How Management Confidence Influences Auditors’ Testing

We examine auditors' response to management's statements of confidence accompanying the inquiry explanation regarding a critical accounting estimate in lower versus higher client risk contexts. Recent research finds that management overconfidence is associated with an increased risk of fraudulent, aggressive and biased financial reporting, and optimistic forecasts that are subsequently missed, which negatively impact shareholder wealth. Understanding how auditors respond to management confidence, the potential causes for the auditors' response, and the impact of confidence when it is associated with inquiry is important because inquiry evidence is highly susceptible to bias and is used pervasively during all phases of an audit. In an experiment, we find that although auditors believe that management confidence in inquiry explanations will not influence their judgment, their decisions on extent and, subsequently, nature of testing were influenced by management confidence in higher client risk contexts. Management confidence did not trigger differences in auditors' response when client risk was lower, however, when client risk was higher, auditors opted for a smaller increase in extent of testing when the client expressed high versus low confidence. This smaller increase in extent of testing in the high confidence-higher risk setting was also associated with an increased likelihood of pursuing inquiry evidence when compared with the low confidence-higher risk setting. Our finding is troublesome because the audit literature and standards anticipate increased testing of management's explanations as client risk increases (ceteris paribus). Thus, this study provides the first evidence that auditors' play a contributing role in the observed association between high management confidence and biased financial reporting and offers a cognitive explanation for this finding