The Effect of Non-Strategic Risk of Error on Auditor Sensitivity to Managers’ Reporting Incentives in a Multi-Account Setting

We examine the effects of making multiple contemporaneous risk assessments on auditor sensitivity to the strategic and non-strategic risk related to managers' financial reporting decisions. We address our research question using a 2x2 between-subjects experiment conducted under the tenets of experimental economics in a multi-account setting. We manipulate whether the two accounts differ in non-strategic risk. We find that when auditors allocate audit resources among accounts that differ in the non-strategic risk of error, auditors will use that difference as a heuristic basis for allocating resources among the accounts, and they will be relatively insensitive to strategic aspects of the audit including the client managers' financial reporting incentives. However, when financial statement accounts do not differ in non-strategic risk, auditor resource allocations are more sensitive to strategic information such as managers' penalties for detected misreporting. Consistent with the neglect of probability literature in psychology, we also find that even when auditors attend to managers' incentives, they do not respond as predicted by game theory but instead increase audit effort when managers' face large penalties for misreporting compared to when those penalties are more modest. This study is of interest to accounting academics, auditors, and regulators