Auditors′ reporting decisions for accounting estimates : the effect of assessments of the risk of fraudulent financial reporting

The dangers of management bias and the resulting increased need for auditors to be cognizant of environmental characteristics may be particularly acute in the area of accounting estimates. Accounting estimates pose relatively unique auditing problems because it is an area where management has significant discretion (to set estimates) and there is limited ability to apply traditional accounting controls. Thus auditors have difficulty obtaining conclusive evidence to challenge management′s estimates. Research examining auditors′ accounting estimate judgments, however, has been scant, especially with regard to the relationship of auditors′ assessment of materiality and risks of fraudulent financial reporting. Reports the results of an empirical study examining the reporting decisions of audit seniors and audit managers related to a client′s decision to change four accounting estimates relative to the prior year. The auditor′s task was to review the changes and to indicate whether audit adjustments proposed by the audit staff were necessary to preserve an unqualified opinion. Three environmental red flags related to management lifestyle, bonus compensation programme and internal audit department strength were manipulated between subjects. The results indicated that the direct effect of the red flags on reporting decisions was limited. The findings provided greater support for an indirect model. In the indirect model, red flags affected auditors′ assessments of management intent, which, in turn, influenced auditors′ reporting decisions in combination with assessed materiality and level of auditor experience.