Academic journal article Academy of Accounting and Financial Studies Journal

The Effects of Expectation Formation on Detecting Unexpected Non-Changes in Account Balances during Analytical Procedures

Academic journal article Academy of Accounting and Financial Studies Journal

The Effects of Expectation Formation on Detecting Unexpected Non-Changes in Account Balances during Analytical Procedures

Article excerpt

ABSTRACT

The effectiveness of audit analytical procedures in identifying financial statement misstatements has been studied from a variety of perspectives. Most analytical procedures research uses unexpected changes in an account balance or ratio to signal a possible misstatement. Some recent misstatements (e.g., Cendant, WorldCom) have involved financial statement accounts remaining the same when they should have changed (i.e., an unexpected non-change). This research assesses whether auditors forming expectations are more sensitive to unexpected non-changes in account balances than auditors not forming expectations. Seventy nine auditors from three different firms participated in an experimental analytical procedure that contained both an unexpected change and an unexpected non-change in a client's accounts. Results indicate that explicit expectation formation increases auditor's sensitivity to unexpected changes in accounts. In the unexpected non-change situation, however, there was no difference between auditors forming expectations and those not forming expectations. Those with more experience were more sensitive to the risk implications of unexpected non-changes.

Keywords: Analytical procedures, expectation formation, audit experience.

INTRODUCTION

U.S. auditing standards (AICPA, 1998) require auditors to perform analytical procedures to identify account balances that may be at a higher risk for material misstatement. As part of the analytical procedures, auditors are expected to form expectations of the balance in each key account. The effectiveness of analytical procedures has been the subject of some recent discussion, (e.g., Cullinan and Sutton, 2002; Weill, 2004) and the Securities and Exchange Commission (SEC) (1998a) has expressed concern about the appropriate use of expectation formation in analytical procedures. The SEC specifically noted that auditors may fail to appropriately assess the risk of misstatement when balances do not change from year to year:

   ... the [SEC] staff has noted [audits in which] balances were
   compared from one year to the next, and as long as the balance did
   not change, the auditor noted that no further work was considered
   necessary. Often such an audit procedure is inadequate in light of
   ongoing changes to the company's business plans, strategies and
   industry conditions.

Analytical procedures have been examined from a variety of perspectives within the accounting literature. Much of this literature deals with the auditor's sensitivity and response to, changes in financial statement accounts from period to period (e.g., Mueller and Anderson 2002; Church et al. 2001). While changes in financial statement accounts can signal a potential misstatement, situations in which an account balance remains relatively static from period to period can also signal potential misstatements. This occurs when the account should change due to changes in business condition and/or recent company initiatives. Auditor insensitivity to non-changes in account balances has been noted in two recent audit failures. The former management of the Cendant Corporation manipulated its financial statements in such a way that the financial statement balances did not change enough to draw additional auditor scrutiny (SEC 2000). In the WorldCom misstatement case, the auditor, noting that "line costs as a percentage of revenue have remained flat at 41.9% of revenue ... concluded that residual audit risk was none." (Andersen, 2002, p.12). The line cost accrual was actually misstated by approximately $3.8 billion.

Our study is motivated by the recent instances of financial statement misstatements (e.g., Cendant and WorldCom) related to non-change in financial statement accounts and/or ratios. McDaniel and Kinney (1995) concluded that an expectation formation process can enhance auditor sensitivity to potential misstatements involving an unexpected change in a financial statement account; our study investigates whether expectation formation can enhance auditors' sensitivity to potential misstatements associated with account balances that do not change when they should change (referred to in this paper as an unexpected non-change). …

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