Overview of Research
on Auditors Detection
of Financial Statement Fraud
Mark F. Zimbelman, Brigham Young
problem confronting the (auditing) profession is as demanding, or as difficult
to resolve as the problem of management fraud and its detection by
(T)he profession must accept responsibility for the detection of
(and) develop means of increasing significantly the likelihood of
detecting fraud. [Public Oversight Board, 1993, p. 42]
The purpose of this article is to provide an overview of academic accounting
research on financial statement auditors detection of fraudulent
financial reporting (hereafter fraud).1
Research on auditors detection of fraud is extremely motivated for at
least three reasons. First, policy makers, academics, government officials, and
practitioners have expressed concern over auditors performance in
detecting fraud for several decades (e.g., see Accounting Series Release No.
19, 1940, p. 4 and Mautz and Sharaf, 1961, p. 113). Importantly, fraud
detection continues to be a priority in the profession as indicated by the
recent issuance of SAS No. 82 (AICPA 1997) and the fraud research projects
funded by the Auditing Standards Board.2
Second, significant audit policies have been adopted to influence
auditors behavior with respect to fraud during the past two decades.
Thus, significant opportunity exists for research to inform audit policy with
respect to detecting fraud. Third, auditors detection of fraud is
extremely important to both the profession and society. One indication of the
validity of this claim is the Securities and Exchange Commissions active
involvement in policy making to address audit failures involving fraud.3
The remainder of this
article is organized as follows: the next section describes the challenging
setting that auditors face in attempting to detect fraud; next, a few
characteristics of this setting are highlighted and extant and future research
issues related to these characteristics are considered; and, finally,
concluding comments regarding the future of research on auditors
detection of fraud are offered.
Detecting fraud is an extremely challenging task for the auditor. First, when
fraud exists, auditee management has likely undertaken complex efforts to
deceive the auditor. Clever teams of highly motivated, knowledgeable managers
who often have considerable political capital that can be used to influence
their employees and auditors, develop fraud schemes. Furthermore, audits
involve extensive complexity spread across time, people, geography, and
economic conditions. Typically, an auditors first consideration of fraud
occurs in the client acquisition/decision (Shelton, Whittington, and Landsittel
1999), which often involves auditors with considerable expertise who assess
numerous interrelated risks (e.g., business, engagement, fraud and audit risk).
Once the client acceptance decision is made, less experienced auditors strive
to conduct the audit efficiently and effectively. Conducting the audit involves
(re)assessing inherent risk, control risk, and fraud risk, developing a
detailed audit program, gathering evidence of varying reliability,
communicating with one another, and reaching an opinion based on a large body
of interrelated evidence. Auditors typically perform these tasks using various
decision tools. In reality, few auditors will encounter fraud and those that do
may not become aware of it until years later, if at all. Additionally, these
auditors must cultivate positive client relations (especially with client
personnel most likely to perpetrate fraud) and their mixed accountability may
lead them to make judgments that are less skeptical than one might expect.
Thus, there is little wonder that the typical fraud goes undetected for more
than three years. Finally, some management fraud may cure itself in times of
economic prosperity, thus inducing greater uncertainty.
Given this setting,
numerous questions arise. Some major issues include: How do auditors and
auditees respond to and anticipate one anothers behavior (i.e. strategic
interaction)? How should and do auditors assess fraud risk and how do these
assessments affect audit plans? What audit methods can be used to optimize
audit decisions for fraud detection?
A key characteristic of fraud and its detection is that both parties must
anticipate their opponents response to be successful. Auditees must hide
the fraud in a way that the auditor will fail to detect it and auditors must
look for fraud where the auditee has hidden it. Failure to consider that
management may be acting strategically, e.g., falsifying audit evidence, may
result in ineffective levels of skepticism and audit failures. Most
experimental research on fraud has not directly examined auditors and
auditees abilities to anticipate and respond to one anothers
behavior. A few recent studies (Bloomfield 1997; Zimbelman and Waller 1999)
present research rooted in behavioral game theory (Camerer 1990). These studies
are motivated by the assumption that fraud introduces behavior that cannot be
understood using theories and experiments framed in a decision theoretic
context (Kinney 1975). Future experimental research should attempt to discover
how boundedly rational auditors decisions can be optimized within a game
theoretic context. For example, how can skepticism be elevated at a reasonable
cost? What proportion of audit procedures should be randomized? Should rotation
for whole audit teams or firms occur periodically? How will auditees and
auditors respond if all audits require forensic audit procedures as proposed by
the Panel on Audit Effectiveness?4
in Fraud Risk Assessment and Audit Decisions
Humans have difficulty achieving accuracy when making complex decisions. As
described above, auditors are confronted with numerous stimuli and many
seemingly conflicting objectives. Research suggests that this environment may
lead to detrimental effects with respect to fraud detection (Braun 2000). Prior
research suggests at least two ways that fraud risk assessment and detection
may be improved to deal with this complexity. Both involve dealing with the
notion of procedural knowledge, which develops over many trials (e.g., Bonner
and Walker 1994; Herz and Schultz 1999). Procedural knowledge frees greater
cognitive resources to consider knowledge germane to the immediate task.
Studies show that requiring auditors to explicitly assess fraud risk results in
changes to the extent but not the nature of audit plans (Zimbelman 1997; Glover
et. al. 2000) and that a specific instruction that the fraud risk task is
primary affects auditors decisions in interpreting audit evidence (Knapp
and Knapp 2000). More research is needed to discover additional effects of
focusing auditors attention on the tasks of fraud risk assessment and
A second response to the
complexity inherent in fraud- related decision contexts is to bring greater
expertise to the decision task. While research in this area is sparse, some
findings suggest that auditors with general experience perform better in
fraud-related judgments (Knapp and Knapp 2000). More research is needed to
determine the effect on fraud detection of experience across varied settings
(e.g., audit structure) and under the demands of strategic interaction. As a
substitute for experience, auditors may be able to provide effective training
to improve fraud detection. For example, unaided audit decision making may be
improved by training auditors to avoid the pitfalls of bounded rationality
(Johnson, Jamal, and Berryman 1991). Additionally, new audit methodologies
might be used to alter auditors cognitive representations to improve
their fraud detection.
and Decision Aids
Recent revisions in audit methodology may affect auditors detection of
fraud (Bell et al. 1997; Lemon, Tatum, and Turley 2000). These new approaches
require that auditors gain a deeper understanding of the economic and
regulatory forces affecting their clients risks and opportunities. In
theory, this knowledge helps auditors understand the economics underlying
clients transactions, which may be crucial for detecting fraudulent
transactions (Erickson, Mayhew, and Felix 2000). More research is needed to
determine the effects of these new audit methodologies on fraud detection.
As for decision aids,
fraud risk models offer the potential for allocating audit effort to detect
fraud in an efficient manner. Empirically derived models generally classify
fraud cases more accurately than unaided auditors (Bell and Carcello 2000) but
classify nonfraud engagements as slightly more likely to have fraud than
unaided auditors (Nieschweitz, Schultz, and Zimbelman 2000). Hansen et al.
(1996) assigned different costs to these two misclassifications and derived an
optimal model suggesting that audit firms might implement a model
using cost-benefit criteria. In this area of research, new sources of data are
needed as many of the extant studies used the same data set. A few recent
studies tested the predictive ability of new sources of fraud cues (Beasley
1996; Summers and Sweeney 1998). Additionally, research should determine how
reliance on these models can be accomplished because research outside of
auditing suggests auditors may be unlikely to rely on these decision aids for
fraud detection (Arkes, Dawes, and Christensen 1986). Research could fruitfully
explore ways to increase auditors propensity to rely on these models.
Extensions are needed for work like that of Eining, Jones, and Loebbecke (1997)
who found that auditors achieved better results using expert systems vs. other
models. Research is also needed to determine potential litigation consequences
that may accompany the use of fraud decision aids and how these consequences
may be mitigated.
In sum, solving the challenges of detecting fraud will likely remain a priority
for the profession for many years. Thus, research will be highly valued by both
academics and professionals as long as academics carefully design studies that
consider prior research findings and the setting that auditors face to
investigate issues that will assist policy makers in their efforts to reduce
the costs of fraud Even so, one challenge remains for academics interested in
conducting fraud research. Because of frauds high profile in litigation
against auditors, some audit firms are very reluctant to participate in fraud
research. For example, even after committing to support the Auditing Standards
Board on SAS No. 82 research projects, the firms were reluctant to participate.
Once academics design meaningful studies, cooperation from auditing firms may
be the key predictor of meaningful progress in this area.
- While the term fraud is
often defined to include employee theft or defalcation, its use in this article
is limited to acts resulting in management fraud or fraudulent financial
reporting. A stream of related, but neglected, research exists in the earnings
management literature (e.g. Phillips 1999). This vast body of research is
beyond the scope of this article (see Healy and Wahlen  for a review). In
excluding earnings management research, I acknowledge the difficulty in
distinguishing these topics and encourage efforts to meld these bodies of
for the AICPAs press release on these projects.
- For a more comprehensive review of
empirical research on auditors detection of fraud see Nieschwietz,
Schultz, and Zimbelman (2000).
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