to why auditors have difficulties in identifying fraud indicators. Many of these researchers noted that a plausible solution was to apply checklists using fraud indicators that identified potential `red flags, similar to the research of Mock and Turner (2005) and Skousen and C.J. Wright (2006). Since the inception of checklist fraud indicators, legislation governing auditing and fraud has been adapted. An example of this is the International Statement of Auditing (hereafter: ISA) 240 and Statement on Auditing Standards (hereafter: SAS) 99, where possible fraud indicators were assigned. This said, other studies have noted that this approach would not be effective at all. Pinkus (1989) and Johnson et al. (1989) argue that 5 of 31

8 by relying on a list with fraud indicators (by means of e.g. a checklist) potentially limits the capacity of the accountant to recognize fraud indicators (c.f. Beasly et al. (2001)). Rose and Rose (2003) stated that although every fraud is different, and as a prescribed set of red flags cannot accurately identify all fraud risks, a separate fraud risk assessment heightens the auditor s awareness of fraud risk. As a consequence auditor behavior could be changed during the audit. Several researchers took the decision to approach the problem from another angle. In 2006, the results of a research of Grazioli et al. (2006) were published. This data determined that, just like the detection and identification of generally misleading behavior, accountants must learn to navigate their way through the perils of everyday accounting occurrences. It could therefore be assumed that lack of experience in the field of fraud inadvertently impacts the findings which in and of itself is duplicitous because most auditors have no experience at all with fraud cases. Consequently it would seem logical to look at the specific experience a forensic accountant has in her / his role as a fraud investigator. Wells (2004) investigated the role of forensic accountants during the audit process. His conclusion was that large audit firms have forensic accountants on staff but they are used reactively rather than proactively. That is, whenever fraud occurs, the support of the forensic accountant is requested. Similar research conducted by Asare and Wright (2004) concluded in their research that fraud risk assessment (hereafter: FRASK) is not associated with the planning of more effective fraud procedures but was directly associated with the desire of the auditor to consult with fraud specialists. Asare and Wright investigated the effect of standard checklists and standard audit programs on fraud detection programs. The aim of the research was to examine the impact on two facets of fraud planning effectiveness : the quality of audit procedures relative to a benchmark developed and validated by a panel of experts and the propensity to consult with fraud experts. The conclusions of their research were that the use of standard audit programs resulted in a less effective fraud program, that the use of standard risk checklists resulted in lower risk assessments and that a higher FRASK was associated with a greater tendency to seek consultation with fraud experts. 6 of 31

9 Two years later DeZoort and Stanley (2006) conducted a study examining the competencies of fraud experts in audit program design. They concluded that in general, fraud experts have limited competencies in audit program design. Therefore Boritz et al. (2008) assumed that fraud specialists may have the ability to investigate a fraud but not necessarily the ability to plan an audit that would detect fraud. This fraud could potentially result in fraud specialists furnishing auditors with unrealistic expectations about the help that those specialists can provide. To validate this assumption they conducted a research among forensic accountants. They concluded that fraud specialists adjusted the audit plan to respond to the fraud risks, but only when they performed the risk assessment themselves. Fraud specialists identified much fewer audit procedures needed to address the fraud risks, however recognized additional procedures that could be effective in establishing fraud risks. The conclusion of Boritz research is that forensic accountants might be better equipped to identify additional procedures that would be effective to address fraud risks, when they perform the risk assessment of an audit themselves. Therefore, Boritz research findings indicate that the risk assessment of an organization with a higher than low fraud risks to include the adjustment of the audit plan is best conducted by a forensic accountant verses an auditor. In theory, forensic accountants should therefore be participatory throughout the entire process instead of called in on a strictly consultative role. However, in practice, the auditor will perform the risk assessment and not a forensic accountant for the simple reason that there are not enough forensic accountants to perform the risk assessment for all audits! Moreover, when additional procedures to address the fraud risks are identified with the help of a forensic accountant, it is not always the case that the auditor is actually able to detect fraud when it occurs. The reason behind the difference in assessing fraud risks between forensic accountants and auditors might also be critical when an audit is being undertaken and fraud needs to be detected. Reducing fraud risk is no guaranty that fraud will not occur. For the most part forensic accountants will react differently to fraud risks. The aforementioned research will be the starting point for this study. I want to investigate why forensic accountants are able to identify additional effective procedures to mitigate fraud risks and why auditors are not able to do so. 7 of 31

10 In general a lot of behavioral accounting research has been conducted examining factors which might influence auditors performance. Research has increasingly focused attention on the attributes of the accounting settings that distinguish them from those settings normally examined by psychologists (Gibbins and Jamal 1993, Libby 1989). Within the Nelson and Tan (2006) study about judgment and decision making research, Nelson and Tan distinguish four topics to analyze research contrasting auditor attributes which have effect on their professional judgment: (1) auditor knowledge and expertise, (2) other individual characteristics, (3) cognitive limitations and (4) decision aids designed to supplement or make good deficiency in an auditor attribute, and thereby improve auditor performance. Libby and Luft (1993) further validated this important research. Their starting premise is that decision performance is a function of ability, knowledge, environment and motivation. This perception is based on the broadened conception of (standard) accounting settings. With respect to the specific accounting setting fraud risk assessment, as far as I am aware a study investigating which factors have the capacity to influence auditors judgment, specifically fraud risk assessment, has never been conducted. Consequently I will be deferring to Libby and Lufts theory to fraud risk assessment within this study. 8 of 31

11 3. Factors influencing fraud risk assessment I will be identifying factors which, according to former research, influence auditors judgment and performance in accounting settings in general. Because a fraud risk assessment is an accounting setting, I am assuming that the factors I will be identifying also have the potential to influence auditors performance in cases that specifically deal with fraud risk assessment. However, my starting point will be professional skepticism, as a major factor that influences the quality of FRASK. Professional skepticism is essential for the evaluation of (invalid) information and (invalid) evidence (Schul et al. 1996, Zimbelman 1997) and therefore of great importance with respect to FRASK. Bell et al. (2005) further stated that if there would have been more skepticism on the part of the auditor this could have reduced the effects of major recent business improprieties. The Enron scandal is an example of an audit failure due to a lack of professional skepticism (Benston and Hartgraves 2002). Beasly et al (2001) found the lack of professionalism to be number 3 (60%) of the cases among the top 10 list of audit deficiencies associated with fraud related SEC cases. The number 1 audit deficiency (80% of the cases) was gathering insufficient audit evidence, which can also be considered an element of professional skepticism. In relation to the aforementioned theory of Libby and Luft (1993) professional skepticism can be considered as a motivational factor being of great importance in regard to auditors decision performance as it relates to FRASK. 3.1 Professional skepticism An important component influencing the disposition of the auditor is the professional attitude, also known as professional commitment and professional skepticism (Kee and Knox 1970, Ajzen and Fishbein 2000, Kalbers and Fogarty 1995). Skepticism is a very important part of the audit process. Professional skepticism during the audit process will improve the effectiveness of the audits with respect to the identification of fraud risk and the design of effective mitigating audit procedures (Shaub and Lawrence (1996), Cushing 2000). 9 of 31

12 The audit function rests largely on judgments of trained experts (Abdomohammadi and Wright 1987). According to SAS 1, auditors are required to exercise professional skepticism by using the knowledge, skill and ability called by the profession of public accounting ( ) (AU Section ). As an alleged consequence of the US standards, IFAC introduced the concept of professional skepticism into ISA 240: In accordance with ISA 200, the auditor shall maintain an attitude of professional skepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, notwithstanding the auditor s past experience of the honesty and integrity of the entity s management and those charged with governance. Professional commitment can be described as: the intensity of an individual s identification with and level of involvement in a profession (Mowday et al. 1982). Professional commitment is developed throughout the education and the first years of the auditor s career. During this initial t stage, the behavior of an auditor toward professional values is strongly formed (Aranya et al. 1982). Professional skepticism is part of this adoption of professional values. Based on literature review, for this study I will use the definition of professional skepticism as described by Nelson (2009): Professional skepticism is expressed by auditor judgments and decisions that reflect a heightened assessment of the risk that an assertion is incorrect, conditional on the information available to the auditor. Various characteristics of skepticism enable the identification of professional skepticism. Quadackers et al. (2009) examined skeptical characteristics which are of particular importance to auditors. The next three skeptical characteristics will be examined in this study: a. Interpersonal trust In academic literature professional skepticism is considered to be the opposite of trust (Cushing 2000, Choo and Tan 2000, Payne and Samsay 2005, Shaub 1996, Shaub and Lawrence 1999, Hurtt et al. 2003). Rotter (1967, 1980) defined interpersonal trust as a generalized expectancy held by an individual or group that the word, promise, verbal or written statement of another individual or group can be relied upon. The lower the level of interpersonal trust is, the more skeptical an auditor is assumed to be. 10 of 31

13 Shaub and Lawrence (1996) developed a model of auditors professional skepticism by adapting Knee and Knox (1970) model of trust and suspicion to apply to auditors. Cognitive and social psychology takes the position that subjects who are suspicious about the validity of information will evaluate this information more effectively, in order to be prepared for the fact that the information might be invalid (Schul et al. 1996). b. Suspension of judgment According to academic literature, suspension of judgment is one of the main characteristics of a skeptic (Bunge 1991, Kurtz 1992 an Hurtt et al 2003). Skeptical auditors gather evidence until they are sure that the information that is stated is correct and without any reasonable doubt. With respect to fraud risks, ISA 240 states that skeptical professionalism of the auditor will increase fraud risk identification and FRASK. Zimbelman (1997) found that auditor s evaluation of evidence can influence the audit process due to judgments based by this evaluation, especially with respect to FRASK. This can result in a suspension of judgment (Quadackers et al. 2009). c. Locus of control; A high internal locus of control means greater analytical skills, thoughtfulness, and alertness (Phares 1978) and is therefore considered of high relevancy for auditors: for example, accepting management information (Quadackers et al. 2009). Bernarini (1994) studied the relationship between locus of control and fraud detection. He found that auditors with a high locus of control are more sensitive to information concerning client integrity. An important issue in academic literature surrounding professional skepticism is about whether professional skepticism means a more presumptive doubt perspective as used by forensic experts (Bell et al. 2005, POB 2000, (Nelson 2009, Cushing 2000)). Forensic accountants generally assume dishonestly by management unless there is evidence that management is honest. The panel on Audit effectiveness recommends that auditors adapt this view (POB 2000) as well as recommends a forensic-field-type-phase of the audit. 11 of 31

14 Presumptive doubt is visible in ISA 240. The objective of this standard is to take into consideration the possibility of an intentional material misstatement, better known as fraud. According to the aforementioned research it can be concluded that professional skepticism is of great importance to an auditors performance. Shaub and Lawrence (1996) state that professional skepticism is influenced by: (1) experience, (2) ethics, and (3) situational factors. I will describe these factors in the following paragraphs. 3.2 Expertise In general, lack of specific experience as part of a broader concept, that being expertise, with respect to fraud, is often recognized as a very important factor influencing FRASK (Grazioli et al. 2006) There are, generally speaking, two academic approaches to the understanding and study of expertise. The first recognizes expertise as the basis of communities of practice. In this view expertise is socially constructed; group members define and use joint rules to think, act and to gain expertise in some domain, e.g. auditing. International Audit Statements apply such rules. The second opinion states that expertise is a characteristic of individuals (e.g. auditors) and is a consequence of the human capacity for adaptation to physical and social environments (Chi 2006). Behavioral decision theory and the expertise paradigm are used to explain how individual auditors make decisions. This theory suggests that performance depends upon an individual s experience, knowledge and ability (Bonner and Lewis 1990, Libby and Luft 1993 and Libby 1995). When combined, experience and knowledge become expertise, which is the ability, acquired by practice, to perform qualitatively well in a particular domain (Bédard and Chi 1993). The expertise paradigm (Einhorn 1976, Bédard 1989, Libby and Luft 1993, Libby 1995 and Solomon et al. 1999) was used in a study to test the decision processes used by industry specialist auditors. This paradigm emphasizes the importance of specific knowledge that is necessary to complete a specific task. The 12 of 31

15 knowledge that is needed to complete the task has to be observable (Libby and Luft 1993). FRASK is to be considered as a specified audit task. The task-specific performance of experts depends upon their individual training and experience. Expertise is a combination of knowledge, ability and experience. Differences in knowledge and ability better explain variance in task performance than experience can. Two auditors with the same number of year s experience but with different clients, training and ability will have different areas of expertise (Bonner and Lewis 1990). Marchant (1990) however, states that research in expertise, in general, enhance the principle that practice makes perfect, translating to mean - the continuous development of ones expertise (Frensch and Sternberg 1989). According to Marchant, an individual auditor might develop his ability to achieve task-specific superior performance. However, studies conducted by Davis and Solomon (1989) suggest that auditors do not receive feedback on their work, so it is rather difficult for them to learn from their environment. Furthermore, auditors perform many different tasks without a strong replication of tasks. On the other hand, research conducted by Libby and Frederick (1990) indicates that more experienced auditors are more capable of explaining audit findings Shaub and Lawrence (1996) state: Auditors with more experience and as a consequence of this, more expertise, demonstrate higher levels of professional skepticism. Payne and Ramsey (2005) found that auditors predisposed to low fraud risk assessments were less skeptical than those with no knowledge of fraud risk. Auditors with no knowledge of fraud risk are less skeptical than those predisposed to moderate/high fraud risk assessments. Extrapolating from the aforementioned theory I divide expertise of the auditor into elements: a. Experience; b. Knowledge; c. Ability (skills). 13 of 31

16 Former research supports the conclusion that more knowledge, experience and ability (skills) have a positive impact on the auditors professional skepticism and therefore on auditors performance. 3.3 Ethical values Shaub et al. (1993) concluded that professional commitment and professional skepticism can be influenced by ethical orientations. There has been a growing interest, especially within the United States over the course of the last few years, into researching business ethics. Ethical problems are inherent in the auditing profession because of the conflict of interests between the diverse stakeholders (Westra 1986, Bazerman et al. 1997). In related studies (Volker 1984 and Bebeau et al. 1985) it was found that professionals who are focused on technical issues have less attention for ethical issues. Research conducted by Shaub and Lawrence (1996) observed that auditors reflecting on situational ethics are less skeptical and less concerned to professional ethics involved. These auditors exhibit less skeptical behavior. Skeptical behavior involves performing more additional testing or directly confronting the client. This process is sequential during the audit. Kohlberg's (1969) classification of moral development has been very important for research with respect to professional skepticism. This classification consists of three principal bases of moral judgment: pre-conventional, conventional, and postconventional). Rest (1979) developed the Defining Issues Test (hereafter: DIT) during the early 1970s as a means of testing an individual's level of moral development. The results of studies applying the DIT-methodology have shown that auditors on the whole do not score at Kohlberg's highest level (post-conventional), despite the strong normative opinions which are inherent to the auditing profession, e.g. the professional code of conduct. This code addresses auditors ethical responsibilities. For the purposes of this paper I define some specific important ethical conceptions of the auditor when conducting an audit as such: 14 of 31

17 a. Integrity The diverse stakeholders of financial statements can cause ethical dilemmas for the auditor, according to Arnold and Bernardi (2005). They examined the principle of confidentiality regarding information obtained from one client assigned to the audit whose opinion was expressed to a second client. The analysis of their empirical research raises questions as to whether strict adherence to confidentiality is in the best interest of all financial statement users. Integrity is a professional responsibility of a professional in general (Karssing 2006). For an auditor, integrity is one of the fundamentals of the auditing profession (Code of Ethics for Professional Accountants, IFAC). From a societal perspective, integrity is a moral obligation of auditors to protect the vulnerable and to strengthen trust in society. The personal perspective of integrity is moral self-respect. b. Independence Auditors are expected to be independent from their clients. However, perhaps not always fairly, auditors are frequently criticized for putting their own economic interests before the interests of their clients or of the public whose interest they are supposed to serve (Gowthorpe et al. 2002, Bazerman et al. 1997). Fearnley et al. (2005) stated that auditors perceive pressure from their clients, and intimidation is found to be the most frequent threat, which can lead to concerns for the auditor about losing a client. These concerns can lead to dependency from the client. Yet intimidation and fear of losing the client receive the least attention in the independence frameworks. Parker (1994) stressed this problem in the context of the auditing profession: ``(...) while public interest is readily proclaimed by professions, economic self-interest is never far from view, both at the corporate and individual levels''. 15 of 31

18 c. Personal moral values of the auditor Barnett and Vaicys (2000) found that individuals behavioral intentions and ethical judgments are directly correlated. Azjen and Fishbein (1980) concluded that there might be a conflict between the professional code of conduct and personal moral values. In a study conducted by Douglas et al. (2001) investigated the personal values of auditors found that personal values can override codes of conduct, because they are closer to the identity of the individual s personality. The professional position or the age of the auditor did not influence attitudes concerning codes (Douglas and Warren 2001, Glenn and Van Loo 1993). Research by Shaun and Lawrence (1996) showed that ethical values of an auditor influence professional skepticism. Former research supports the conclusion that ethical conceptions influence auditors professional skepticism and therefore on auditors performance. 3.4 External audit factors According Shaub and Lawrence (1996) situational factors are part of professional skepticism. Skeptical judgments and decisions are therefore situational specific (Bhattacharrya et al. 1998). For the purpose of this study I have defined some specific situational factors. I call these factors external audit factors. As external audit factors I identify: a. Expectations of clients and society as a whole to the auditor Iyer and Rama (2004) focused on factors that influence the relative power between client and auditor: Clients' perceptions of their ability to persuade the auditor in an accounting dispute which lacks clear professional guidelines; The vulnerability of auditors in the beginning of an auditor's tenure; 16 of 31

19 Suggestion that long auditor tenures do not erode auditor independence and objectivity; Finding that perceptions about the ability to persuade were positively linked with the importance of the client to the audit partner-in-charge. One important potential incentive an auditor faces during an audit is client risk. This client risk is expected to increase skeptical judgments and decision (Johnstone et al and 2002, Nelson 2009). The study of Iyer and Rama (2004) indicates that auditors react to perceived client pressure. This pressure influences an auditor s judgment in either a positive or a negative way. Fearnley et al. (2005) concluded that managerial motivation is found to be a key driver of pressure on an auditor, and intimidation is found to be the most frequent threat, which can lead to concerns about client retention for the auditor. For this reason client pressure can lead to Reduced Audit Quality (here after: RAQ). Ex post, litigants tend to blame auditors in hindsight for failing to foresee and anticipate subsequent financial problems of their audit clients. The study of Anderson et al. (1993) showed that judgments of auditors' performance are subject to hindsight bias. Juxtaposing the question as to whether the judgments of auditors performance are fair or unfair, RAQ may have consequences e.g. negative media attention or the threat of litigation (Hackenbrack and Nelson 1996). This might (or should) be a good motivation for auditors to do their upmost to increase audit quality. b. Accounting firm pressure Malone and Roberts (1996) found that whenever auditors perceive a strong qualitative control and a strong set of review procedures within the accounting firm, strength of their firm's quality control and review procedures and penalties for RAQ behaviors, the audit quality is higher. Also, auditors' need for approval and need for achievement are inversely related to RAQ behaviors. King (2002) found that bad judgment and decision making, which might occur during a FRASK, is less when auditors have the feeling that they belong to a group, and therefore 17 of 31

20 are aware of social pressure to meet group norms. An accounting firm can be such a social group. DeZoort and Lord (1994) found that whenever auditors who receive inappropriate or unclear instructions from their manager or partner, were significantly more likely to violate professional norms or standards than auditors who receive clear and appropriate instructions. c. Time budget pressure. Understanding the different conditions under which time budget pressure can impact on audit work is important because time budget pressure has been shown to be an important pressure faced by professional accountants. The study of Coram et al. (2000) investigates the effects of time budget pressure and level of risk of misstatement on auditors' incline to commit RAQ acts in the execution of an audit. Under time budget pressure, a higher risk of misstatement reduces the incline of auditors to commit RAQ by using smaller than appropriate audit samples, but not for accepting doubtful audit evidence. Coram et al. (2000) found that auditors tend to accept doubtful audit evidence in the presence of high time budget pressure regardless of the level of risk, but appear to fail to test all items in a selected sample in the presence of high time budget pressure only when the level of risk is low. It seems that it is perceived by auditors as more tolerable to accept doubtful audit evidence than to audit a sample that is too small. The research conducted by Braun (2000) showed that auditors under high time pressure may be less likely to identify and detect red flags than auditors under low time pressure. He found that RAQ with respect to the detection of red flags may be observed at a lower level of time pressure than RAQ with respect to the accuracy with which auditing tests of details are executed. Asare and Wright (2004) point out that an auditor may reduce his assessment of fraud risk in order to avoid high costs of consultation fraud experts or missing important engagement deadlines. 18 of 31

21 Owrin (2002) found a negative linear relationship between time pressure and audit effectiveness. The more complex (ratio analysis) tasks are more adversely affected by increases in time pressure, than that the less complex (compliance-testing) tasks. The results of the study of Gundry (2006) also found a positive relationship between time budget pressure and the likelihood that auditors will engage in one RAQ. From the aforementioned research, it can be concluded that expectations of clients and society as a whole, accounting firm pressure an time/budget pressure influence professional skepticism and therefore auditors performance. 19 of 31

22 4. Research approach Introduction In this chapter I develop a conceptual model that specifies how (i.e. through which mediating (causal) variables) the factors defined in Chapter (1) influence the ability of auditors and forensic accountants to identify effective audit procedures to mitigate the identified fraud risks. In paragraph 2.2 I will develop the hypotheses that constitute the model using theoretical insight from the accounting and psychology literatures. The conceptual model indicates how the hypotheses are linked to the research question being investigated. Behavioral accounting studies in judgment performance often make use of a survey or an experiment design (Brownell and Trotman 1988, Nieschwietz et al. 1999, Trotman 1996). For my research I chose to use both approaches. In paragraph 2.3 I will describe the participants in this study. In paragraph 2.4 I will describe the experiment I will conduct to test the ability to identify effective additional procedures to mitigate the identified risk factors. In paragraph 2.4 I will describe the survey that will be used to test my hypotheses regarding the influencing factors with respect to the ability to identify effective procedures to mitigate fraud risks. 4.2 Research hypotheses and conceptual model The studies of DeZoort and Stanley (2006) and Boritz et al. (2008) state that forensic accountants may not be as capable in designing an audit plan, however that they are able to create adjustments to the audit plan that mitigate the fraud risks. This is only the case when the forensic accountants perform the risk assessment themselves. Fraud specialists identify much fewer audit procedures to address the fraud risks than auditors do, but forensic accountants identify other additional procedures that would be effective to address the fraud risks. Auditors tend to adjust the audit plan with more procedures they had already intended to perform. The conclusion of Boritz research is that forensic accountants might be better equipped to identify additional procedures that would be effective to address fraud risks whenever they perform the risk assessment of an audit. 20 of 31

23 Factors that in general influence auditors performance can be assumed to influence auditors ability to identify more effective additional procedures to mitigate the identified risk factors. To test this, I argue that: H1: Professional skepticism has a positive effect on the ability to identify additional effective procedures to mitigate fraud risks. H2: Expertise has a positive effect on professional skepticism and therefore on an effective FRASK. H3: Budget pressure and time pressure have a negative effect on professional skepticism and therefore on an effective FRASK. Expectations of client and society as a whole, as well as accounting firm pressure, have a positive effect on professional skepticism and therefore on an effective FRASK. H4: Integrity and independence have a positive effect on professional skepticism and therefore on an effective FRASK. Personal moral values of the auditor have a negative effect on professional skepticism and therefore on an effective FRASK. H5 Expertise as a positive effect on ethical values. The conceptual model for this research is presented in figure of 31

24 Figure 4.1 Conceptual model Independent Variables Variable Dependent Hypotheses H0, and H1 will be tested by means of an experiment, as described in paragraph 2.4. Hypotheses H2, H3, H4, and H5 will be tested by means of a survey, as described in paragraph Participants The participants of this study are auditors and forensic accountants from each of the Big 4 accounting firms in Australia, The Netherlands and the United States. The participants will all be experienced auditors or forensic accountants with an auditing background. They are all experienced in risk analyses and risk assessment of an audit. Depending on the hierarchical structure of the audit firm the auditors are senior managers. The participants participated in both the experiment and the survey as described in paragraph 2.4 and paragraph 2.5, respectively. Experiment The goal of the experiment will be to show the existence of a causal relationship between professional skepticism and the ability to identify effective procedures to mitigate fraud risks. In this experiment I will vary the independent variables expertise, external audit factors and ethical values 2. 1 At this stage of my research I have not yet decided which of the independent variables to test in this study. 2 At this stage of my research I have not yet decided which of the independent variables to vary in the experiment. 22 of 31

25 The experimental task involves a description of a hypothetical audit client by means of cases. The cases will differ with respect to variety of the independent variables. The participants will randomly be assigned to the different cases. The description consists of information about the client s business, its business risks and its system of internal control. Specific fraud risks will be described. This hypothetical client is supposed to be a new audit client for the participants who will be the auditor. The participants will be asked to conduct a (general) risk analysis. After listing the audit risks the auditors will create a fraud risk assessment. They will be asked to develop procedures to effectively mitigate the fraud risks they identified. I will use a (general) manufacturing client to mitigate the influence of specific industry knowledge. Taylor (2002) found that when auditors do not have specific industry knowledge they tend to anchor on their knowledge of the general manufacturing industry. To make the experiment valid it is necessary that all participants are prone to the same environmental circumstances while assessing the case. The participants will receive written procedures concerning their specific task with respect to the experiment. The cases will be developed with the help of experts in the field of auditing, forensic auditing and specific fraud experts. These experts will form the expert panel. The expert panel will receive written procedures concerning their specific tasks with respect to the experiment. The expert panel will define fraud risks that will be described in the cases. The panel will also define the procedures to mitigate those fraud risks. The specific fraud risks and the procedures to mitigate these risks effectively must be extremely clear in description, without the need for any discussion. This is an absolute requirement to validate the experiment. The experts will be asked to score the fraud risks and the procedures to mitigate these risks in order of importance and relevance by distributing 100 points in total among the defined fraud risks and procedures. As a result, the fraud risks and procedures which will be identified by the participant can be scored. Before conducting the experiment the cases will be tested. Twelve Big 4 partners (four Australian, four Dutch, and four US partners) will read through the cases. 23 of 31

26 The outcomes of the experiment will be individually discussed with each participant. During this discussion the participant will be asked why he identified this risk as a fraud risk and why he chose the procedures to mitigate these risks. In doing so, it will be possible to judge whether the identified fraud risks are founded on the correct assumptions. The outcomes of the case will give a score per individual participant. Finally, these scores will be analyzed by using ANOVA analysis techniques. An experiment is the primary tool for studying causal relationships (Campbell and Stanley 1963 i, Babbie 2001). The main advantage of an experiment lies in the isolation of the experimental variable which ensures internal validity. Secondly, an experiment lends it selves to a logical rigor that is often much more difficult to achieve in other models of observations. The third advantage is that an experiment can easily be replicated several times using other (groups) of subjects. This replication strengthens the confidence in the validity and generalization of the research findings. A disadvantage of the experiment is its artificiality. What occurs within an experimental setting may not reflect what transpires in a real business environment. As a consequence, external invalidity is often considered to be a disadvantage of an experiment (Brownell 1995). However, it is possible to create an experimental design that logically controls such problems to ensure experimental and mundane realism and maximize the amount of external validity (Schulz 1999). Within the design of the experiment, attention must be given to a main concern. The concepts used in this study have to be consistently stable, ensuring external validity. Among other things, these concepts will be defined in such a way that stability is promoted. Survey After finishing the experiment, the participants will be asked to complete a written questionnaire. The aim of the survey is to collect documented perceptions and data from auditors and forensic accountants about the factors that influence professional skepticism and therefore 24 of 31

27 the auditors performance with respect to the identification effective additional procedures to mitigate the identified risk factors. The survey data will enable me to interpret the experimental data as well as to control the experimental settings. From the survey data collected I will identify the participants with a low and a high level of expertise. I will test whether the level of expertise influence the level of professional skepticism and in that way influence the ability to identify effective procedures to mitigate fraud risks in an experimental setting (see paragraph 2.4). The perceptions of the participants with respect to the other independent variables will enable me to interpret the experimental data concerning the independent variables that are varied in the cases in the same way. In general the low response rate is considered to be a big disadvantage of surveys using written questionnaires. However, for this study I have/ will try to get the full cooperation of management of the Big 4 accounting firms. Their commitment will be used to ensure a considerable response rate among their own auditors and forensic accountants. After finishing the experiment, the participants will be asked to complete a written questionnaire. The questionnaire will be pretested. Five Australian, five Dutch auditors, and five US auditors will be asked to complete the questionnaire. The questionnaire will contain an introduction with clear instructions for the participants. The participants will receive questionnaires in their native language to minimize bias due to difficulties in understanding the questions. The data collected by the survey will be analyzed by using Structural Equation Modeling. A survey using a written questionnaire is recognized as a good method to collect data for describing a population too large to observe directly, such as auditors and forensic accountants. In general, the fact that the data collected by means of a written questionnaire documenting perceptions couched in professional opinions is considered to be a disadvantage (Babbie 2001). In this study, however, that is exactly what the survey is intended to achieve: collecting perceptions and opinions from individual auditors and forensic accountants. 25 of 31

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