The eects of experience and explicit fraud risk assessment in
detecting fraud with analytical procedures
$
Carol A. Knapp
a,*, Michael C. Knapp
baUniversity of Central Oklahoma, College of Business Administration, 100 North University Drive, Edmond, OK 73034, USA bUniversity of Oklahoma, Michael F. Price College of Business, 307 West Brooks, Norman, OK 73019, USA
Abstract
This paper reports the results of an experiment that examined the eects of audit experience and explicit fraud risk assessment instructions on the eectiveness of analytical procedures in detecting ®nancial statement fraud. The results of this study suggest that audit managers are more eective than audit seniors in assessing the risk of fraud with ana-lytical procedures. Additionally, explicit fraud risk assessment instructions resulted in more eective assessments of the presence of fraud. These results have implications for the assignment of auditors to tasks and the structuring of these tasks.#2000 Elsevier Science Ltd. All rights reserved.
1. Introduction
This paper reports the results of an experiment that examined the eects of audit experience and explicit fraud risk assessment instructions on the eectiveness of analytical procedures in detecting ®nancial statement fraud.1The experimental
mate-rials used in this study include fraudulent ®nancial statements issued by a public company and the subsequently restated and reissued ®nancial state-ments of the same company. Audit seniors and
managers applied analytical procedures to ®nan-cial statements and assessed the risk of fraud. The subjects were divided into four groups, each of which received one of four combinations of ®nan-cial statements and explicit fraud risk assessment instructions. The ®nancial statements presented to the auditors were either fraudulent or fairly stated. One-half of the subjects received explicit instruc-tions stating that the objective of their task was to assess the risk of ®nancial statement fraud, while the remaining subjects did not receive such instructions. The results of this study suggest that audit managers are more eective than audit seniors in assessing the risk of fraud with analytical proce-dures. Additionally, explicit fraud risk assessment instructions resulted in more eective assessments of the presence of fraud.
The remainder of this paper is organized as fol-lows. Section two develops the motivation and hypotheses for the study. The research design and results are presented in Sections three and four,
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$ Data availability: The data upon which this research is
based may be obtained from the authors on request.
* Corresponding author. Tel.: 405-974-2444; fax: +1-405-974-3853.
E-mail address:cknapp@ucok.edu (C.A. Knapp).
1 The type of fraud addressed in this paper is ®nancial
respectively. Finally, Section ®ve discusses the results and their potential implications for practice andresearch.
2. Motivation and hypotheses
In 1988, the Auditing Standards Board (ASB) issued Statement on Auditing Standards No. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities (AICPA, 1988). This standard imposed greater responsibility on audi-tors to detect ®nancial statement fraud. The ASB formed a task force in 1993 to reconsider auditors' responsibility for the detection of fraud. Among other recommendations, this task force concluded that the concepts of professional skepticism and reasonable assurance discussed in SAS 53 needed to be developed further and that a new SAS devoted strictly to the issue of fraud detection was necessary. The new SAS No. 82,Consideration of Fraud in a Financial Statement Audit (AICPA, 1997), delineates auditors' responsibility for the detection of fraud more precisely thanSAS 53and provides operational guidance to practitioners.
Fraud is an intentional act designed to deceive or mislead another party (Arens & Loebbecke, 1996). This study focuses speci®cally on ®nancial statement fraud by business executives or man-agers who have sucient authority to override an organization's internal controls. Generally, such fraud involves deliberate distortion of accounting records, falsi®cation of transactions, or misapplica-tion of accounting principles. Regardless of how the fraud is manifested, it is typically dicult for auditors to discover since the perpetrators take steps to deliberately conceal the resulting irregula-rities. Given the diculty that auditors face in detecting ®nancial statement fraud, coupled with their increasing responsibility to detect it, there is a de®nite need to develop audit procedures or strategies more speci®cally focused on fraud detection.
Analytical procedures have long been used by auditors, although the profession has required them to be incorporated in ®nancial statement audits only since 1988. The potential for using analytical procedures for fraud detection purposes
has been discussed widely in the professional lit-erature. Nevertheless, there is little evidence that these procedures have been extensively applied by auditing ®rms for the speci®c purpose of detecting ®nancial statement fraud.
Explicit fraud risk assessments have been recom-mended as an audit procedure that would improve the auditor's likelihood of detecting fraud (Loeb-becke, Eining & Willingham, 1989; Shibano, 1990). Explicit fraud risk assessments are included as a required audit procedure in SAS No. 82, Con-sideration of Fraud in a Financial Statement Audit (AICPA, 1997).2 Recent research onSAS No. 82
indicates that implementation of the speci®c fraud risk assessment varies greatly across ®rms (Shel-ton, Whittington & Landsittel, 2000). Shelton et al. looked at the practices of all of the Big Five ®rms and two second-tier ®rms. Their study reported that three of the Big Five and both sec-ond-tier ®rms incorporate fraud risk assessment into the overall risk assessment process. The impact of requiring a separate fraud risk assess-ment on audit eciency has been examined recently by Zimbelman (1997). He found evidence that requiring a separate fraud risk assessment increased auditors' attention to fraud cues and in¯uenced audit planning decisions. The current study looks at the eect of separate fraud risk assessments on audit eectiveness. The ®ndings indicate that fraud risk assessment is more eec-tive when a separate, explicit fraud risk assessment is performed. Potentially, several audit ®rms could improve fraud risk assessment by requiring a separate assessment rather than incorporating it in the overall risk assessment.
Shelton et al. (2000) also reported that two of the Big Five and one second-tier ®rm perform the fraud risk assessment at the client acceptance/ continuance stage of the audit. The remaining ®rms studied perform the fraud risk assessment during planning. In the current study, the fraud risk assessment is performed during planning with analytical procedures. Practice improvement may be possible for several ®rms by changing the fraud risk assessment to the planning stage of the audit
2 At the time of this study, explicit fraud risk assessments were
rather than at the client acceptance/continuance stage.
In addition, the practice aids used to assess fraud risk by the ®rms studied by Shelton et al. (2000) almost all involve checklists. Prior research on practice aids has provided evidence that the use of checklists may not be eective in assessing the risk of fraud (Eining, Jones & Loebbecke, 1997; Pincus, 1989). The present research indicates that for experienced auditors performing an explicit fraud risk assessment with analytical procedures, eectiveness is improved. Hopefully, the current study will contribute to the accounting pro-fession's continuing eort to improve the fraud detection capability of ®nancial statement audits and the implementation ofSAS No. 82.
2.1. Analytical procedures as a method of fraud detection
In 1987, the Treadway Commission reported, ``The potential of analytical review procedures for detecting fraudulent ®nancial reporting has not been realized fully (National Commission on Fraudulent Financial Reporting [NCFFR], 1987).'' Based upon a review of actual fraud cases, the Treadway Commission observed that ®nancial statement frauds tend to be very similar in terms of how they are perpetrated. Most fraudulent cases involve improper revenue recognition, overstatement of assets, and/or improper deferral of expenses. Typically, analytical procedures involve compar-ing actual ®nancial statement amounts with expec-ted amounts that are derived from the application of a naive or complex prediction model. Since the misstatements resulting from fraudulent mis-representations result in dierences from predicted amounts, they should be potentially detectable with analytical procedures.
The central task of an auditor in applying ana-lytical procedures is to develop expectations. The expectations the auditor develops will be based upon both the external information that the audi-tor encounters and his/her own existing knowledge stored in memory. An auditor's existing knowledge is an important factor in his/her understanding and interpretation of information, and can be expected to in¯uence the auditor's eectiveness in assessing
the risk of ®nancial statement fraud. Research on experience and expertise suggests that an indivi-dual's knowledge changes as experience increases (Chi, Glaser & Rees, 1982), thus an auditor's per-formance of analytical procedures may be aected by experience.
Previous research in both psychology and auditing has found that as individuals gain rele-vant experience their knowledge structures change and develop (Chi et al., 1982). Generally the ®nd-ings indicate that experienced individuals have greater total knowledge (Christ, 1993; Knapp, 1995; Libby & Frederick, 1990; Tubbs, 1992), more understanding of relationships between variables (Chi et al., 1982; Frederick, 1991; Moeckel, 1990), and an ability to go beyond the surface features of information and identify the true, underlying pro-blem (Biggs, Mock & Watkins, 1988; Chi et al., 1982; Christ, 1993; Moeckel, 1990). All of these characteristics of knowledge are potentially important to the task of fraud risk assessment with analytical procedures.
Two empirical studies of particular importance to the issues addressed here have both found sig-ni®cant knowledge dierences between audit managers and seniors. Christ (1993) studied audi-tors' planning knowledge (of which preliminary analytical procedures are a subtask) with a recall task. She found signi®cant dierences in the knowledge structures of audit managers/partners as compared to senior and junior auditors. Knapp (1995) examined auditors' knowledge of factors that may indicate the existence of ®nancial state-ment fraud and found signi®cant dierences. Managers were able to recall a greater number of ``factors that may suggest the existence of fraud in a set of ®nancial statements'' than were audit seniors. Given that signi®cant knowledge dier-ences have been identi®ed between experience levels of auditors, this knowledge dierence will likely aect auditors' understanding and inter-pretation of information during analytical proce-dures and, thus, their ability to eectively assess the risk of ®nancial statement fraud.
that greater experience will positively aect auditors' performance in this context.
H1.Audit managers will assess the risk of ®nancial statement fraud more eectively with analytical procedures (higher when fraud is present, lower when fraud is not present) than will audit seniors.
2.2. Explicit fraud risk assessment as a fraud detection procedure
Extensive psychological research has investi-gated the existence and structure of knowledge utilized by decision makers, factors that in¯uence the activation of the correct or most appropriate knowledge in a given decision-making context, and the impact of knowledge on the eectiveness and eciency of decision-making processes (e.g. Lesgold, 1984; Lurigio & Carroll, 1985; Mandler, 1984; Rumelhart, 1980). This research indicates that prior knowledge facilitates the encoding of new information, the interpretation of the information being processed, and the retrieval of relevant infor-mation (Alba & Hasher, 1983).
For analytical procedures to be bene®cial in enabling an auditor to eectively assess the risk of ®nancial statement fraud, an auditor must possess the relevant knowledge required to uncover the fraud if it is present and the ability to ``trigger'', or activate, that knowledge when needed. An indivi-dual cue within the ®nancial statements may trig-ger the auditor's fraud knowledge if it is material enough. Or, it may be necessary for an auditor to identify several cues to trigger his/her fraud knowledge. Financial statement fraud involves an attempt by management to ``fool the auditors''. One way to try to hide the fraud is with a series of manipulations of accounts, none of which is material enough on its own to trigger the auditor's suspicion of fraud.
It may be possible to improve fraud detection by requiring auditors to explicitly assess the risk of fraud. Zimbelman (1997) found that auditors explicitly assessing fraud risk pay more attention to fraud cues than do auditors not making explicit fraud risk assessments. In addition, his results suggest that requiring auditors to explicitly assess the risk of fraud will lead to increased audit hours
for both high- and low-fraud risk cases. Unan-swered is the question of whether explicit fraud risk assessments lead to more accurate fraud risk assessments. It is possible that requiring auditors to separately assess the risk of fraud on a ®nancial statement audit will only decrease audit eciency by increasing audit hours. Also, fraud risk assess-ment instructions may only increase fraud risk assessments for both fraud and no-fraud ®rms simply because they increase auditors' assessment of the prior probability of fraud.
Research in psychology provides support for more accurate fraud risk assessments with explicit instruc-tions (Graesser & Nakamura, 1982; Rumelhart, 1980; Shank & Abelson, 1977; Taylor & Crocker, 1981). Explicit fraud risk assessment instructions should activate the auditor's fraud knowledge and initiate a search for evidence that supports the possibility of fraud. The auditor's fraud knowl-edge should guide the search for relevant cues indicative of fraud. If evidence is not identi®ed that supports the possibility of fraud, the auditor should assess the risk of fraud as low. Thus, explicit fraud risk assessment instructions will serve as a prime that triggers the auditor's fraud knowledge and, thus, improve his/her performance in asses-sing the risk of fraud. Based upon the above, the following is hypothesized:
H2.The presence of explicit fraud risk assessment instructions will improve auditors' eectiveness (higher when fraud is present, lower when fraud is not present) in assessing the risk of ®nancial statement fraud with analytical procedures.
3. Research design
Study participants were 119 auditors (57 man-agers and 62 seniors) from six dierent international accounting ®rms. Table 1 provides descriptive sta-tistics of the participants' average years of auditing experience. The task required the auditors to apply analytical procedures to a set of ®nancial statements for an actual company that had issued fraudulent ®nancial statements.
and the presence/absence of explicit fraud risk assessment instructions. Audit eectiveness is assessed as the signed dierence between fraud risk assessments between the fraud and no-fraud case for each experience level/instructions treat-ment combination. The ®rst hypothesis is addres-sed by comparing the eectiveness of audit managers and audit seniors in assessing the risk of ®nancial statement fraud. Hypothesis two is tested by comparing the eectiveness of auditors receiv-ing explicit fraud risk assessment instructions with auditors not receiving such instructions.
3.1. Case materials and procedures
A case with two versions, fraud and no fraud, was constructed using annual and 10-K reports of an actual company. The case included a narrative description of the company's business, its pro-ducts, markets, competition and management. The narrative description of the case was followed by a full set of ®nancial statements with related notes. In addition, to facilitate the performance of analytical procedures, the ®nancial statements
were followed by common-size balance sheets and income statements and selected ®nancial ratios.
The selected company had received a clean opi-nion from a major accounting ®rm despite the presence of ®nancial statement fraud. The Secu-rities and Exchange Commission (SEC) conducted a lengthy investigation of the company and con-cluded that the company had used a variety of manipulative devices to overstate earnings in its ®nancial statements. The SEC required this com-pany to restate and reissue its ®nancial statements. In the no fraud condition, the restated ®nancial statements were presented to the subjects. In the fraud condition, the originally issued ®nancial state-ments were presented to the auditors. The fraudulent and restated income statements and balance sheets are presented in the Appendix.
The data for the case was based upon publicly available information from 1981 and 1982. The name of the company and its ocers were ®ctiona-lized. All other information was based upon pub-lished facts. The dated nature of the case should reduce the possibility that auditors would recognize the company. The use of a historical ®nancial state-ment fraud has two major advantages in this experiment. First, it provides a criterion outcome for evaluating auditor eectiveness in assessing the risk of fraud. Second, its real-life complexity enhances the external validity of the task.
Participants were randomly assigned to experi-mental conditions. The auditors were provided with the case materials, lined paper, pencils, and Table 1
Descriptive statistics of experience levels
Rank n Mean S.D. Minimum Maximum
Managers 57 8.5 years 2.6 years 5 years 17 years Seniors 62 3.1 years 0.9 years 1 year 5.1 years
calculators. Each auditor was asked to perform preliminary analytical procedures on a set of ®nancial statements. The auditors were asked to assume they were in the initial planning stages of the audit of a new client, a medical products manufacturer. They were asked to list unusual items noted in the ®nancial statements and pro-vide potential explanations for the unusual items noted. Subjects were not allowed to use reference materials or confer with one another while com-pleting the experiment.
Participants in the explicit fraud risk assessment condition were asked to perform a preliminary ana-lytical review of the ®nancial statements with the speci®c objective of assessing the risk that ®nancial statement fraud was present. Financial statement fraud was de®ned as the ``intentional distortion of the ®nancial statements by management.'' Auditors in the no instructions condition were simply asked to perform preliminary analytical procedures on the ®nancial statements. In this condition, a speci®c objective was not stated.
Immediately after completing the preliminary analytical review task, participants were asked to perform a risk assessment task. The auditors were asked to express, on a scale, their judgment of the likelihood of various risks,3including the risk of
®nancial statement fraud, for the client described in the case. Although the fraud risk assessment was the dependent measure of interest, it was ``hidden'' among other risk assessments to reduce any demand eects.
3.2. Experience requirements
The task requires the participants to have pre-vious experience performing analytical proce-dures. The use of audit seniors and audit managers for this task is justi®ed, since audit seniors typically perform preliminary analytical review. In the post-experimental questionnaire, subjects in this study were asked, ``In your ®rm, at what position or rank does an auditor typically
perform preliminary analytical procedures?'' The responses were as follows:
Senior 82.9%
Senior/Manager Team 4.5%
Sta 6.3%
Other 6.3%
Audit managers have performed analytical pro-cedures earlier in their careers and, typically, review the work of the senior accountant. All of the auditors indicated that they had previous experience performing preliminary analytical pro-cedures. The experience groupings in this study allow for a comparison of auditors who typically perform preliminary analytical review to a group of more experienced auditors.
3.3. Independent and dependent variables
The independent variables Ð whether or not fraud is present in a set of ®nancial statements and whether or not explicit fraud risk assessment instructions are provided Ð were manipulated on a between-subjects basis. In addition, the auditors' rank, manager or senior, is treated as a classi®cation factor.
The dependent variable is the participants' risk assessments of the presence of fraud in the ®nancial statements. The response scale used for eliciting likelihoods was a zero-to-ten scale, with zero being most unlikely and ten being most likely.
3.4. Manipulation check
To assess whether auditors attended seriously to the explicit fraud risk assessment instructions, participants were asked in the post-experimental questionnaire about the objective of the analytical procedures they had performed. Sixty-six percent of the auditors in the explicit fraud risk assessment instructions condition answered speci®cally that the objective was the assessment of the risk of fraud. An additional 19% of these participants responded that the objective was to identify spe-ci®c risks or possible misstatement. None of the auditors in the no instructions condition respon-ded that detection of the risk of fraud was the objective of the preliminary analytical procedures
3 All subjects were asked to assess each of the following risks:
task. This analysis indicates that the explicit fraud risk assessment manipulation was successful.
A potential explanation for the results found in this paper would be that managers paid more atten-tion to the risk assessment instrucatten-tions than did seniors. To test for this potential threat to internal validity, managers' responses to the manipulation check were compared to seniors' responses. Using a chi-square test (chi square 0.223, d.f. 1), a statisti-cally signi®cant dierence in the responses of man-agers and seniors was not found.
4. Results
Table 2 presents the mean fraud risk assessments conditional on fraud/no fraud and instructions/no instructions. Additionally, explicit instructions do not appear to have created a demand eect, evi-denced by the failure of auditors to assess the risk of fraud as high in the no fraud with instructions groups.4
The dierences in assessment of the risk of fraud across experience level, fraud condition, and explicit fraud risk assessment instructions were tested in a 222 ANOVA model, where risk of fraud was the dependent variable, and experience, fraud/no fraud, and instructions/no instructions were categorical variables with two levels each. Table 3 reports the results of the analysis of variance. The analysis is based on results from 119 auditors receiving the fraud and no fraud conditions. The
results show interactions between (1) fraud and experience (P=0.0001) and (2) fraud and instruc-tions (P=0.0641).
This indicates that, consistent with our hypoth-eses, experience and explicit fraud risk instructions increased the dierence in risk assessments between the fraud and no fraud cases. One potential criti-cism of the research design is that the subjects could have taken the explicit fraud risk instructions to mean that there was a greater probability of fraud than usual in the experimental case. If this had been the perception of the subjects, there would have been a main eect of instructions, but not the interaction with fraud/no fraud as was found.
The signi®cant experience and fraud-by-instructions interactions necessitate further analysis to identify the sources of the dierences. Tables 4 and 5 provide multiple comparisons of the simple main eects to identify the sources of the dierences. Table 4 indicates that managers assessed the likelihood of fraud as higher in the fraud treatment than did seniors (P<0.0001). This is consistent with H1. The results also indicate that managers assessed the likelihood of fraud as higher in the fraud treatment than in the no fraud treatment (P<0.0001). There was not a signi®cant dierence in the likelihood assessments of seniors in the fraud and no fraud treatments. These results indi-cate that more experienced auditors are more eective in assessing fraud (higher when fraud is present, lower when fraud is not present) than are seniors, as predicted by H1.
Table 2
Mean risk assessments of fraud (standard deviation) [n=119]
Managers Seniors
Fraud No fraud Fraud No fraud
No instructions 5.4 3.9 3.2 4.4 (2.5) (1.5) (1.9) (2.0)
[14] [15] [15] [15] Instructions 6.8 3.8 4.4 4.6 (1.1) (1.5) (1.7) (1.3)
[14] [14] [18] [14]
Table 3
222 ANOVA: overall model of factors aecting assessment
of risk of fraud [n=119]
Fraud 1 17.846 17.846 5.94 0.0164 Experience 1 19.334 19.334 6.44 0.0126 Instructions 1 13.548 13.548 4.51 0.0359 Fraud*exper 1 66.863 66.863 22.26 0.0001 Exper*instr 1 0.045 0.045 0.01 0.9031 Fraud*instr 1 10.501 10.501 3.50 0.0641 Fraud*instr
experience 1 0.447 0.447 0.15 0.7003 Error 111 333.368 3.003 Ð Ð
4 The seniors/fraud/no instructions group assessed the risk
When fraud was not present, there was not a signi®cant dierence in the likelihood assessments of managers and seniors. In all cases, seniors assessed the risk of fraud as relatively low.
Table 5 provides multiple comparisons of the simple main eects of the risk of fraud related to the fraud-by-instructions interaction. As predicted, there was a dierence in auditors' risk assessments when instructions were present (P<0.10);5
like-lihoods were higher when fraud was present and lower when fraud was not present. This eect was independent of experience; i.e. the increase in risk assessments with instructions was the same for both managers and seniors in the presence of fraud. This result is consistent with H2.
The results indicate that when fraud was present auditors assessed the likelihood of fraud as higher in the instructions condition than in the no instructions condition (P<0.10). There was no signi®cant dif-ference in the likelihood assessments of auditors in
the fraud and no fraud conditions without instructions. When fraud was not present there was no signi®cant dierence in the risk assess-ments with or without instructions.
4.1. Eects of manipulations on other risk assessments
As discussed previously, the fraud risk assess-ment task included other risk assessassess-ments, i.e. the risk of a departure from GAAP, the risk of a material error, the risk of a material uncertainty, the risk of a contingent liability, and the risk of a consistency problem. The primary reason for the multiple risk assessments was to disguise the real purpose of the task, fraud risk assessment and, thus, reduce any demand eects. The eects of the manipulations on the other risk assessments pro-vide additional information about the auditors' task eectiveness.
The case materials provided to the auditors in the fraud condition contained information that could be interpreted to represent potential depar-tures from GAAP, a potential contingent liability, and a consistency problem (see Appendix). Both errors and fraud represent misstatements; the pri-mary dierence between the two is intent. It seems logical to expect auditors to assess the risk of a material error as high when they assess the risk of fraud as high.
The dierences in assessments of the ``other'' ®ve risks were tested in ®ve 222 ANOVA models. The independent variables in each model were experience level, fraud condition, and the presence or absence of explicit fraud risk instruc-tions. In each model, the relevant risk assessment was the dependent variable. In all models, a sig-ni®cant fraud-by-experience interaction was found. The presence or absence of explicit fraud risk assessment instructions did not have a signi®cant eect on any of the other risk assessments. Table 6 provides the mean risk assessments for the fraud-by-experience conditions for all of the additional risk assessments made by the auditors.
Given the signi®cant fraud-by-experience interac-tions, multiple comparisons of simple main eects were performed. Table 7 provides a summary of the results.
Table 5
Multiple comparisons of simple main eects of risk of fraud Ð fraud-by-instructions, critical value q0.10, 115: 1.1507
Comparisons of mean risk of fraud Value Computed
P-value
Instructions vs no instructions with
fraud 1.1616
<0.10
Instructions vs no instructoins without
fraud 0.0810 ns
Fraud vs no fraud with instructions 1.2232 <0.10 Fraud vs no fraud without instructions 0.1425 ns Table 4
Multiple comparisons of simple main eects of risk of fraud Ð fraud-by-experience, Tukey's HSD test, critical value q0.05, 115: 1.1932
Comparisons of mean risk of fraud Value Computed
P-value
Manager vs senior with fraud 2.2587 <0.001 Manager vs senior without fraud ÿ0.6897 ns Fraud vs no fraud by seniors ÿ0.6688 ns
Fraud vs bo fraud by managers 2.2796 <0.0001
5 Although the level of signi®cant is marginal, instructions
The results presented in Table 7 are consistent with the previous results. Managers were more eective in assessing the ``other'' risks than were seniors.
Several interesting points can be noted from Table 6. Managers and seniors on average asses-sed the ``other'' risks higher than they assesasses-sed the risk of fraud. Auditors seem to be more con-servative in their fraud risk assessments. This may re¯ect their prior probabilities; i.e. fraud is a rare event. Consistent with prior fraud risk results, seniors do not have much separation in their ``other'' risk assessments.
4.2. Auditors' analytical review responses
Prior to performing the risk assessment task, the auditors were asked to read the ®nancial state-ments and to identify unusual items and generate likely explanations for the items identi®ed. To gain additional insight into the auditors' eective-ness in performing analytical procedures, their responses to the analytical procedures task were analyzed. The results should provide information about two important questions.
Did the auditors identify the key areas that were misstated in the ®nancial statements, i.e. were they
eective in identifying the misstatements? And, did the auditors generate explanations indicating that they suspected that the ®nancial statements might be intentionally misstated?
Table 8 presents the percentages of auditors in the fraud condition that identi®ed each of the key misstated areas in the ®nancial statements.
Several points can be noted from these percen-tages. First, more managers identi®ed the key misstatements than did seniors. These results are consistent with H1 and previous results. Secondly, more managers with explicit fraud risk instruc-tions identi®ed the key misstatements than did managers and seniors without instructions. These ®ndings are consistent with H2. Seniors with instructions did not identify more key misstate-ments than seniors without instructions.
The analytical review task responses for all audi-tors were reviewed for explanations indicating that intentional misstatement of the ®nancial statements might be present. Examples of phrases used by sub-jects that were considered to be indicative of inten-tional misstatement are ``manipulation,'' ``padding,'' ``arti®cially in¯ate,'' ``suspicion of improper cost deferment,'' and ``fraudulent reporting.'' Table 9 reports the percentages of auditors in each group that used language in their analytical review Table 6
Mean risk assessments from risk assessment task (standard deviation) [n=119]
Managers Seniors
Risks Fraud [n=28] No fraud [n=33] Fraud [n=29] No fraud [n=29]
Departure from GAAP 7.68 (1.39) 4.86 (2.07) 5.67 (1.91) 5.90 (1.82) Material error 7.82 (0.86) 4.83 (1.77) 5.55 (1.66) 6.00 (1.77) Material uncertainty 5.79 (2.25) 4.45 (2.21) 5.24 (1.82) 5.90 (2.02) Contingent liability 6.00 (2.21) 4.24 (1.86) 5.19 (2.24) 6.17 (1.91) Consistency problem 8.39 (1.07) 5.14 (2.07) 6.79 (1.78) 6.58 (1.76) Fraud 6.11 (2.01) 3.83 (1.44) 3.85 (1.86) 4.52 (1.70)
Table 7
Signi®cance summary from tests of simple main eects on other risk factors
GAAP Error Uncertainty Contingency Consistency
responses indicating that the ®nancial statements might be intentionally misstated.
Two things can be observed from these percen-tages. More managers in the fraud treatments used the ``fraud terminology'' than did seniors in the fraud treatments, supporting the results of H1. Generally, more auditors with explicit fraud risk assessment instructions used ``fraud terminology'' than did auditors in the no instruction conditions. The one exception to this was seniors in the fraud condition. This is consistent with prior results. Additionally, it is interesting to note that neither seniors nor managers in the no fraud/no instruction treatments used ``fraud terminology.''
5. Summary and conclusions
This study provides empirical tests of the eects of experience and explicit fraud risk assessment instructions on auditors' ability to use analytical procedures to eectively assess the risk of fraudu-lent ®nancial reporting. Audit managers and
seniors were asked to read either a fraud case or a no fraud case, perform an analytical procedures task, and provide fraud risk assessments. With respect to experience, audit managers were sig-ni®cantly more eective in assessing the risk of ®nancial statement fraud with analytical proce-dures than were audit seniors, i.e. managers asses-sed the risk of fraud as high when fraud was present and low when fraud was not present. In contrast, the risk assessments of audit seniors did not dier signi®cantly when fraud was or was not present.
With respect to explicit fraud risk assessment instructions, the results indicate that auditors' fraud risk assessments are more eective when explicit fraud risk assessment instructions are pre-sent than when they are not prepre-sent. Auditors with explicit instructions assessed the risk of fraud as high when fraud was present and low when fraud was not present. In contrast, auditors without explicit fraud risk assessment instructions did not assess the risk of fraud as signi®cantly dierent in either the fraud condition or the no fraud condition.
Table 8
Percentages of auditors identifying key misstated areas
Managers Seniors
Case misstatements Explicit fraud risk instruction (n=14)
No instruction (n=14)
Explicit fraud risk instruction (n=18)
No instruction (n=15)
Molds & dies overstatement 0.86 0.79 0.44 0.53 Machinery & equipment overstatement 0.64 0.57 0.33 0.20 Other assets overstatement 0.93 0.71 0.33 0.53 Cost of goods sold understatement 0.14 0.14 0.11 0.13 Selling, general, & adm. understatement 0.14 0.07 0.00 0.07 Change in accounting for tooling costs 0.86 0.50 0.33 0.47 Change in estimated lives of patents 0.86 0.43 0.33 0.27 Change in estimated lives of ®xed assets & salvage values 0.71 0.50 0.33 0.27
Table 9
Percentages of auditors using ``fraud terminology'' [n=119]
Managers Seniors
Fraud No fraud Fraud No fraud
Finally, the combination of greater experience and explicit fraud risk assessment instructions resulted in the most eective fraud risk assess-ments. Audit managers with explicit fraud risk assessment instructions were signi®cantly more eective in assessing the risk of fraud than were audit managers not receiving such instructions. All of the Big Five ®rms indicate that the fraud risk assessment required by SAS No. 82 must be per-formed or reviewed by the partner or manager. Future research might address dierences in the eectiveness of fraud risk assessments which are actually performed rather than reviewed by man-agers and partners.
Taken in total, the main ®nding of this study is that analytical procedures may be a useful audit technique for detecting fraud if it is performed by an auditor with adequate experience. The results of this study indicate that, on average, audit seniors are not eective in assessing the risk of fraud with analytical procedures. One potential reason for this ineectiveness may be that seniors do not yet possess the requisite knowledge for the task of fraud detection.
In addition, the current study adds to our understanding of the impact of SAS 82. Zimbel-man (1997) examined the eects of SAS 82 on audit eciency. His ®ndings indicate that the new audit standard will increase auditors' attention toward fraud risk and will increase their audit eort. The current study suggests that explicit fraud risk assessments, such as those required by the SAS 82, are useful in enhancing auditors' eectiveness in assessing fraud. An important fac-tor in detecting fraud is recognizing when the risk of fraud is high. Additionally, it is important for audit eciency to accurately assess the risk of fraud. Explicit fraud risk assessments appear to trigger an auditor's relevant knowledge, thereby directing his/her attention to the appropriate information in the ®nancial statements.
This study has extended previous audit research which has found knowledge dierences between experience levels of auditors (e.g. Christ, 1993; Knapp, 1995) and identi®ed that these dierences aect the task of fraud risk assessment. The results of this study may have potentially important implications for both the assignment of auditors
and the structuring of the task of analytical pro-cedures for the purpose of fraud risk assessment.
Appendix
Fraud and no fraud ®nancial statements
Following are the income statements and bal-ance sheets provided to the auditors in the ``fraud'' and ``no fraud'' cases. The key dierences between the two are in cost of goods sold, selling, general, and administrative expenses, accounts receivable, inventories, molds and dies, machinery and equip-ment, and other assets. In addition, the footnotes in the ``fraud'' case indicated a change in accounting for molds and dies, a change in the estimated useful lives of patents, a change in the estimated useful lives of ®xed assets, a change in recognizing salvage values, extended useful lives on molds and dies, and an unresolved lawsuit against the company.
Medical Products Company
Consolidated Income Statements (000s omitted)
Fraud Case
December 31,
19X3 19X2 19X1
Net sales $111,800 $86,214 $60,876
Cost of products sold 47,983 32,300 25,659 Selling, general, and adm. 45,015 37,740 23,935
Interest 5,898 4,063 3,403
98,896 74,103 52,997
Income before
income taxes 12,904 12,111 7,879
Income taxes 1,120 4,226 2,750
Net income $11,784 $7,885 $5,129
No Fraud Case
December 31,
19X3 19X2 19X1
Net sales $113,662 $82,602 $58,376
Cost of products sold 58,803 33,079 24,784 Selling, general, and adm. 49,042 37,743 23,902
Interest 5,898 4,063 3,403
Income before
income taxes (81) 7,717 6,287
Income taxes (3,394) 2,078 1,952
Net income $3,313 $5,639 $4,335
Medical Products Company Consolidated Balance Sheets (000s omitted)
Fraud Case
December 31,
19X3 19X2 19X1
Current assets
Cash $426 $1,243 $596
Receivables (net) 36,670 30,475 22,557 Inventories
Finished goods 29,216 9,860 5,685 Raw materials 26,053 21,473 8,518
55,269 31,333 14,203 Other current assets 7,914 1,567 1,820
Total current assets 100,279 64,618 39,176 Property, plant,
and equipment
Land 2,502 2,371 1,027
Buildings 32,416 18,511 13,019 Molds and dies 32,082 15,963 8,777 Machinery and
equipment 40,227 23,762 12,362 107,227 60,607 35,185 Allowance for
depreciation (14,953) (9,964) (6,340) 92,274 50,643 28,845
Other assets 14,786 3,842 2,499
Total assets $207,339 $119,103 $70,520
Current liabilities $18,675 $14,432 $13,413 Long-term debt 80,642 47,569 33,497 Deferred income taxes 7,466 2,956 1,384 Stockholders' equality 100,556 54,146 22,226
Total liabilities and stockholders' equity
$207,339 $119,103 $70,520
No Fraud Case
December 31,
19X3 19X2 19X1
Current assets
Cash $426 $1,243 $596
Receivables (net) 32,790 24,733 20,057
Inventories
Finished goods 31,880 12,161 6,935 Raw materials 26,053 21,473 8,518
57,933 33,634 15,453 Other current assets 7,796 1,567 1,904
Total current assets 98,945 61,177 38,010 Property, plant,
and equipment
Land 2,502 2,371 1,027
Buildings 32,416 18,511 13,019
Molds and dies 22,182 15,963 8,777 Machinery and
equipment 36,412 21,187 11,987
93,512 58,032 34,810 Allowance for
depreciation
(14,14) (9,666) (6,307)
79,388 48,366 28,845
Other assets 9,917 3,574 2,499
Total assets $188,250 $113,117 $69,012
Current liabilities $18,675 $13,927 $13,606 Long-term debt 80,642 47,569 33,497 Deferred income taxes 565 699 854 Stockholders' equity 88,368 50,922 21,055
Total liabilities and
stockholders' equity $188,250 $113,117 $69,012
Acknowledgements
We acknowledge the input from two anony-mous reviewers, as well as suggestions from Bart Ward, Mark Zimbelman, Steve Butler, Lee Will-inger, Dipankar Gosh and Chuck Gettys.
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