Alan G. Mayper.

Investigation of auditor's perceptions and decision processes regarding evaluation of material internal accounting control weaknesses online

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AN INVESTIGATION OF AUDITOR'S PERCEPTIONS AND

DECISION PROCESSES REGARDING EVALUATION OF

MATERIAL INTERNAL ACCOUNTING CONTROL WEAKNESSES



ALAN G. MAYPER



A DISSERTATION PRESENTED TO THE GRADUATE COUNCII
OF THE UNIVERSITY OF FLORIDA IN
PARTIAL FULFILLMENT OF THE REQUIREMENTS
FOR THE DEGREE OF DOCTOR OF PHILOSOPHY



UNIVERSITY OF FLORIDA
1981



Copyright 1981

by

Alan Gale Mayper



ACKNOWLEDGED NTS

I thank my committee members: Charles McDonald, Douglas Snowball,
William Messier, and Richard Griggs, for their invaluable guidance,
contributions and encouragement. I am also indebted to Dennis Patz
and Gary Holstrum who provided helpful suggestions and criticisms
at all stages in the research.

I also wish to thank the auditors who generously provided their
time and attention in participating in this research.

Finally, my greatest debt is to my close friends,
Tracie Erin Lee and Robert Thompson. Without their encouragement
and "ears" this dissertation (and my doctoral studies) would never
have been done .



TABLE OF CONTENTS

PAGE

ACKNOWLEDGMENT iii

LIST OF TABLES vii

LIST OF FIGURES viii

ABSTRACT IX

CHAPTER I INTRODUCTION TO THE STUDY 1

Nature cf Study 1

Professional Judgment 1

Materiality Judgments 2

Significance of the IACW Materiality Judgment 3

Statement on Auditing Standards Number 20 4

The Cohen Commission 4

Foreign Corrupt Practices Act of 1977 5

The SEC 6

Statement on Auditing Standards Number 30 6

Significance of Changing Responsibilities 7

Nature of the IACW Materiality Judgment 7

Elements of the Judgment

Auditor's Decision Process 8

Statement of the Problem 10

Research Questions Addressed 13

Judgment Factors 14

Descriptive Models of the Judgment Process 15

Consensus 15

Auditor's Self-Insight into the Judgment Process 16

Methodology 16

Pre-Experimental 17

The Field Experiment 17

Scope Limitations 18

Organization of the Study 19

Notes 20

CHAPTER II MATERIALITY OF INTERNAL ACCOUNTING CONTROL

WEAKNESSES: POTENTIAL FACTORS 21

Introduction 21

Factor Criteria 22

Chapter Methodology 22

Auditors' Evaluation of Internal Accounting Control 24

Properties of Internal Control 24

Personnel 25



Segregation of duties 25

Authorization of procedures 26

Adequate documents and records 27

Proper procedures for record keeping 27

Physical control over records and assets 27

Independent checks on performance 28

The Materiality of Internal Accounting Control

Weaknesses 29

Concept of Materiality 32

Definition 32

Financial Accounting Materiality Versus Auditing

Materiality 39

The Internal Accounting Control Weakness

Materiality Decision 42

Categorization of Materiality Factors 43

Materiality Factor Description and Application of

the Factor Selection Criteria 48

Environmental Factors 48

Description 48

Criteria application 49

Enterprise Related Factors 50

Description 50

Criteria application 53

Accounting Policy Related Factors 58

Description 58

Criteria application 59

Uncertainty of the Existing state of Nature 60

Description 60

Criteria application 61

Surrounding Circumstances Associated with the

Existing State of Nature 62

Description 62

Criteria application 64

Dollar Effects 66

Description 66

Criteria application 69

Summary of Factors Satisfying the Factor

Selection Criteria 70

Summary of Interview Results Concerning Factors

in the IACW Materiality Judgment 72

Summary and Conclusions 75

Notes 76

CHAPTER III METHODOLOGY 79

Introduction 79

The Model 80

ANOVA 80

Pairwise Comparison Measure 81

Complete pairwise comparison procedure 82

Incomplete pairwise comparison procedure 83

Experimental Design 85

Experimental Setting and Subjects 85



Independent Factor Selection 85

Background Data 87

Dependent Variables and Tasks 87

Pairwise comparison task 89

Single rating task 94

Description of the Auditor's Judgment Process 95

Auditors' Consensus 101

Auditor's Insight into His Judgment Process 101

Additional Analyses 102

Administration of the Experiment 103

Pilot tests 103

Primary study 105

Limitations of the Experiment 107

Summary 109

Notes 110

CHAPTER IV RESULTS OF THE EXPERIMENT 113

Introduction 113

ANOVA Models — Individual Analyses 113

ANOVA Models — Group Analyses 124

Judgment Consensus 131

Correlation Analyses 132

Percentage Consensus Analysis by IACWs 135

Self-Insight 140

Subjective Weights 141

Self-Insight Index 145

Additional Data 149

Specific Comments and Additional Information

Desired by S_s 149

Task Evaluation 150

Summary- 150

Notes 152

CHAPTER V SUMMARY, IMPLICATIONS AND SUGGESTIONS FOR

FUTURE RESEARCH 153

Summary of Problem, Research and Experimental

Results 153

Implications 157

Future Research 161

Notes 164

APPENDIX A PRE- EXPERIMENTAL INTERVIEWS 165

APPENDIX B EXPERIMENTAL MATERIALS 186

REFERENCES 209

BIOGRAPHICAL SKETCH 217



LIST OF TABLES

PAGE



TABLE



(Correlation Criterion for Subject Retention)
SUMMARY OF Ss BY FIRM, CITY AND EXPERIENCE LEVEL 107



2.1 A SUMMARY OF RESEARCH ON THE FACTORS WHICH

AFFECT MATERIALITY JUDGMENTS ' '

2.2 FACTORS WHICH SATISFIED THE THREE SELECTION ^

CRITERIA 7 -

2 3 SUMMARY OF PRE-EXPERIMSNT INTERVIEWS

(Perceived Important Factor Responses)

3 1 DOMINANCE RANKINGS OF SELECTED STANDARD SETS . . . • • • - 91
3.2 COMPARISON OF PAIRWISE SCALE TO SINGLE_RATING SCALE i-

3.3

4.1 SUBJECT'S SIGNIFICANCE LEVELS AND R- SQUARES- ^

MODEL 1 AND MODEL 2 ^

4.2 SUMMARY OF ANOVA RESULTS • • • '

4.3 SELECTED EXAMPLES OF DIFFERENCES IN THE IMPORTANCE

OF FACTOR USAGE TO THE VARIOUS Ss

4.4 RELATIVE IMPORTANCE OF THE IACW MATERIALITY ug

FACTORS AND INTERACTIONS •

4 5 DISTPIBUTION OF Ss BY TOTAL VARIANCE EXPLAINED ^

4*6 AVERAGE OMEGA-SQUARE VALUES OF SIGNIFICANT

EFFECTS BY VARIOUS SUB-GROUPS

4 7 JUDGMENT CONSENSUS AMONG Ss BY FIRMS, EXPERIENCE

LEVELS CTTIES, STANDARD SET AND ORDER GROUP ^

4.6 SUBJECT MATERIALITY AGREEMENT ABOUT INDIVIDUAL ^

lACWs ' i 37

IACW MATERIALITY JUDGMENT AGREEMENT BY FIRM

IACW MATERIALITY JUDGMENT AGREEMENT BY CITY

IACW MATERIALITY JUDGMENT AGREEMENT BY EXPERIENCE ^

LEVEL 142

VALUE OF SUBJECTIVE WEIGHTS BY Ss

qEIECTED EXAMPLES OF DIFFERENCES BETWEEN S S '

SUBJECTIVE AND STATISTICAL WEIGHTS . . . . • •

VALUE OF SUBJECTIVE WEIGHTS BY VARIOUS SUB-GROUPS ^4

SELF- INSIGHT INDICES FOR INDIVIDUAL Ss ■ ^ q

SELF-INSIGHT BY VARIOUS SUB-GROUPS



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4


11


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4


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LIST OF FIGURES

FIGURE PAGE

1.1 OVERVIEW OF THE AUDITOR'S DECISION PROCESS 11

2.1 AUDITOR'S EVALUATION OF IACWs 3C

2.2 THE CONCEPT OF MATERIALITY 35

2.3 APPLICATION OF THE CONCEPT OF MATERIALITY TO

FINANCIAL ACCOUNTING AND TO AUDITING CONTEXTS 40

3.1 EXPERIMENTAL DESIGN 88

3.2 PAIRWISE COMPARISON CALCULATIONS 93

3.3 SUMMARY OF EXPERIMENTAL ANALYSES 104

4.1 GRAPHS OF TYIAC X AS INTERACTION EFFECTS 121

4.2 FIRM X FACTOR EFFECTS 127

4.3 EXPERIENCE AND RISK X FACTOR EFFECTS 130



Abstract of Dissertation Presented to the Graduate Council

of the University of Florida in Partial Fulfillment of the

Requirements for the Degree of Doctor of Philosophy



AN INVESTIGATION OF AUDITOR'S PERCEPTIONS AND

DECISION PROCESSES REGARDING EVALUATION OF

MATERIAL INTERNAL ACCOUNTING CONTROL WEAKNESSES

By

Alan G. Mayper

March 1981

Chairman: Charles L. McDonald
Major Department: Accounting

This dissertation explored the auditor's judgment process in
making an internal accounting control weakness (IACW) materiality
decision. The auditing literature clearly has indicated the im-
portance of judgment to this type of decision. The two general
objectives of this study were 1) to develop a conceptual framework
which related the concept of materiality to the auditor's evaluation
of IACWs , and 2) to empirically test some implications of this
framework using a human information processing methodology.

The development of the conceptual framework required an ex-
tensive review of both the internal control literature and the
materiality literature. A simple, yet rigorous, definition of
materiality formed an important part of this framework. The concept
of materiality was defined as

The perceived importance of a difference between
an existing state of nature and some other (generally
a standard or ideal) conceived state of nature.



The auditor's evaluation of the materiality of an IACW was presumed
to consist of the following two components: 1) the auditor's es-
timation of the expected dollar exposure due to the IACW, and

2) the auditor's evaluation of the importance of the expected dollar
exposure (i.e., the comparison of the expected dollar exposure to
the auditor's materiality threshold) . The conceptual framework

led to the selection of a set of factors considered potentially
relevant to the auditor's IACW materiality judgment. The factors
were relevant to estimating either the probability or dollar exposure
of errors due to an IACW. Three of the selected factors (two
probability oriented factors and one dollar exposure oriented
factor) were incorporated into an experiment relating to auditors '
IACW materiality judgments.

The experiment provided a mechanism by which the study could
evaluate the importance of the materiality factors to the auditors'
IACW materiality judgments, examine the extent of judgment consensus,
and assess the extent of auditors' self-insight into their judgment
process. Thirty-eight auditors participated in the experiment. Tne
auditors evaluated the materiality of 12 IACWs using a pairwise com-
parison procedure and a single rating procedure.

The major results of the experiment indicated 1) the ANOVA
models explained a high proportion of variance in the auditor's IACW
materiality judgments, 2) individual differences existed among the
auditors concerning the importance of each materiality factor,

3) substantial configural processing in regards to the rwo probability
oriented factors, 4) a moderate degree of consensus among the auditors,
and 5) a low degree of self-insight. The above results are subject to
the many limitations discussed throughout the study.



In summary, this research has provided some insights into the
IACW materiality decision and the concept of materiality. This
dissertation has shown that abstract judgment situations can be
examined empirically, with some rigor. Since this dissertation
was only an exploratory study, no conclusion was made in regard
to the need for guidance in the auditor's IACW materiality judgment.
It is hoped only that this study will provide some assistance to
future research that examines the concept of materiality and the
auditor's judgment process in IAC evaluation.



CHAPTER I
INTRODUCTION TO THE STUDY



Nature of the Study
This study concerns a particular type of professional judgment
exercised by auditors: the assessment of the materiality of internal
accounting control weaknesses (IACWs) . This opening chapter is
intended to show that the materiality judgment:

1) is of current significance and is growing in importance;

2) is one for which there is little authoritative guidance
provided the auditor; and

3) is one where empirical research (hitherto not performed)
could aid the development of effective authoritative
guidelines .

Professional Judgment

The auditor relies heavily upon his personal judgment in the
collection and evaluation of evidence in an audit engagement. This
is referred to as the application of professional audit judgment.
Professional judgment represents the decision process the auditor
uses in the evaluation of evidence and in analyzing the effect of
internal accounting controls (IACs) on the audit. It is generally
agreed that professional judgment plays a major role in auditing and
deserves academic inquiry. This is supported by Bernstein [1967,
p. 90] when he says:



Judgment is, of course, a vital part of any professional
work. In accounting it plays an important role every
step of the way. But that does not mean that it is a
mysterious process, undefinable and inexplicable. We
know that the processes that feed judgment are varied
and complex, yet it does not follow that we cannot
make some progress in their analysis and description.

Recent empirical research concerning professional judgment has

examined the auditor's judgment process (e.g., Ashton [1973]; Joyce

[1976]; Messier [1979]). Common purposes underlying these studies are

to determine if auditors can make consistent judgments and to describe

what cues (factors) are important in the auditor's decision process.

By addressing these issues, researchers have sought evidence as to the

need for guidance in specific professional judgments made by auditors.

The prior studies have used a methodology that models the auditor's

judgment process and indicates the consistency of auditor's judgments.

The underlying assumption has been that if inconsistencies are found

in auditors' judgments, then more authoritative guidance is needed to

eliminate the inconsistencies. It is assumed also that the judgment

models obtained may help policy makers establish this authoritative

guidance. The present study constitutes a continuation of empirical

efforts to enhance understanding of professional audit judgment.

Materiality Judgments

Numerous and important professional judgments by the auditor
frequently concern the determination of the materiality of an event.
This is borne out by the American Institute of Certified Public Account
ants' [AICPA, 1973] codified Statement on Auditing Standards Section
150.04 (SAS) , which states, "[T]he concept of materiality is inherent
in the work of the independent auditor." The materiality concept is
normally thought of in relation to the average user; that is, an



event is material if knowledge of that event would cause some dif-
ferential action to be taken by an average user. However, it is
not the user who makes the materiality judgment, but the auditor
(or preparer) , who must make it for the user.

The most common materiality judgment examined concerns the
auditor's evaluation of an item related tc the current year's audit
of the financial statements. Specifically, researchers have examined
the auditors' materiality judgments related to a disclosure of an event
or a correction of an error related to the financial statements of the
current period. Several empirical studies have been performed in these
"financial reporting" contexts and these will be summarized in Chapter
II (e.g., Boatsman and Robertson [1974]; Hofstedt and Hughes [1977]).
However, their findings clearly cannot be generalized to other auditing
contexts. Factors related to the general concept of materiality have
not been put into a coherent framework and the judgment has been
categorized merely as within the realm of subjective professional
judgment [Financial Accounting Standards Board (FASB) , Discussion
Memorandum, 1975] . A major purpose of this study is to rectify the
lack of precision with which the materiality concept has been addressed.

Significance of the IACW Materiality Judgment
Recent developments have created a renewed interest in the
auditor's evaluation of internal accounting controls and especially
IACWs. Traditionally, the auditor's primary purpose in the study and
evaluation of lACs was to establish a basis for reliance on the IACs
in order to assist him in determining the nature, timing, and extent
of auditing procedures to be performed in the examination of financial
statements. Thus the auditor was required to review an IAC system and



perform compliance tests only if he planned to rely on the internal
control as it related to the audited financial statements. The fol-
lowing section highlights current developments which appear to expand
the traditional responsibilities of auditors in the study and
evaluation of IACs .

Statement on Auditing Standards Number 20

In 1977 the purpose of the IAC review was extended by the AICPA's

Statement on Auditing Standards Number 20, "Required Communication of

Material Weaknesses in Internal Accounting Controls" (SAS No. 20) .

SAS No. 20 established a requirement that:

. . .the auditor communicate to senior management and the
board of directors cr its audit committee material
weaknesses in internal accounting control that come to
his attention during an examination of financial state-
ments made in accordance with generally accepted
auditing standards. [emphasis added — AICPA, 1977, p. 1]

Prior to this statement, it was common for auditors to issue management
letters which contained their reservations and recommendations con-
cerning IACWs discovered during the audit engagement. The signifi-
cance of SAS No. 20 lies in the explicit requirement to consider
material weaknesses and communicate them to the board of directors.

The Cohen Commission

The proposals concerning the auditor's responsibility in relation
to IACs as presented by the AICPA's Cohen Commission go beyond SAS
No. 20. Tne Commission was one of the first advocates of public
reporting on the IAC system and of disclosure of material weaknesses.
In the Commissions' Report, "The Commission on Auditor's Responsi-
bilities: Report, Conclusions, and Recommendations" they recommended:



i) that management should include an assessment of all internal
accounting controls in the financial statements and 2) the independent
auditor should state in his report whether he agrees or disagrees
with management's description, and should describe any material
uncorrected weaknesses not disclosed by management [AICPA, 1978a,
pp. 60-63] .

Foreign Corrupt Practices Act of 1977

The public sector recently became involved in the issue of
evaluation of IAC through the Foreign Corrupt Practices Act of 1977.
Although this Act does not directly concern the auditor's evaluation
of IAC and IACWs , it will most likely influence the auditor's
judgments. The Act requires publically held companies to maintain
adequate IACs to provide "reasonable assurances" that the following
objectives are met:

1) transactions have management's general or specific
authorizations .

2) transactions are properly recorded to permit preparation
of financial statements and accountability of assets.

3) access to assets have proper authorization.

4) the recording of assets and accountability of assets
are verified and differences are reconciled.

The above objectives are specified without materiality limits or guide-
lines being provided to judge compliance with the Act. It is reasonable
to assume that the independent auditor will assist management in
complying with the Act; indeed, the above objectives are identical with
the definitional objectives of "Accounting Control" as stated in the
AICPA' s SAS No. 1, section 320.28. The primary difference is that
these objectives now have the force of law, under the jurisdiction of
the Securities and Exchange Commission (SEC) .



The SEC

In response to the Foreign Corrupt Practices Act the SEC
advocated public reporting on IAC systems — by management, but with
direct involvement of auditors. Initially the SEC sought to require
management to issue a report concerning the adequacy of IACs and to
require the auditor to issue an opinion on management's statement on
IACs. In late 1979, however, the SEC withdrew a proposal concerning
these requirements. Among the reasons for withdrawing the proposal
included 1) that there were no materiality standards included in
the proposal; and 2) the SEC was presently satisfied as to the number
of companies issuing voluntary management reports that included a
statement about IACs [Business Week, 1979 and Ernst and Whinney, 1980] .
Nevertheless, the SEC have stated that they expect the outside auditor
to eventually become involved with IAC reports and that management or
auditors will be responsible for the public reporting of material
IACWs [Ernst and Whinney, 1980] .

Statement or. Auditing Standards Number 30

In 1980 the AICPA issued Statement on Auditing Standards Number 30
(SAS No. 30), "Reporting on Internal Accounting Control." This
statement described the procedures to be applied by the auditor when
issuing reports concerning IACs for either special reports or normal
audit engagements. Included in the procedures were the requirements
that auditors identify IACWs in the accounting system and evaluate the
materiality of the individual IACWs. The auditor also is to include a
description of the material IACWs in his report. These reports are not
considered to be public reports but are intended solely for management,
specified regulatory agencies or other specified third parties.



Significance of Changing Responsibilities

The foregoing indicates that auditors ' judgments related to IAC
and IACWs extend beyond the traditional responsibilities described
earlier. The evaluation of IACWs has become a much more explicit
task for the auditor. The determination of whether IACWs, once
identified, are material or not represents an increasingly important
task for auditors; both because of the requirements imposed by
SAS No. 20 and SAS No. 30, and because of the possibility that public
disclosure will become a reality.

Nature of the IACW Materiality Judgment

Elements of the Judgment

The particular judgment of interest brings together two basic

auditing concepts, IACWs and materiality. An IACW is defined as the

"absence of controls" which may lead to an error or irregularity

[Arens and Loebbecke, 1976, p. 177] . Materiality, from the auditor's

view, typically deals with dollar significance to the financial

statements. In combining these two concepts SAS No. 1 describes a

material IACW as follows:

. . .a condition in which the specific control procedures
or the degree of compliance with them do not reduce to
a relatively low level the risk that errors or ir-
regularities in amounts that would be material in
relation to the financial statements being audited may
occur and not be detected within a timely period by
employees in the normal course of performing their
assigned functions .

[section 320. 6S ]

Given this description, then, it follows that the judgment requires

the auditor to assess the probability of an error or irregularity

occurring, that would (a) not be corrected on a timely basis in the



normal course of business, and (b) would materially affect the
financial statements. Both the probability assessment and the
assessment of the materiality to the financial statements are
unlikely to be direct and explicit judgments. Instead from available
evidence it seems likely that the auditor uses both quantitative and
qualitative factors as surrogates for the concepts contained in the
material IACW description. Furthermore, the description highlights
that two important factors in judging the materiality of an IACW are
probability and dollar exposure of the potential errors and ir-
regularities .

Auditor's Decision Process

In order to understand the likely decision process followed by
auditors in evaluating material IACWs , the auditors' evaluation of the
IAC system must first be understood. A review of the authoritative
literature (e.g., SAS's) and descriptions of the auditor's decision
process in recent auditing textbooks (e.g., Arens and Loebbecke,
[1976 and 1980]; Robertson [1979]) provide some guidance in this
respect. The general perception seems to be that the auditor's
evaluation of IAC is made to satisfy the second standard of field-
work as provided in SAS No. 1 (a proper study and evaluation of IAC)
and to satisfy the objectives previously mentioned in the Foreign
Corrupt Practices Act section of this chapter. The essence of these
objectives is that the auditor should be satisfied that the IAC system
provides reasonable assurances that: 1) transactions are authorized
and properly recorded; and 2) assets are safeguarded, properly
accounted for, and that access to the assets are authorized.



ion



In order tc satisfy these objectives the auditor will partit
the IAC system into different cycles (e.g., sales and receivables,
cash disbursements and inventory) . For each cycle the auditor will
go through a three-step evaluation process;

1) preliminary evaluation — understanding the system as
given by the client.

2) compliance testing and re-evaluation — assessing
whether the system works as given to the auditor.

3) audit tests of account balances (substantive tests) ,
re _ e valuation if needed, and reporting of final
recommendations .

The preliminary evaluation may consist of IAC questionnaires,


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Online LibraryAlan G. MayperInvestigation of auditor's perceptions and decision processes regarding evaluation of material internal accounting control weaknesses → online text (page 1 of 14)