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  THE EFFECT OF MANAGEMENT INCENTIVES AND AUDIT COMMITTEE QUALITY ON INTERNAL AUDITORS’ PLANNING ASSESSMENTS AND DECISIONS Stephen Asare University of Florida Ronald A. Davidson  Arizona State University West  Audrey A. Gramling Georgia State University  April 2003 We gratefully acknowledge the financial support we have received from our respective institutions and thank Mark Zimbelman for allowing us to modify his case for our experiment. We gratefully acknowledge comments received on an earlier version of this paper from Bill Felix, Steve Salterio, Joe Schultz, and workshop participants at Georgia State University.  THE EFFECT OF MANAGEMENT INCENTIVES AND AUDIT COMMITTEE QUALITY ON INTERNAL AUDITORS’ PLANNING ASSESSMENTS AND DECISIONS  ABSTRACT: We examine the sensitivity of internal auditors’ fraud risk assessments and audit effort decisions (i.e., budgeted hours) to variations in management’s incentives to intentionally misstate their financial position, and in the quality of a firm’s audit committee. Internal auditors are an integral part of an organization’s monitoring scheme and it is important to understand how, and how well, their judgments are influenced by factors known to be associated with fraudulent financial reporting. We hypothesize that internal auditors’ fraud risk judgments and audit effort decisions will vary with management incentives and quality of audit committee, consistent with documented archival evidence and professional prescriptions. The experimental results, based on responses from 60 internal auditors completing a hypothetical case regarding a potential acquisition target, indicate that internal auditors’ fraud risk assessments are responsive to management incentives and variations in the quality of the audit committee. Our results also indicate that internal auditors’ budgeted audit hours are sensitive to variations in management incentives to misreport financial information, but are not sensitive to variations in audit committee quality. This latter result implies that internal auditors are aware that stronger audit committees decrease the risk of fraudulent financial reporting, but do not use that knowledge to reduce fraud related work. These results generally hold for a second experiment in which another group of internal auditors was asked to complete the same hypothetical case, but rather than evaluating an acquisition target, they made planning judgments for an audit area of the company in which they were employed. Thus, the results generally hold whether the internal auditors are performing due diligence for a possible acquisition or are auditing their own organization where they may have incentives congruent with organization management, and may have familiarity with the audit committee. Key Words:  Audit committees, Audit planning, Fraud risk, Internal auditors, Management incentives Data Availability:  Contact the authors.   2 THE EFFECT OF MANAGEMENT INCENTIVES AND AUDIT COMMITTEE QUALITY ON INTERNAL AUDITORS’ PLANNING ASSESSMENTS AND DECISIONS 1. Introduction This study provides evidence on whether internal auditors’ fraud risk assessments and audit effort decisions (i.e., budgeted hours) are sensitive to the level of management incentives to misreport their financial results and variations in the quality of the audit committee.    As part of their responsibility to assess the reliability and integrity of information, internal auditors are increasingly expected to play an important role in preventing and detecting fraudulent financial reporting (e.g., Beasley et al. 1999b). 1  However, the broadening of internal audit activities that is occurring throughout the internal audit profession, and reflective in the Institute of Internal  Auditors’ (IIA) updated definition of internal auditing (see Krogstad et al. 1999), may result in internal auditors shifting from a focus on financial reporting to a focus on operational activities (O’Regan 1999). This shift in focus has caused some to be concerned that internal auditors may not have a sufficient focus on, and awareness of, relevant aspects of fraudulent financial reporting (AuditWire 1999; Thompson 1999). The importance of the role of the internal audit function in quality financial reporting has recently been highlighted by proposed and approved exchange listing requirements mandating that corporations implement an internal audit function (see IIA 2003, p. 22 for an overview). Further, the potential for internal auditors to play an integral role in quality financial reporting has recently been demonstrated in the WorldCom and other situations, where “internal auditors played a major role in surfacing 1  For additional discussion on this role for internal auditors see Thomas and Clements (2002).   3 and helping disclose the accounting errors instigated by certain key management officials.” (Bishop 2002). Having a role in preventing and detecting fraud requires that internal auditors be able to identify and appropriately respond to potential indicators and mitigators of fraud (IIA, 1995 Section 280; IIA, 2001, Section 1210.A1). Prior archival evidence suggests that management incentives and audit committee quality are two factors associated with the incidence of fraudulent financial reporting. Management incentives exert pressure on management to present optimistic financial statements, while a quality audit committee limits opportunities for fraudulent financial reporting. The evidence from this study, therefore, speaks to the potential effectiveness and efficiency of internal auditors as part of a corporate fraud monitoring system. Obtaining such evidence is important given that, to date, little research exists on internal auditors’ fraud risk assessments. 2  Most importantly, no research has directly focused on whether auditors’ fraud risk assessments, and related audit effort decisions, are sensitive to variations in management incentives and the quality of audit committees. 3  The results of this study should be of value to regulators, auditing practitioners, and auditing researchers, all of whom are concerned about the quality of financial reporting. Internal auditors can have an important influence on the quality of financial reporting through appropriately assessing fraud risk, and allocating sufficient resources 2  Church et al. (2001) examine issues tangentially related to our study. They specifically investigate internal auditors’ consideration of fraudulent financial reporting as a potential explanation for an unexpected difference noted during analytical procedures. Their findings, however, don’t suggest that management incentives alone (i.e., an earning based bonus plan) affect internal auditors’ assessments and decisions in this analytical procedures task. 3  Extant research on auditors’ fraud risk assessments focuses primarily on external   auditors’ judgments, and includes archival studies addressing the usefulness of red flags to predict the presence of fraud, experimental studies of how various factors influence fraud assessment, and studies designed to develop and test tools to be used for the fraud assessment task (see Nieschwietz et al. 2000). However, even these studies do not provide evidence on the effects

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