Impact of the Type of Audit Team Discussions on Auditors’ Generation of Material Frauds

Executive Summary

Recent changes to international auditing standards make it compulsory for members of the audit team to discuss at the planning stage the susceptibility of an entity to material misstatements due to fraud. The Public Company Accounting Oversight Board reminds auditors to be diligently focused on their responsibilities to detect fraud and has urged auditors to take the requirements of SAS No. 99 seriously. SAS No. 99 introduces a new audit procedure that must be performed on every engagement: a brainstorming session. Members of the audit team must meet to exchange ideas about how and where they believe the entity’s financial statements may be susceptible to material misstatements due to fraud and to discuss how management could perpetrate and conceal fraudulent financial reporting or misappropriate assets. Internationally, ISA No. 315 and ISA No. 240 similarly require the members of the audit team to discuss, at the beginning of the audit, the susceptibility of the entity’s financial statements to material misstatement due to fraud or error. Although the intention and wording of the international standards are similar to SAS No. 99, one notable difference is that SAS No. 99 refers to brainstorming, whereas the international standards do not stipulate the type of group discussion.

There appear to be numerous group formats that would satisfy SAS No. 99 and the international standards, including interacting groups (both face-to-face and electronic), various forms of brainstorming, and other techniques involving mental simulations. We use a rich case scenario developed by a Big 4 audit firm to compare three different forms of group discussions: an interacting group without brainstorming guidelines (interacting group), an interacting group with brainstorming guidelines (brainstorming group), and an interacting group with pre-mortem instructions (pre-mortem group). In particular, we consider the way these groups list potential misstatements due to fraud, estimate the likelihood of a material misstatement due to fraud, and conduct mental simulations of a potential misstatement due to fraud, including how the fraud could have been perpetrated.

The only difference between the interacting group and the brainstorming group in this study is that the latter is provided with standard brainstorming guidelines (Osborn 1957): “criticism is ruled out; freewheeling is welcome (the more creative the idea, the better); combination and improvement are sought; and most important: quantity is wanted”. The purpose of these instructions is to guide the participants to defer judgment and place emphasis on quantity, which leads to a greater number of ideas.

Klein (1999) shows how experts (e.g., pilots, nurses, military leaders, nuclear plant operators) use their experience to make decisions in field settings. Klein suggests that these experts draw on a large set of abilities that are sources of power. One such source is the power of mental simulation that allows individuals and groups to imagine how a “course of action might be carried out”. Pre-mortem is a variation of the mental simulation idea that gives individuals a perspective from which they actively search for a flaw in their plans. Our operationalization of the pre-mortem treatment involves auditors being told to imagine a scenario where it is months after an audit has been completed and no material fraud was uncovered. However, it has just been announced in the press that a material financial reporting fraud concerning that client has occurred. Thus, a basic difference between pre-mortem and our other two treatments is that the former takes a backward-thinking perspective while the latter takes a forward-looking perspective, and these perspectives involve different cognitive processes.

We conducted an experiment using a case developed by a Big 4 firm. Participants were randomly allocated to one of three treatments. Participants in treatment 1 — interacting group — were told to document as many potential material misstatements due to fraud as they could in the time allowed, using their normal level of skepticism. Participants in treatment 2 — interacting group with brainstorming guidelines — were given the brainstorming rules to follow while conducting their discussion and to document as many potential material misstatements due to fraud as they could in the time allowed, using their normal level of skepticism. Participants in treatment 3 — interacting group with pre-mortem instructions — were given the pre-mortem treatment described above.

There were two stages to the experiment. Stage 1 was completed as a group of three. Each group was asked to list the potential material misstatements due to fraud that may occur for the company in the case. Participants were asked to be as specific as possible. Stage 2 of the experiment was carried out using individuals for all treatments. In this stage the participants were asked how likely they thought it was that a material misstatement due to fraud had occurred for the company for the financial year. They were given an 11-point likelihood scale ranging from 0 (not at all likely) to 1.00 (extremely likely). They were then asked to select and describe one potential material misstatement due to fraud that could occur for the company. They were told to imagine how that fraud could have been perpetrated and how the perpetrator could cover up the fraud.

Our study selects three particular techniques (interacting groups without brainstorming guidelines, interacting groups with brainstorming guidelines, and interacting groups with pre-mortem instructions) and examines these group formats on a rich case developed as part of training for a Big 4 firm. In an environment where the auditors were under tight time constraints, we found that both the brainstorming treatment and the pre-mortem treatment resulted in a larger number of potential frauds than our interacting group without brainstorming guidelines. We suggest that the quantity of items listed is important, because the mere mention of them in the meeting is likely to increase the level of skepticism of the auditors and alert them to a range of possible frauds. From an audit firm’s perspective, the quality of the items listed is also important. Quality can be measured in many ways, including uniqueness, criticality, impact, and likelihood and difficulty of detecting. In our case a panel of experts from the Big 4 firm identified the frauds it considered most important for this case, and we used this as a measure of quality. Again, the brainstorming and pre-mortem treatments listed more “quality” items than the interacting group. In addition, in an audit environment, obvious potential frauds are likely to be known and, therefore, what may be advantageous is to generate frauds that are rare and less likely to occur. Our results did not show significantly different numbers of rare to common frauds between our treatment groups. However, the numbers are in the expected direction and future research should address this issue.