Auditors' Consideration of Material Income-Increasing versus Material Income-Decreasing Items during the Audit Process

Abstract

SUMMARY: We examine how auditors' consideration of material items is affected by each item's directional impact on income. Prior research indicates that auditors face greater litigation risk for non-detection of fraudulent income-increasing items compared to income-decreasing items. Therefore, we expect that auditors will spend greater cognitive effort evaluating material income-increasing (as opposed to income-decreasing) items, resulting in superior memories for such items. However, in an effort to direct auditors' attention to both increasing and decreasing material items, we manipulate whether or not auditors were asked to form expectations about the future effects of material items. Our results indicate that auditors' memories for income-increasing items are significantly greater than that for income-decreasing items when auditors are not asked to form expectations about the future effects of the items. However, this difference is not observed when auditors are asked to form expectations about future effects of each item. Furthermore, our results indicate that auditors are less likely to refer back to the work papers to verify the accuracy of income-decreasing items compared to income-increasing items. This suggests that auditors are not inclined to compensate for their poor memory of income-decreasing items by referring to working papers. However, it also suggests that auditors compensate for the greater risk associated with income-increasing items by requiring greater verification of such items. Data Availability: Contact the authors.

Impact of company level information on auditor conservatism

“…Second, auditors also face a greater litigation risk when they fail to detect false income-increasing items compared to false income-decreasing items (Heninger, 2001; Beaver, 1993; Lys and Watts, 1994), which in turn forces auditors to focus more on income-increasing items and make the auditor even more conservative when dealing with such items. The results of Desai and Gerard (2013) corroborate these findings and document that even within material items of similar magnitude, auditors focus more on income-increasing items compared to income-decreasing items.…”

“…While performing an audit, auditors tend to focus more on material items compared to non-material items (Sprinkle and Tubbs, 1998). Even within the material items, auditors tend to focus more on income-increasing items compared to income-decreasing items (Desai and Gerard, 2013). This is because auditors are trained to be more conservative (Basu, 1997) and also because the risk of litigation is significantly higher for failing to detect material income-increasing items compared to material income-decreasing items (Heninger, 2001).…”

“…The prior studies examining auditors’ consideration of audit information (Sprinkle and Tubbs, 1998; Desai and Gerard, 2013) do not manipulate the overall company-level factors to examine how such factors affect auditors’ evaluation of transaction-level details encountered during an audit. It is necessary to examine the impact of such factors on audit process because various accounting standards have endorsed the developing of an overall understanding of the business as an effective audit tool (American Institute of Certified Public Accountants, 2002; Schultz et al , 2010).…”

“…It is possible that in the absence of any information about such risks, auditors would, by default, approach an audit conservatively, i.e. spend a greater effort in verifying the accuracy of income-increasing items (Desai and Gerard, 2013). However, if such holistic information is available, auditors’ conservatism could be moderated by the presence of such information (irrespective of the type of transaction-level information being evaluated).…”

External Auditors' Judgment and Decision Making: An Audit Process Task Analysis

“…Desai and Gerard () focus on a more specific treatment rather than a more global mindset. The authors examine whether auditors' consideration of material items, as evidenced by recognition memories, is influenced by income increasing or decreasing material items.…”