Auditing: A Journal of Practice & Theory Vol. 31, No. 2 May 2012 pp.

1941

American Accounting Association DOI: 10.2308/ajpt-10239

The Joint Inuence of the Extent and Nature of Audit Evidence, Materiality Thresholds, and Misstatement Type on Achieved Audit Risk
David V. Budescu, Mark E. Peecher, and Ira Solomon
SUMMARY: We use simulation to investigate the joint effects of materiality, evidence extent, evidence nature, and misstatement type on achieved audit risk, i.e., the risk of undetected material financial statement misstatement due to error or fraud. Our primary results are fourfold. First, contrary to conventional audit wisdom, we show that elevating the extent of testing decreases achieved audit risk only under certain conditions and may well increase it. Second, reducing materiality (attempting to perform a more precise audit) can either enhance or jeopardize audit effectiveness. Third, learning about the quality of the internal controls over financial reporting not only can help the auditor to perform an integrated audit, but also helps the auditor to reach better judgments about the extent to which and how evidence from the auditee organizations management and/ or information systems may be distorted as a result of misstatement, reducing the risk that the auditor would be misled by such evidence. Fourth, when financial statements are biased intentionally due to fraud, it is especially important for the external auditor to supplement more traditional audit tests with tests that produce evidence that is less likely to be biased by management. Auditors who do not understand these four results run a heightened risk of compromising audit effectiveness. Keywords: audit risk; audit evidence; fraud; error; materiality; misstatement.

INTRODUCTION he external auditor lends credibility to nancial statements by attesting to the veracity of such statements relative to agreed-upon criteria (e.g., U.S. generally accepted accounting principles or International Financial Reporting Standards). The task faced by the external auditor at an operational level is to gather evidence of sufcient quantity and quality so as to support an opinion about such veracity. Audit evidence is obtained when the external auditor
David V. Budescu is at Professor at Fordham University, Mark E. Peecher is a Professor at the University of Illinois, and Ira Solomon is a Professor at Tulane University.
We thank Timothy Bell, Nonna Martinov-Bennie, Yoon Ju Kang, Robert Knechel, Rennie Radich, Hun Tong Tan, Ken Trotman, as well as workshop participants at The University of Kansas Auditing Symposium, Macquarie University, and Nanyang Technological University for helpful comments. We also thank the KPMG Foundation for funding this project. Editors note: Accepted by Ken Trotman.

Submitted: March 2011 Accepted: November 2011 Published Online: February 2012

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performs audit procedures and interprets information acquired in light of specialized knowledge about the auditee organizations business and industry. While professional and regulatory standards provide some guidance, the external auditor must determine the quantity and quality of such procedures and of resultant audit evidence. If the evidence on which the auditors opinion rests was inadequate, achieved audit risk could very well exceed planned levels. We seek to raise the awareness of audit practitioners, researchers, standard setters, and regulators to factors that heretofore have not been fully recognized in terms of how they jointly affect achieved audit risk. We use simulation to model how achieved audit risk depends jointly on the extent and nature of audit evidence, materiality levels, and the type of misstatements that may distort an organizations nancial statements. An important observation we make is that the same phenomena that ultimately cause misstatements to arise in nancial statements also can taint the evidence that auditors use to evaluate assertions made by management, with different misstatement types having different implications for the degree to which audit evidence becomes distorted and, thus, for the auditors ability to achieve the low levels of audit risk that they target. We report four main results. First, we show that increasing the extent of testing decreases achieved audit risk only under certain conditions and actually can increase it. This nding signicantly qualies the historical perspective that, generally, an inverse relation exists between the extent of evidence and achieved audit risk, at least as has been discussed in audit standards. This nding is signicant also because, as discussed in prior research, the most common way auditors try to mitigate against heightened risk of material misstatement is by increasing the extent of evidence (Bedard et al. 1999; Chen et al. 2011). Second, reducing materiality levels (i.e., for a more precise audit) may or may not enhance audit effectiveness as, depending on the nature and extent of evidence and misstatement type, achieved audit risk actually can be increased rather than decreased. Third, learning about the quality of the internal controls over nancial reporting not only helps the auditor to perform an integrated audit, but also can help the auditor to better judge the extent to which evidence from the auditee organizations nancial reporting systems may be distorted as a result of intentional or unintentional misstatement. Fourth, when nancial statements are distorted due to fraud, it is essential for the auditor to supplement more traditional audit tests with tests that produce evidence of a nature that is relatively unlikely to be biased by management. Collectively, these results reveal how these four factorsmisstatement type, the nature and extent of audit evidence, and materiality thresholdsinteract to collectively help or hinder the auditors attempt to attain targeted levels of achieved audit risk. The rest of this paper unfolds as follows: In the second section we discuss background literature on the assessment of audit risk. In the third and fourth sections, we identify assumptions underlying our simulation and discuss our simulation context, independent variables, and dependent variable. We provide theory and illustrative results in the fth section, and in the last section we provide conclusions and implications for future research. BACKGROUND LITERATURE Much of todays thinking about audit risk assessment and management has roots in the Committee on Audit Procedures audit risk model (ARM) (see AICPA 1972, SAP No. 54).1 Initially, the ARMs scope was relatively narrow, guiding auditors evidence extent decisions in statistical sampling contexts. Over time, however, auditors application of the intuition underlying the ARM evolved to the
1

As reviewed in Nelson and Tan (2005), prior research identies several ways in which the algebraic formulation of the ARM can cause under-estimation of audit risk (e.g., Cushing and Loebbecke 1983). We are not primarily interested in further critiquing the documented shortcomings of the algebraic specication of the ARM, but we are interested in challenging the idea that current thinking about audit risk assessment and management is sufciently rich to help auditors plan and execute the audit.

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point at which it became the descriptive lens by which they planned and executed the audit (e.g., Ashton 1974; Joyce 1976; Gaumnitz et al. 1982; Jiambalvo and Waller 1984; Libby et al. 1985; Hackenbrack and Knechel 1997; Allen et al. 2006).2 A most salient aspect of the ARMs underlying intuition is that the auditor must compensate for the pre-audit assessed risk of material misstatement (RMM) by sufciently lowering detection risk (e.g., Houston et al. 1999; Bell et al. 2005; Allen et al. 2006). Lowering detection risk is accomplished by increasing the persuasiveness of evidence that, in turn, occurs as a result of increasing its quality (nature) and/or quantity (extent) (see, e.g., Mautz and Sharaf 1961).3 It is commonly pointed out in audit standards, textbooks, and articles that a greater extent of evidence increases persuasiveness (e.g., Houston et al. 1999), although the incremental persuasiveness from a larger sample rather quickly asymptotes (cf. Matsumura and Tucker 1992; Sedlmeier 2006). The overarching perspective in current audit standards is that more audit evidence may reduce or, at worst, have no effect on achieved audit risk (see, e.g., AS No. 13, paragraph 42 [PCAOB 2010a] and ISA 330.A15 [IFAC 2010]); we are unaware of any discussion in extant audit standards to the effect that more extensive evidence can increase audit risk.4 Scholars have long noted that the ARM can cause under-estimation of the risk of material misstatement due to fraud (Fellingham and Newman 1985; Shibano 1990), and there recently has been substantial increase of concern among scholars, regulators, and standard setters along these lines (e.g., Bell et al. 2005; PCAOB 2005, 2007a, 2007b; Popova 2008). This renewed focus has helped to identify new reasons why fraud risk may be under-estimated (e.g., Povel et al. 2007; Popova 2008). Povel et al. (2007) argue that fraud risk can increase precisely under conditions in which the ARM is likely to lead to lower fraud-risk assessments, such as when monitoring costs decrease. Popova (2008) shows that auditors provide higher assessments of RMM after decomposing it into RMM-error and RMM-fraud than after traditionally decomposing it into inherent risk (IR) and control risk (CR). Bell et al. (2005) argue that the compensatory, reductionistic conceptualization that comes to ones mind when studying the traditional ARM (especially in its algebraic form) takes the spotlight off of the more fundamental issues of how and the conditions under which auditors should use different congurations of audit evidence to assess and manage audit risk. Finally, regulators, based on their inspections of audit working papers, have criticized auditors for insufciently and mechanically responding to key fraud risk factors (PCAOB 2007b). Two key research questions we address are: how robustly does the application of the ARM lead to satisfactorily low levels of achieved audit risk, and is fraud the only kind of misstatement for which the utility of the ARM is suspect? Our simulation suggests that a useful way to assess and manage audit risk is to more fully recognize that it is not only nancial statements that may be misstated, but also the evidence available to the auditor that is subject to distortions by misstatements. It is vital to carefully map from different misstatements to different patterns of distortions in different kinds of audit evidence.
2

3 4

This evolution is evident in that language in SAP 54 appears in numerous extant auditing standards. The AICPA (e.g., SAS 107, AICPA 2006), PCAOB (via AS 8 through AS 15), and International Auditing and Assurance Standards Board (IAASB) (see, e.g., IFAC 2010) all use terms found in SAP No. 54, although denitions have been rened. The IAASB denes audit risk as the risk that the auditor expresses an inappropriate audit opinion when the nancial statements are materially misstated, and characterizes it as a function of the risk of material misstatement (i.e., the risk that the nancial statements are materially misstated prior to the audit) and detection risk (i.e., the risk that the auditor will not detect misstatements that could be material individually or when aggregated with other misstatements). They also characterize the risk of material misstatement as a function of inherent risk and control risk. We fold the timing of evidence into the nature of evidence for expositional purposes. A link might be drawn between extensive increases in the extent of testing and heightened risk of auditor judgment error, but we do not focus on auditor judgment risk in this paper (cf. Solomon and Shields 1995; Nelson and Tan 2005), nor do we address the facets of auditors being circumspect about their own judgments (Bell et al. 2005; Grenier 2010; Nelson 2009; Peecher et al. 2010). Finally, we also do not address how auditee management might react to substantive evidence of a different nature or extent, to different materiality thresholds, or to heightened auditor skepticism (but see, e.g., Chen et al. 2011).

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ASSUMPTIONS UNDERLYING OUR SIMULATION In this section, we characterize the nancial reporting process and discuss misstatement types, nature and extent of evidence, evidence persuasiveness, and implications of different types of misstatement for evidence persuasiveness. This discussion provides the foundation for our discussion of simulation context, independent variables, and dependent variable in the next section. The Financial Reporting Process Exhibit 1 provides one way to model the nancial reporting process (Bell et al. 2005; Peecher et al. 2007). According to this model, nancial statements contain management business representations (MBR). Management asserts that these representations faithfully depict underlying entity business states (EBS). These consist of all past, present, and future (probabilistic) transactions; business strategies; business processes; business conditions; and economic events, including the entitys relationships with other entities (e.g., customers, suppliers, regulators, creditors, and investors). To faithfully capture and represent EBS in nancial statements management, if honest, aspires to properly use certain management information intermediaries (MII). There are two basic kinds of MII. One kind is concerned with the preparation and reliability of nancial statements and consists primarily of traditional internal controls over nancial reporting (ICOFR), nancial accounting standards, and supporting personnel (e.g., bookkeepers, internal auditors, controllers).5 We label this kind of MII as MII-FR, to denote its nancial reporting emphasis. Management uses the other kind of MII primarily to help make key strategic, operating, business-process, and investing decisions. It consists of enterprise-wide information systems and most of the entities operating and executive personnel (e.g., sales and marketing representatives, production workers, middle and plant managers, research and development personnel). We use MII-NFR for this subset of MII, to emphasize it is not primarily related to nancial reporting. Some examples of EBS, MII-NFR, and MII-FR evidence appear at the bottom of Exhibit 1. There are other ways one could capture key elements of the nancial reporting process, but an advantage of this approach is its well-established theoretical heritage from psychology, specically from Brunswiks (1955) lens model. This lens model schematically represents how organisms (e.g., auditee management) use a different fallible lens (here MII-FR and MII-NFR) to try to capture, monitor, and interpret a (potentially large and dynamic) set of cues about what has gone on, is going on, or will go on, within some underlying environment (e.g., EBS). The quality of the organisms lens is critical inasmuch as its interpretations of the environment, not the environment itself, determine the organisms attributions, conclusions, forecasts, diagnoses, communications, etc., about the underlying environment (see, e.g., Hammond and Stewart 2001). The quality of the lens used to interpret an underlying environment varies across organisms and within an organism over time. Another way to think of the external auditors professional responsibilities, therefore, is that they must verify the quality of the lens being used as well as the outputs from that lens.6

Auditing Standard No. 5 denes internal control over nancial reporting as a process designed . . . and effected by the companys board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of nancial reporting and the preparation of nancial statements for external purposes in accordance with GAAP (PCAOB 2007, Appendix A, A5). While the Brunswik lens model has served as theoretical framework for a large stream of audit research, i.e., specically to conduct policy-capturing studies and, later, process tracing methods of auditors judgments, we are unaware of an instance in which it has been tapped to help model the entire nancial reporting process (for a review see, e.g., Solomon and Shields [1995]).

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EXHIBIT 1 Evidence Nature Proxied by Sources of Evidence in Bell et al. (2005)

Entity business states (EBS) are all of the entitys business strategies, conditions, processes, and economic actions/events, as well as past, current, and likely future business relationships with other entities. The nancial statement auditors concern extends to the subset of EBS of potential relevance to any assertion(s) associated with the entitys nancial statements. Managements information intermediaries can be conceptually divided into those that transform selected EBS for nancial reporting purposes (MII-FR) and those that transform the same selected EBS, related EBS, or different EBS for strategic or resource allocations or to monitor operations. MBR are the asserted nancial statement numbers along with the underlying journals and ledgers (or computerized analog).

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Misstatement Types Assuming management is honest, material misstatements in nancial statements originate because managements understanding of EBS, which depends on the quality of MII-FR (including ICOFR) and of MII-NFR (including business process controls), is always to some degree impoverished. Even honest management teams have bounded rationality, and thus are subject to both judgment bias and random judgment error. Management likewise creates or purchases information systems that are at least to some degree imperfect and, thus, are subject to bias and/or random processing errors. In addition, there always is the possibility that management is dishonest, so there may be intentional bias not only in managements nancial statements, but also in fallacious judgments and information system outputs that they could employ to dupe auditors and investors. While there are numerous specic types of nancial statement errors and frauds that occur, and/ or at least are detected with various frequencies across particular industries (e.g., Ashton 1991; ACFE 2010; Beasley et al. 2010), we distinguish three general types: (1) unintentional misstatements due to random errors in management judgments or information system outputs, (2) unintentional misstatements due to bias in management judgments or information systems, and (3) intentional misstatements due to fraud.7 Unintentional bias can manifest in nancial statements, especially in complex estimates (e.g., Peecher et al. 2010), due to phenomena such as motivated reasoning, egocentric bias, and conrmation proneness by management (see, e.g., Solomon and Shields 1995). Unlike unintentional misstatements due to random error, which tend to mean revert over time (e.g., an undetected cutoff error that overstates revenue this year will understate next years revenue), unintentional misstatements due to bias can persist and accumulate over time (causing, for example, lease-related restatements among restaurants, retailers, and wireless telephone companies during the early 2000s).8 The Extent and Nature of Evidence Audit standards, textbooks, and prior research emphasize that, to increase evidence persuasiveness, auditors can gather evidence to greater extent, of a different nature, or both (Mock and Wright 1993, 1999; OKeefe et al. 1994; Elder and Allen 2003; PCAOB 2010a, 2010b). Taking this notion as given and combining it with the Bell et al. (2005) characterization of nancial reporting,9 the auditor ascertains whether material misstatements exist in nancial statement MBR, by varying the extent and/or nature of evidence.
7

Audit standards and textbooks usually speak in terms of two general types of misstatement: unintentional (errors) and intentional (fraud). Some unintentional misstatements, however, will contaminate audit evidence in a manner that is similar to the way that fraud does because of systematic bias due to phenomena such as motivated reasoning and conrmation proneness, some of which occurs at the subconscious level. Evidence consistent with unintentional bias exists in Kinney and Martin (1994), inasmuch as auditorrecommended adjustments tend to decrease pre-audit gures by multiples of materiality. If random error were the only issue, auditor-recommended adjustments would tend to be just as likely to increase or decrease pre-audit gures. It conceivably and alternatively could be the case that unintentional misstatements occur more as a result of random error, but the auditor more frequently nds and asks management to adjust overstatement realizations of random error. The main results of our model and simulation are not dependent on our evidence categories of EBS, MII-FR, MII-NFR, and MBR from Bell et al. (2005), and there are alternative ways to categorize audit evidence of varying nature. Audit textbooks sometimes allude to nature of the audit procedureconrmations, inquiry, analytical procedures, etc.as a way to vary the nature of audit evidence (see, e.g., Messier et al. 2012). We use the Bell et al. (2005) approach mostly because it provides a convenient way to illustrate how bias and noise can vary across alternate sources of evidence, because of its simplicity and tractability, and because of its articulation with the Brunswikian framework.

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The auditor increases the extent of evidence by making more ventures into evidence of a given nature. The venture construct refers to an ensemble of audit procedures, some of which might require sampling and others might not (e.g., analytics, inquiry, walk-throughs, interviews). If the auditor performs this ensemble of procedures once, the auditor will have made one venture into the evidence space. Finally, in our model and simulation, there is just one assertion.10 As such, the auditor can vary the nature of audit evidence by strategically deciding to venture into EBS, MII-FR evidence, MIINFR, or hybrids of these three. Evidence Persuasiveness Our proxy for evidence persuasiveness is how diagnostic it is of the true value that should appear in MBR, or the representations that ought to appear in managements nancial statements, if conditioned on a perfect, complete understanding of EBS. We proxy for how diagnostic evidence is by the bias and noise present in the evidence (cf. Hogarth 1978; Birnbaum and Stegner 1979; Soll 1999).11 Auditors acquire evidence of a given nature by venturing into EBS, MII-NFR, MII-FR, or combinations thereof, and each venture provides the auditor with a signal. Consistent with reasonable assurance, however, acquired signals collectively provide only imperfect, incomplete pictures of EBS. When the auditor makes more than one venture into evidence, the overall persuasiveness of evidence is an equally weighted aggregation of signals obtained from all the sources of evidence examined. That is, if the auditor makes three ventures into the evidence and receives similar signals from two of these ventures, but a different signal from the third, the auditor still would weight each signal to the same degree.12 This aggregation determines the auditors normative expectations of the true value that management should report to fairly capture the underlying EBS. The auditor compares this expectation against managements asserted representation, in light of judged materiality, to reach an opinion of whether a material misstatement exists.13 The auditor varies the nature of evidence by combining evidence from EBS, MII-FR, and MIINFR to corroborate or dispute values in MBR reported in nancial statements. Combining evidence
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If there were two or more assertions, the auditor could also venture into MBR, to ensure the inter-assertion correlations make sense (e.g., credit sales tend to increase the balance of accounts receivable). Bias refers to systematic error, or the degree to which the expected signal from a source of evidence does not equal the true value, and noise refers to random error or the variance in signals one would get from a source of evidence with multiple ventures (Einhorn et al. 1977). To clarify differences between bias and noise, it may be useful to consider two scales. Scale 1 is biased but has zero noise, and Scale 2 has zero bias but is noisy. Scale 1 always weighs people as 5 pounds less than their true weight. An implication of zero noise is that if you knew the magnitude of Scale 1s bias, you could deduce a persons true weight after just one measure. Scale 2 is subject only to random error. On average, it gives an unbiased measure of true weight, but its measures randomly uctuate by up to 3 pounds on either side of a persons true weight. So, a person who actually weighs 180 could step on Scale 2 ve times and receive readings of 183, 178, 180, 177, 182. As a result, even if you knew about the magnitude of Scale 2s non-systematic error, you could not know a persons weight after one measurement. To obtain a good estimate of true weight, you could measure a person on Scale 2 repeatedly and take the average reading. Alternate evidence weighting approaches could be used but would make our simulation unnecessarily more complex. Our simple approach also is biased against supporting the value of evidentiary triangulation, as discussed in Bell et al. (2005). They advocate for an approach whereby an auditor, using professional judgment, would reduce the weight accorded MII-FR evidence that ostensibly supports an inated asserted level of revenue when MII-NFR and EBS each indicate that a materially lower level of revenue should be reported. Our auditor equally weights all sources of evidence, regardless of these kinds of discrepancies. We do not consider the relative cost of acquiring different evidence sets, nor do we consider the cost to the auditor, investors, or others of issuing an incorrect unqualied audit report. That is, in this paper we do not attempt to measure auditor utility or social welfare.

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amplies strengths and mitigates weaknesses associated with evidence of a given nature, and provides a more rigorous test of managements nancial statement assertions.14 If MBR in nancial statements completely and accurately portray EBS, signals coming from evidence differing in nature would converge. That is, if gathered to a sufcient extent, they would contain the same overall message: no material misstatement exists. If the auditor obtains conicting signals from evidence differing in nature, however, there would be elevated concern that a material misstatement exists. Implications of Misstatement Types for Evidence Persuasiveness In considering differences across EBS, MII-NFR, and MII-FR evidence, it is useful to consider implications of the misstatement type of primary concern. If management has committed fraud, it is likely that management (unless incompetent) also will attempt to conceal it with strategic manipulation of evidence under its control (Fellingham and Newman 1985; Wilks and Zimbelman 2004; Bell et al. 2005). Such concealments almost certainly would distort MII-FR evidence.15 In comparison to the incidence rate of material misstatement due to fraud (e.g., Dyck et al. 2011), the incidence rate of material misstatement due to unintentional bias likely is higher. Thus, the auditor also nds it useful to consider what evidence is likely to be contaminated when nancial statements are materially misstated as a result of unintentional bias on managements part. Since management relies extensively and perhaps exclusively on MII-FR to generate nancial statements, it is likely that MII-FR evidence is itself biased. In such circumstances, the auditor is ill advised to rely extensively on MII-FR evidence and should signicantly rely on EBS and MII-NFR evidence. Keep in mind that MII-NFR evidence, although under managements control, originates and continues to exist to help management make better strategic and operating decisionsdecisions qualitatively removed from the nancial statement preparation process (MII-NFR). Finally, if unintentional material misstatement exists as a result of random error in managements judgments or MII outputs, the likelihood that MII-FR is biased does not appreciably increase. It is, however, more likely that MII-FR is noisier when a material misstatement is caused by random error compared to when no material misstatement exists. Based on these rationales we make the following ordinal assumptions about relative bias and noise across MII-FR, MII-NFR, and EBS given different types of misstatement. Bias is the difference between the mean signal provided by the evidence and the assertions true value, and noise is the standard deviation (r) of evidences signal. For cases of fraud and unintentional misstatement due to bias: Bias MII-FR . Bias MII-NFR . Bias EBS and r MII-NFR r MII-FR r EBS. For cases of unintentional misstatement due to random error in management judgment or information system outputs: Bias MII-FR Bias MII-NFR . Bias EBS and r MII-NFR r MIIFR r EBS. In addition, we assume that bias in MII-FR and MII-NFR tends to be higher conditional on fraud than on unintentional misstatement due to bias or random noise. We can offer some further anecdotal and eld-based support for these ordinal assumptions, starting with noise. It is commonly argued that while industry or strategic analyses of an
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Using EBS, MII-FR, and MII-NFR to verify or refute MBR assertions has been called triangulation (Bell et al. 2005; Peecher et al. 2007), with the triangulation term emphasizing how strengths and weaknesses of evidence vary with its nature. An emerging series of research examine determinants of auditors (lack of ) prociency at triangulation (e.g., Harding and Zhao 2010; Trotman and Wright 2012). Social scientists use the triangulation term to connote a similar idea, as combining diverse research methods with different strengths and weaknesses enables more rigorous tests of scientic hypotheses (cf. Harvey et al. 2000). Luft (2009) does not use the triangulation term but emphasizes a similar idea: that studying non-nancial performance measures can help one better understand implications of nancial measures. There are numerous examples of blatant strategic manipulation of evidenceMII-FR, MII-NFR, and even EBS evidence (see, e.g., Domanick 1989; Erickson et al. 2000).

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organizations business operations, risks, and strategic positioning provide insightful and potentially new perspectives about audited entities, these analyses also can provide relatively noisy signals of normative nancial statement assertions or the optimal mix of audit procedures (Eilifsen et al. 2001; Power 2007; Luft 2009). A related concern is that EBS evidence presents auditors with noisy signals about whether they can gather less extensive amounts of evidence of a different (i.e., traditional) nature (Curtis and Turley 2007). According to this concern, the greater noise caused by relying on EBS evidence would lead to higher incidence of false positives or false negatives in auditors opinions. Turning to the relative noise in MII-NFR versus in MII-FR, management arguably desires reliable information systems to a greater degree with respect to guiding their strategic, resource-allocation, and operational decisions than their nancial reporting decisions (see, e.g., Jensen and Meckling 1976; Harrington 1991; Brickley et al. 2001). With respect to bias, we assume that EBS evidence is the least biased (Bell et al. 2005). We can further rely on the earnings management literature, which suggests that MII-FR, the primary management source for MBR assertions, provides evidence that tends to be optimistic (e.g., Schipper 1989; Graham et al. 2005). It is also worth noting that our assumptions of relatively low bias for MII-NFR and EBS are supported by recent research showing that non-nancial performance indicators that signal a different story than nancial statement measures are diagnostic of fraud (Brazel et al. 2009). SIMULATION CONTEXT, INDEPENDENT VARIABLES, AND DEPENDENT VARIABLE Overview We use a simple context in which there is just one MBR assertion, i.e., revenue. The true revenueor the revenue warranted based on EBS and in accord with a prevailing accounting frameworkis $10.2 billion ($10.2b). Independent Variables We manipulate four factors: quantitative materiality, evidence extent, evidence nature, and misstatement type. We discuss these in turn. The manipulation of quantitative materiality is at six levels, operationalized as six percentages of true revenue (0.5 percent, 1 percent, 1.5 percent, 2 percent, 3 percent, and 5 percent). These six levels include both commonly used materiality thresholds for revenue (e.g., 0.5 percent to 1 percent of revenue) (see Acito et al. 2009; Messier et al. 2005), but also more generous thresholds (e.g., 2 percent to 5 percent of revenue). We manipulate evidence extent at two levels, at one versus six ventures. These two levels create a powerful but realistic manipulation, in the sense that one level gives noise its maximum chance to affect achieved audit risk and the other level gives noise a qualitatively lower, although still non-trivial chance.16 Further, we nest our manipulation of evidence nature within each level of evidence extent. That is, for the one-venture level of evidence extent, evidence nature is manipulated at three levels (MII-FR, MII-NFR, EBS). For the six-venture levels of evidence extent, we examine four hybrid levels of evidence nature (3 MII-FR and 3 MII-NFR; 3 MII-FR and 3 EBS; 3 MII-NFR and 3 EBS, 2 from each).
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This is true because our auditor randomly draws signals from evidence sources that have a normal distribution, n ; (l, r), and this means the auditors distribution of signals is also normal, n ; (l, r/=n). Thus, the noisiness of the signal the auditor draws given six ventures is a bit less than half that given one venture (specically 41 percent 1/=6).

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Misstatement type is manipulated at two levels: an unintentional overstatement due to biased estimates and an intentional overstatement due to fraud. As one would do in an experimental study, we pick specic parameters for each level of the misstatement type manipulation, such that they are both reasonable given the ecology to which we want our theory to generalize and sufciently large to help ensure a reasonable powerful manipulation (Kerlinger and Lee 2000). To do so, we implement both a different magnitude of bias in the MBR revenue assertion (2 percent given unintentional misstatement due to bias versus 10 percent given fraud) and by having a different pattern of bias and noise across different kinds of evidence (i.e., in MII-FR, MII-NFR, and EBS). More specically, we operationalize the 2 percent unintentional overstatement as asserted revenue of $10.4 billion, with the 2 percent translating into it being $0.2b too high. Evidence from EBS is unbiased but also relatively noisy, EBS bias $0.0b and EBS s $0.32b (i.e., bias 0 percent and noise 3.2 percent). Compared to MII-FR, company management is more careful with MII-NFR, because this information forms the foundational basis for making strategic decisions, monitoring business operations, and allocating resources. The particular parameter we choose for bias in MII-NFR is $0.05b (i.e., 0.5 percent instead of 2 percent). For noise, we choose 0.8 percent for MII-NFR (i.e., $0.08b) and 1.6 percent for MII-FR (i.e., $0.16b). Thus, for noise, we simply use multiples of 13, 23, and 43 going from MII-NFR ($0.08b), MII-FR ($0.16b), to EBS ($0.32b).17 Exhibit 2, Panel A illustrates distributions of EBS, MII-FR, and MII-NFR evidence for these parameters associated with an unintentional misstatement due to bias. In the misstatement type level that features an intentional misstatement due to fraud, a different magnitude of MBR bias and pattern of bias and noise exists across the evidence available to the auditors. Management fraudulently asserts revenue of $11.22b, which is a $1.02b, or 10 percent, overstatement of actual gross revenue. The fraud does not change the bias and noise parameters EBS evidence from the unintentional misstatement level. Nor does fraud increase noise parameters for MII-FR and MII-NFR. The absolute and relative levels of bias in MII-NFR and MII-FR, however, do increase for the fraud level. MII-NFR now has a bias of $0.10b, or 1 percent of actual revenue, or twice the bias as in the unintentional misstatement case. MII-FR now has bias of $1.02b, or 10 percent of actual revenue, which is ve times as large as in the unintentional misstatement case. Bias increases in MII-FR because management is trying to conceal fraud and expects the auditor to obtain and examine MII-FR evidence. Concealment is facilitated when MII-FR provides evidence that appears to corroborate managements revenue as asserted in MBR. Bias increases, albeit to a lesser degree in MII-NFR. The modest increase in MII-NFR bias is reasonable, as management presumably has stronger directional goals when fraud occurs, which cause their MII-NFR to be subject to greater unintentional motivated reasoning bias (even if management does not strategically fabricate MIINFR evidence in anticipation of the auditor examining MII-NFR).18 Exhibit 2, Panel B illustrates the distributions of EBS, MII-FR, and MII-NFR evidence for the fraud level of misstatement type.

17

18

Our estimates of noise are more difcult to support with empirical referents than are our estimates of bias. While the noise parameters we choose for illustrative purposes are arbitrary, they also help ensure a powerful manipulation of the nature of evidence. Empirical evidence of alleged instances of fraud provide support for our assumed bias of 10 percent of revenue. For example, Beasley et al. (2010) report a median alleged fraud of just over $12 million and total revenues of just below $100 million in their sample of 347 rms alleged by the SEC to have fraudulent nancial statements during the period 19982007. Although fraud likely is less common than errors, recent evidence suggests its incidence rate could be considerably higher than previously thought (Dyck et al. 2011). Dyck et al. 2011 estimate that among large public companies, 7 percent start a new, multi-period fraud each year so that, on an ongoing basis, fraud exists at between 11.2 percent and 13.2 percent of rms.

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EXHIBIT 2 Misstatement Type Manipulation Panel A: 2 Percent Overstatement in MBR Due to Unintentional Bias

The assumptions for this gure are that EBS $10.20; MBR $10.40.
Source of Evidence EBS (solid line) MII-NFR (dashed line) MII-FR (dotted line) Bias $0.00 or 0% $0.05 or % $0.20 or 2% Noise $0.32 or 3.2% $0.08 or 0.8% $0.16 or 1.6%

Percentages in table are with respect to the true value of revenue. EBS refers to entity business states. These include all of the entitys business strategies, conditions, processes, and economic actions/events and business transactions, as well as past, current, and likely future business relationships with other entities. The nancial statement auditors concern extends to the subset of EBS of potential relevance to any assertion(s) associated with the entitys nancial statements. MII-NFR and MII-FR refer to managements information intermediaries. MII are conceptually divided into those that transform selected EBS for nancial reporting purposes (MII-FR) and those that transform the same selected EBS or different EBS for strategic or resource allocations or to monitor operations. MBR are the asserted nancial statement numbers along with the underlying journals and ledgers (or computerized analog).

(continued on next page)

Dependent Variable Our dependent variable is achieved audit risk. We compute achieved audit risk as the probability that the auditors normative expectation for revenue departs from the true value ($10.2b) by at least a material amount. More specically, achieved audit risk ows from a single, random draw from a specic bivariate normal distribution from Exhibit 2 if evidence extent is one venture, or from a combination of draws from multiple bivariate normal distributions from Exhibit 2 if evidence extent is six ventures. We
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EXHIBIT 2 (continued) Panel B: 10 Percent Overstatement in MBR Due to Fraud (Intentional Bias)

The assumptions for this gure are that EBS $10.20; MBR $11.22.
Source of Evidence EBS (solid line) MII-NFR (dashed line) MII-FR (dotted line) Bias $0.00 or 0% $0.10 or 1% $1.02 or 10% Noise $0.32 or 3.2% $0.08 or 0.8% $0.16 or 1.6%

Percentages in table are with respect to the true value of revenue. EBS refers to entity business states. These include all of the entitys business strategies, conditions, processes, and economic actions/events and business transactions, as well as past, current, and likely future business relationships with other entities. The nancial statement auditors concern extends to the subset of EBS of potential relevance to any assertion(s) associated with the entitys nancial statements. MII-NFR and MII-FR refer to managements information intermediaries. MII are conceptually divided into those that transform selected EBS for nancial reporting purposes (MII-FR) and those that transform the same selected EBS or different EBS for strategic or resource allocations or to monitor operations. MBR are the asserted nancial statement numbers along with the underlying journals and ledgers (or computerized analog).

rely on probability theory surrounding the behavior of multiple signals drawn from the same normal distribution and/or from combinations of normal distributions with different means and standard deviations, to compute how one versus multiple ventures from one source of evidence or multiple sources would converge to a given probability of detecting versus missing a material misstatement.19
19

It is not necessary to run bootstrapping or resampling techniques given the tractability of our assumptions. If we were to relax some of our assumptions, tractability would decrease so that computation alone may not sufce. For example, if we were to allow for different kinds of stochastic or systematic auditor judgment errors, for example, generation of empirical distributions and perhaps a different means of simulation, e.g., agent-based modeling (see Davis et al. 2003) would have greater potential appeal.

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If the auditors normative expectation for revenue were itself materially wrong in the overstatement direction, management would be able to report a materially overstated asserted amount. The gist is that audit risk accretes when the auditor assesses as too low the risk that managements revenue MBR is materially overstated in light of evidence collected.20 RESULTS Beginning with Figure 1, Panel A, we use line graphs that feature achieved audit risk on the y-axis and materiality levels ranging from 0.5 percent to 5 percent of revenues on the x-axis. Separate lines on each graph represent a different set of evidence. Thus, one can treat differences between where various lines appear within a given graph as an indicator of how different sets of evidence cause achieved audit risk to differ (y-axis), conditional on different materiality levels (x-axis) and the nature of misstatement. Figure 1, Panel A presents our simplest cases, plotting how achieved audit risk changes with materiality given either one venture (solid lines) or six ventures (dotted lines) into MII-FR. Panels B and C of Figure 1 depict the same comparative for one versus six ventures into MII-NFR and EBS, respectively. Several observations are in order. One, elevating the extent of audit evidence does not necessarily decrease and can even increase achieved audit risk (see Panel A of Figure 1). Observe that the position of the MII-FR line corresponds to higher audit risk for greater extent (six times the evidence) for materiality levels ranging from 0.5 percent to about 2 percent of revenues. It is not until materiality thresholds are above 2 percent of revenue that a greater extent of MII-FR evidence yields less audit risk than a lesser extent of MII-FR evidence. Turning to Panel B of Figure 1, a greater extent of evidence from MII-NFR does not strictly reduce audit risk (no decline in audit risk occurs for materiality of 0.5 percent of revenues). The only set of evidence for which substantially greater extent evidence strictly reduces audit risk for all graphed levels of materiality is EBS evidence (Figure 1, Panel C).21 A simple and yet generalizable explanation accounts for these results: For all instances in which the magnitude of evidence bias exceeds the materiality threshold, audit risk will increase as the extent of evidence increases. This results because increasing the extent of testing from biased but noisy evidence reduces the degree to which the noise in the evidence distorts the auditors normative expectation of an assertion, making it more likely that any bias in the evidence will distort the auditors normative expectation. Thus, the intuitively appealing idea described in current auditing standards (see, e.g., AS No. 13)that increasing the extent of evidence strictly decreases or, at worst, does not increase audit riskholds only under relatively restrictive conditions, i.e., only if the evidences bias is lower than the materiality threshold. Before discussing our next observation, it is worth distinguishing this observation about shortcomings to increasing evidence extent from the more established idea in audit sampling theory that if the auditor already believes a control failure rate exceeds the tolerable failure rate, the auditor generally will not test that control. A related established idea is that if the auditor conducting substantive tests believes the population misstatement rate to be greater than the tolerable misstatement rate, the auditor will either ask management to adjust their books or vastly increase sample size (and probably revise his or her beliefs midstream). In those situations the auditor is not
20

21

The auditor gives managements asserted revenue no weight in forming the normative expectation in our simulation. This design choice, given the presence of material misstatements, decreases achieved audit risk. Recall that our parameter for the amount of bias for MII-FR 2 percent and for MII-NFR 0.5 percent. Hence greater extent of evidence hurts (helps) for MII-FR (MII-NFR) for all materiality thresholds lower than 2 percent of revenue (0.5 percent of revenue).

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FIGURE 1 Effect of Evidence Extent Given 2 Percent Overstatement Due to Unintentional Bias Panel A: MII-FR Evidence

Panel B: MII-NFR Evidence

(continued on next page)

worried about the evidence failing to reveal deciencies or misstatements, should they exist. The expectation is that the evidence would all too often reveal deciencies or misstatements, and so the costs of testing likely exceed the benets. Here, however, we are referring to the more troubling possibility that the very evidence the auditor is relying on to reveal extant material misstatements fools the auditor. For the unintentional misstatement level of misstatement type manipulation, this evidence is the same evidence that
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FIGURE 1 (continued) Panel C: EBS Evidence

inadvertently caused a misstatement to arise in MBR. Conversely, for the fraud level of misstatement type, it largely is evidence that management has planted in MII-FR. As Bell et al. (2005, 34) discuss, when the concern is that fraud is present, merely collecting more of the same evidence is unlikely to help. Here we build on that argument to show that relying more extensively on biased evidence can increase achieved audit risk. Moving on to our next observation, even small increases in materiality, such as from 0.5 percent to 1 percent of revenues, can cause a widely different degree of decrease to occur in achieved audit risk. There is no simple or linear relation between materiality and audit risk. Consider the results in Panel A of Figure 2. The increase in materiality from 0.5 percent to 1 percent dramatically reduces achieved audit risk for MII-NFR, but less substantial drops in achieved audit risk occur for MII-FR and for EBS. The dual reason for the larger drop for MII-NFR is a rapid dissipation of the effects of noise (as it was the least noisy evidence to begin) and the fact that bias in MII-NFR, at 0.5 percent of revenues, is smaller than the bias in MBR and smaller than quantitative materiality of 1 percent of revenues. In contrast, the relatively small drop in achieved audit risk in MII-FR is predominantly caused by the fact that MII-FR bias, at 2 percent of revenues, exceeds materiality at both 0.5 percent and 1 percent of revenues. There is a different reason for the small drop in achieved audit risk for EBS evidence, as a bias of zero cannot distort the auditors normative expectations. Instead, the reason for the small reduction in achieved audit risk given EBS evidence is that the noise in EBS continues to problematically distort the auditors normative expectations of revenue.22
22

When achieved audit risk is quite sensitive to changes in materiality, management of auditor judgment error becomes all the more critical. Along these lines, we note that participants playing the role of auditors tend to make less accurate fraud risk assessments when their optimal audit strategies are especially sensitive to those assessments (Bloomeld 1997).

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FIGURE 2 Effect of Evidence Nature Given 2 Percent Overstatement Due to Unintentional Bias (Extent 63) Panel A: Constant Nature Evidence63

Panel B: Mixed Nature Evidence63

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We further illustrate the tradeoffs involved with different amounts of bias and noise in evidence, given different levels of materiality, in Figure 2, Panel B. There, we show results for evidence extent equaling six ventures and vary the nature of audit evidence via four different combinations of these three fundamental sources of evidence: 3 MII-FR and 3 MII-NFR; 3 MII-FR and 3 EBS; 3 MII-NFR and 3 EBS; or 2 MII-FR, 2 MII-NFR, and 2 EBS. Observe that combinations of evidence that do not rely on MII-FR, which is biased at $0.20, help the auditor form better normative expectations than those that weight MII-FR (biased at $0.05) or EBS (unbiased). The best combination of evidence relies on both MII-NFR and EBS evidence, but not at all on MII-FR evidence. It is not a simple case that less bias is always better, however. Again, whether EBS plus MII-FR versus MII-NFR plus MII-FR is better depends on a tradeoff between bias and noise in light of different materiality levels. In this illustration, one can see that for relatively small materiality levels, EBS evidence is better (i.e., for materiality levels from 0.5 percent to about 1.5 percent), but as the materiality threshold gets larger and approaches the bias level associated with MII-NFR evidence (around 2 percent), MII-NFR becomes better than EBS. The tipping point for the dominance of MII-NFR over EBS occurs near, and somewhat before, the equivalency of MII-NFR bias and materiality (i.e., at 1.5 percent instead of at the equivalency point of 2 percent). The reason MII-NFR begins to dominate before the equivalency point is that EBS is twice as noisy as MII-NFR. If MII-NFR and EBS had been equally noisy, a different result would occur. Specically, the tipping point would have occurred at a materiality threshold of 2 percent. In addition, if a still greater extent of evidence had been collected, the effects of larger noise in EBS would be ameliorated, so that the tipping point would be at a materiality threshold of 2 percent.23 Finally, in Figure 3, we contrast achieved audit risk based on six ventures into alternative sets of evidence conditioned on either the unintentional bias case (Panel A) or on the intentional bias (fraud) case. Panel B shows that in the case of fraud, relying on any set of evidence that includes MII-FR evidence makes it highly likely the auditor will miss the material misstatement and render an unqualied opinion despite material fraud. The reason for this result is that there is just too large of a difference between the 10 percent bias in MII-FR and the highest materiality threshold graphed, i.e., 5 percent. A perhaps counterintuitive observation is that greater noise in evidence actually can be desirable for evidence biased the same direction as an assertion is misstated. Noise makes it possible that, by chance, an auditors evidence-driven belief could be that a material misstatement exists. Observe that for low levels of materiality (i.e., 0.5 percent of revenues), there is an increase in achieved audit risk, even when the auditor relies on MII-NFR, when going from unintentional to intentional misstatement. CONCLUDING REMARKS In this paper, we use simulation to model how achieved audit risk depends jointly on the extent and nature of audit evidence, materiality levels, and the type of misstatements that may distort an organizations nancial statements. We provide four main results. First, we show that one of the
23

As bias and noise are jointly considered here, it is noteworthy that people frequently misunderstand how to trade off bias and noise in choosing whether and how much to acquire evidence from different sources to learn the most about true states of the world (e.g., Soll 1999). Generally, however, any two sets of evidence would have the same probability of detecting a misstatement if each set produced the same standard scores (i.e., Z-score). These scores, in turn, depend on four parameters: materiality (m), bias (b), noise (r), and the true value corresponding to an assertion (T). In particular, if Set1 and Set2 have different combinations of evidence from MII-FR, MII-NFR, and EBS, they will provide equal achieved audit risk when the ratio of the difference between materiality and signal bias, each expressed as a percentage of true value, equals the ratio of signal noise (i.e., [m/ T b1/T]/[m/T b2/T] r1/r2).

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FIGURE 3 Effect of Source of Misstatement (Unintentional Error versus Fraud) Panel A: 2 Percent Error Mixed Nature Evidence63

Panel B: 10 Percent Fraud Mixed Nature Evidence63

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most common ways to try to mitigate against heighted audit risk, i.e., increasing the extent of testing, reduces achieved audit risk only when the bias in audit evidence is less than quantitative materiality. We show that an increase in audit testing can increase achieved audit risk when the bias present in audit evidence exceeds quantitative materiality. The real possibility that more extensive audit testing can increase audit risk is not salient in extant audit standards or audit research. This nding also is interesting because it raises a new empirical question: How often is it reasonable, within natural audit situations, for auditors to believe that the bias in audit evidence is safely lower than their quantitative materiality levels? One factor that auditors should carefully consider in answering this question is the base rate of material fraudulent nancial reporting. Although difcult to estimate, the base rate of ongoing corporate fraud according to a recent study is estimated at 11.2 percent of U.S. publicly traded rms (Dyck et al. 2011). To the extent this estimate is valid, a professionally skeptical auditor would be well advised to anticipate that management at a U.S. publicly traded rm may well try to distort audit evidence under its control a little over 10 percent of the time.24 In answering this question, the auditor also needs to consider how often misstatements due to unintentional bias manifest (as may be common for complex estimates, or even systemic as in the banking crisis). When these kinds of misstatements emerge, the accounting information systems that provided management with overly optimistic signals are likely to also provide the auditor with optimistically distorted signals. Thus, in practice, assuming that collecting more evidence ordinarily will reduce audit risk may be tenuous; empirical research both of an archival and experimental nature is warranted to learn more about the conditions under which auditors are and/or should be concerned that more extensive evidence can increase audit risk. Second, reducing materiality (attempting to perform a more precise audit) may or may not enhance audit effectiveness as, depending on the evidence gathered and nature of misstatement, achieved audit risk actually can be increased rather than decreased. Third, learning about the quality of the internal controls over nancial reporting not only helps the auditor to perform an integrated audit, but also helps the auditor to better judge the extent to which and how evidence from the auditee organizations nancial reporting and other information systems may be distorted as a result of certain kinds of misstatement. Fourth, when nancial statements are distorted due to fraud, it is especially important for the external auditor to supplement more traditional audit tests with tests that produce evidence that is less likely to be biased by management. Collectively, these four primary results underscore that the presence of a material misstatement of a given nature has implications for whether and how the auditee management and/or nancial reporting system may have contaminated key subsets of the audit evidence available to the auditor for assessing and trying to manage audit risk. These four main results collectively have potential to embellish prior audit theory and practice with respect to how one should think about the sufciency, relevance, and reliability of audit evidence. The latter, for example, is sometimes dened as whether a particular type of evidence can be relied upon to signal the true state of an assertion (Messier et al. 2012). While bullet-point lists of cues to reliability appear in textbooks and standards (e.g., AS No. 15 [PCAOB 2010b])such as whether the source of evidence is knowledgeable or independent of management, the effectiveness of managements internal controls, the auditors direct knowledgewe are unaware of a systematic attempt to condition evidence reliability on misstatement types via the ensemble of intentional bias, unintentional bias, and random noise present in the evidence, together
24

Dyck et al. (2011) derive this estimate via Bayesian analysis that starts with a sample of 230 fraud rms. Notably, their denition of material fraud is broader than just nancial statement fraud, as indicated by their ancillary nding that 57 percent of their fraud rms required restatements. Nevertheless, even a 6.4 percent base rate of ongoing fraudulent nancial reporting (i.e., 11.2 percent 3 58 percent) would be quite worrisome.

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with variation in materiality. In this sense, the present paper builds on a stream of articles that use (behavioral) game theory to work around intentional bias in audit evidence as a result managements fraud concealment (e.g., Shibano 1990; Wilks and Zimbelman 2004). Future research can examine the inuence of factors that we have omitted from our simulation that may moderate our results in interesting ways. One such factor, for example, is auditor specialization. Specialists may be able to extract more information from EBS in a less biased or less noisy manner (e.g., Hammersley 2006; Low 2004; Owhoso et al. 2002; Solomon et al. 1999), and they may be better able to anticipate how different types of misstatement (and particular misstatements within types) distort audit evidence of differing nature. Future research can examine the moderating role of auditor specialization and other potential moderators; it is likely that experimental research can be used to investigate such questions. Additional illustrative research questions also come to mind in light our simulation-based ndings:


What auditor or audit environment characteristics enable auditors to more reasonably consider the degree to which bias and noise likely prevail in substantive evidence of a different extent and/or nature? Under what conditions, if any, do auditors respond to a heightened likelihood of intentional misstatement by revising their beliefs about the degree to which bias exists in evidence that is under managements inuence compared to evidence that is not under managements inuence (cf. Trotman and Wright 2011)? What conditions, training, decision aids, or traits help auditors to more readily revise their preliminary interpretations of positive signals from evidence that is relatively susceptible to management bias upon receipt of contrary signals from evidence that is relatively unsusceptible to management bias?

In pursuing these and related research questions as well as in thinking of the implications of this study, it is important to keep in mind its limitations. While simulation enabled us to obtain results for a complex research design with numerous experimental conditions, the results are sensitive to the assumptions we have made about how misstatement types generate qualitatively different levels of bias and noise in the different types of evidence available to the auditor. Of course others (audit professionals) with access to eldwork data may be able to provide better estimates of bias and noise in evidence and how they both vary with different misstatement types. Despite these limitations, the discussion and simulation reported herein points out likely and testable benets of assessing and managing achieved audit risk from an evidence-driven perspective. This evidence-driven perspective takes into account the implications of alternative misstatement types, and challenges conventional wisdom about audit risk by showing more audit evidence readily can increase achieved audit risk.

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