Experimental Economics Research in AuditingExperimental Economics Research in Auditing

Steven KachelmeierSteven Kachelmeier

University of Texas at AustinUniversity of Texas at Austin

… and some broader observations

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Today’s programToday’s program

Current auditing issuesResearch tools

Analytical Experimental economics Empirical Behavioral

Getting it published

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Today’s program, as reorganizedToday’s program, as reorganized

Current auditing issuesResearch tools

Analytical modeling Empirical (based on data)

Archival or other naturally occurring data Experimentally generated data

Behavioral judgment / psychology paradigm Experimental economics paradigm

Getting it published

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What exactly differentiates the “experimental What exactly differentiates the “experimental economics” paradigm?economics” paradigm?

Wrong answer:

Experimental economics studies are motivated by economic theories instead of psychology theories.

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What exactly differentiates the “experimental What exactly differentiates the “experimental economics” paradigm?economics” paradigm?

A better answer (in my opinion):

Experimental Economics

Behavioral Judgment

Dependent Variable

Actions Judgments and Hypothetical Decisions

Incentives Decision-based compensation

No payments or fixed payments

Nature of Decisions

Interactive Individual

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Does experimental economics warrant equal billing Does experimental economics warrant equal billing on today’s program?on today’s program?

- 300 6800 5600

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Total auditing studies published in Total auditing studies published in JARJAR and and TARTAR, , 1980-20041980-2004

020406080

100

120140160180200

Analytic Archival J/DM Exp. Econ.

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Total auditing studies published in Total auditing studies published in JARJAR and and TARTAR, , 1995-20041995-2004

0

10

20

30

40

50

60

Analytic Archival J/DM Exp. Econ.

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Takeaways thus farTakeaways thus far No, I probably don’t warrant equal billing. However, I spent a lot of time looking at the

Tables of Contents of JAR and TAR for the last 25 years, and I’m sure as heck going to show it to you.

This exercise will illustrate two important behavioral phenomena:– Sunk cost fallacy– Escalation errors

Time permitting, I will return to the experimental economics theme at the end.

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Total articles published in Total articles published in JARJAR and and TARTAR: 1980-2004: 1980-2004

0102030405060708090

100

TotalJARTAR

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Total studies in Total studies in JARJAR and and TARTAR: 1980-2004: 1980-2004

0

50

100

150

200

250

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350

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450

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

TARJAR

                             

   

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Total studies in Total studies in JARJAR and and TARTAR: 1980-2004, by topic: 1980-2004, by topic

0

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'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

FinMgrlTaxAudit

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Each topic as percent of total: 1980-2004Each topic as percent of total: 1980-2004

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100%

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

FinMgrlTaxAudit

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Total studies in Total studies in JARJAR and and TARTAR: 1980-2004, by method: 1980-2004, by method

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250

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450

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

ArchivalAnalyticExperiments

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Each method as percent of total: 1980-2004Each method as percent of total: 1980-2004

0%10%20%30%40%50%60%70%80%90%

100%

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

ArchivalAnalyticExperiments

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Total studies in Total studies in JARJAR and and TARTAR: 2000-2004, : 2000-2004, by topic and methodby topic and method

0

50

100

150

200

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Audit Tax Managerial Financial

ArchivalAnalyticExperiments

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Total studies in Total studies in JARJAR and and TARTAR: : 1980-19841980-1984, , by topic and methodby topic and method

0

50

100

150

200

250

Audit Tax Managerial Financial

ArchivalAnalyticExperiments

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Audit studies as % of total: 1980-2004Audit studies as % of total: 1980-2004

0

5

10

15

20

25

30

35

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

OverallJARTAR

Highest year: 1982 (38%) Lowest year: 2002 (9.6%)

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Frequency of audit issues investigated in Frequency of audit issues investigated in JARJAR and and TARTAR, 1980-2004, 1980-2004

1. Strategic interactions between auditors and managers, including studies of fraud

67

2. Planning, screening, and risk assessment 43

3. Internal controls 37

3. Audit fees and the market for audit services 37

5. Evaluation of substantive audit evidence 35

6. Audit sampling 34

7. Analytical review procedures 31

8. Perceptions of and market reactions to auditing 26

9. Going concern assessments and reports 20

10. Effects of non-audit services on independence 18

Freq.

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Frequency of audit issues investigated in Frequency of audit issues investigated in JARJAR and and TARTAR, 1980-2004, 1980-2004

11. Organizational issues involving CPA firms

(e.g., evaluations, job satisfaction, staffing)

16

12. Audit review process 15

13. Internal auditing 9

14. Materiality 8

15. Nontraditional services / assurance services 7

16. Attribution of responsibility for failures 6

Freq.

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1. Strategic interactions between auditors and 1. Strategic interactions between auditors and managers, including studies of fraudmanagers, including studies of fraud

02468

10

1214161820

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

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2. Planning, screening, and risk assessment2. Planning, screening, and risk assessment

02468

10

1214161820

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

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3 (tie). Internal controls3 (tie). Internal controls

02468

10

1214161820

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

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6. Audit sampling6. Audit sampling

02468

10

1214161820

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

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10. Effects of non-audit services on independence10. Effects of non-audit services on independence

02468

10

1214161820

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

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11. Organizational issues involving CPA firms11. Organizational issues involving CPA firms

02468

10

1214161820

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

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12. Audit review process12. Audit review process

02468

10

1214161820

'80-'84 '85-'89 '90-'94 '95-'99 '00-'04

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Where I see your futureWhere I see your future

1. Impact of SOX on auditor-manager interaction

2. Internal controls (back to the future)

3. Auditing estimates

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Comparative advantages of experimentationComparative advantages of experimentation

Can isolate the incremental effect of one thing while holding everything else constant.

Can examine things that do not yet exist in practice.

For further comments, see Kachelmeier and King, Accounting Horizons, September 2002

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Comparative advantages of experimental economic Comparative advantages of experimental economic methods in particularmethods in particular

Four features that distinguish accounting and auditing tasks from more generic tasks:

1. Multiperiod and multiperson interaction

2. Enormous financial consequences

3. Market forces

4. Unique institutional considerations

From Ashton and Ashton, 1995, p. 6 –

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Recipe for a successful study following the Recipe for a successful study following the experimental economics paradigmexperimental economics paradigm

Ten years ago –

1. Construct or borrow a rigorous economic model of strategic considerations in auditing.

2. Translate the model into instructions that even students can understand.

3. See if they do.

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Recipe for a successful study following the Recipe for a successful study following the experimental economics paradigmexperimental economics paradigm

Today --

1. Motivate an interesting auditing question into an interactive experimental task.

2. Consider what economics-based theory would predict.

3. Consider what psychology-based theory would predict.

4. If 2. and 3. do not yield distinct, interesting predictions, go back to 1. Your study lacks behavioral tension.

Three quick examplesThree quick examples

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Example 1 (Hobson and Kachelmeier, Example 1 (Hobson and Kachelmeier, Accounting Accounting ReviewReview, July 2005 forthcoming), July 2005 forthcoming)

Not an auditing example, but what the heck.

Question: How do investors react to partial information disclosures?

Economics: They infer something about the private information management chose not to disclose.

Cognitive psychology: They anchor on the disclosed information and adjust insufficiently for missing information.

Results: Both predictions can hold simultaneously.

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Example 2 (Mayhew and Pike, Example 2 (Mayhew and Pike, Accounting ReviewAccounting Review, , July 2004)July 2004)

Question: Does it make any difference whether the auditor is hired by management or is hired directly by investors?

Economics: It shouldn’t make any difference so long as the market is efficient and reflects rational inferences.

Social psychology: Perceived role conflict will be more likely to favor independence when investors hire auditors.

Results: The psychological perspective helps to explain behavior.

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Example 3 (King, Example 3 (King, Accounting ReviewAccounting Review, April 2002), April 2002)

Question: Does peer pressure from other auditors mitigate auditor moral hazard?

Economics: Not unless there are direct monetary penalties associated with such pressure.

Social psychology: Yes, if auditors value their social identity.

Results: The psychological perspective helps to explain behavior.

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Two other auditing studies that caught my eye upon Two other auditing studies that caught my eye upon scanning 25 years of scanning 25 years of JARJAR and and TARTAR

Maher, Michael W., “The Impact of Regulation on Controls: Firms’ Response to the Foreign Corrupt Practices Act.” The Accounting Review 56 (October 1981): 751-770.

Knapp, Michael C., “An Empirical Study of Audit Committee Support for Auditors Involved in Technical Disputes with Client Management.” The Accounting Review 62 (July 1987): 578-588.

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Questions?Questions?