2005 AAA Auditing Section Doctoral Consortium Mark Penno University of Iowa

My Talk: Analytical Auditing Research: New Directions From Several Disciplines Highlights

Most background material (including most cites) for this talk is contained in a paper with the same title..

To download this paper: Google mark-penno, where you will find: SSRN Author Page for Mark Penno SSRN Author Page for Mark Penno

Click and you will find: Analytical Auditing Research: New Directions from Several Disciplines Mark Penno

Or me:

BASIC PREMISE 1: The economic paradigm has been a dominant paradigm in analytical auditing research.

BASIC PREMISE 2: While the traditional modeling approach has made important contributions, it does not adequately represent the auditors role...

CURRENT DEVELOPMENTS: …recently economic theory has benefited from recent developments in sociology, psychology, philosophy, artificial intelligence, and jurisprudence…

It is necessary for auditing academics to familiarize themselves with these issues in order to better inform experimental and archival efforts, and perhaps even take part in the analytic work itself.

THE TRADITIONAL ECONOMIC PARADIGM: Economic actors: T1) are self-interested (with guile); T2) maximize their discounted utility of personal payoffs; T3) have complete & transitive preferences.

Observation (T1): Self interest is a simplification useful for modeling various phenomena.

…amoral behavior without empathy or remorse.

Purely self-interested person: Psychopath?

Statement on Auditing Standards No. 78, 1995:

The effectiveness of controls cannot rise above the integrity and ethical values of the people who create, administer, and monitor them..

Audits of completely self- interested agents are probably very difficult/costly to do.

Observation (T2): Utility maximization of expected payoffs: is a simplification useful for modeling various phenomenon.

Much of what we do (in life) is rule- driven

That is, we typically follow rules rather than performing expected utility maximizations over consequences for each decision that we make.

James March..most of the time, most people in organizations follow rules even when it is not obviously in their self-interest to do so….

…Much of the behavior in an organization is specified by standard operating procedures, professional standards, cultural norms, and institutional structures linked to conceptions of identity.

My point: Accounting is mostly about rules..

Observation (T3): Complete & transitive preferences : a simplification useful for modeling various phenomenon.

We all experience dilemmas:

If we COULD neatly order our preferences over payoffs, we would NEVER face dilemmas…. Just choose the highest ranking alternative.

ILLUSTRATION: From Keim and Grant (2003, 398): You [auditor] have just returned from a lunch with Jay Hoffman [long-time relationship], the new chief financial officer (CFO) for Bell Manufacturing….

…He then told you …xxxx…. and asked that you keep this in confidence.

Conflicts between rules (principles): Rule 1) Keeping confidences; Rule 2) Obligation to identify ethically-challenged individuals.

Problem: incommensurability. A. Impossible to measure or compare. B. Lacking a common quality on which to make a comparison.

Illustrations Of Research Related to These Issues

Norm-following (Schelling)

Consider a sign, DO NOT WALK ON THE GRASS. If it were a quiet sunny afternoon between classes at a university, most people would obey that sign. But …

Dynamic setting: Rule-following

Cressman, Morrison, and Wen (1998) : Owners (principals) face opportunists (agents). An owner chooses a probability of monitoring p1, and an opportunist chooses a probability of not-stealing, q1.

EQ1: the rate of increase in the probability of not stealing, q1, increases (decreases) with the probability of monitoring, p1; EQ2: the rate of increase in the probability of monitoring p1 decreases with the probability of not-stealing, q1.

Cressman, Morrison, and Wen (1998) provide an interesting discussion of these models and effects in their examination of crime dynamics….

A related setting for tax compliance dynamics is examined by Davis, Hecht and Perkins (TAR, 2003).

Multiple-selves models

Shefrin and Thaler (1981) present a dual-self model with 1) short-term self, and 2) long-term self.

Similarly, Carrillo J. and T. Mariotti, 2000, Strategic Ignorance as a Self- Disciplining Device

Tirole (2002) presents a simple description of their idea. The agent has a utility function of the form:

The agent has an opportunity to learn about a future state of nature. When given the opportunity, she may decline.

… She is afraid of what future selves will do with this information…

SOME OTHER EXTANT UTILITY REPRESENTATIONS

Laffont (1975) describes an approach called Kantian economics.

Kants first categorical imperative is: "Act only according to that maxim by which you can at the same time will that it should become a universal law."

Laffont first supposes that a particular agent has utility function, U(x,y,P) where the agent has direct choices x and y (two consumption items) and P represents the cumulative (say, additive) effect of this y and all other agents -choices

RECALL: Kants first categorical imperative is: "Act only according to that maxim by which you can at the same time will that it should become a universal law."

That essentially implies that P=Ny

Or: U(x,y,P) = U(x,y,y)

There are more recent, but related, formulations as well: E.g.,. Brekke, K, S. Kverndokk, and K. Nyborg, 2003, A Economic Model of Moral Motivation, Journal of Public Economics

Modeling considerations: Ethical/norm-driven decisions have some interesting properties..

For example, Etzioni (1988, 76): Choices that are relatively heavily loaded with moral considerations, including many economic choices, are expected to be..

1) unusually difficult to reverse (i.e., they are asymmetrical), 2) to be very lumpy (highly discontinuous) 3) to reveal a notch-effect (a resistance to pass through a threshold, that makes the behavior sticky before it is passed; the reluctance is greatly lost once passage is completed

It is interesting to note the paper by Gneezy and Rustichini (2000), which appears in the Journal of Legal Studies.

Problem they examined: Late- coming parents at an actual day- care center.

RESULTS 1) the number of late-coming parents significantly increased when a day-care center introduced a fine for late-comers 2) no reduction in late-coming occurred after the fine was removed – suggesting a permanent change in the parents behavior

1)Big changes IN BEHAVIOR may indicate multiple equilibria. 2) Big changes IN BEHAVIOR may indicate that we play language games.

Multiple equilibria

Language game: A set of rules about how to talk, think and act in different situations from: Koppl, 2002, Big Players and the Economic Theory of Expectations, Palgrave.

There are many other interesting issues to discuss…..but time is short… but…

Problems of INFINITE REGRESS

1)I know that you know, 2) I know that you know that I know, 3) I know that you know that I know, that you know etc… This is an example of an infinite regress.

It is not clear that the human mind can handle this sort of complexity. There must be a mechanism to make this problem manageable.

By adopting stereotypical (rule- driven) behavior, the need for second-, third-, etc., conjectures disappear. To the extent that stereotypic behavior enhances the predictability of others, it enables cooperation.

Battle-of-the Sexes One person likes going to the football game, the other likes opera. However, both prefer going to the less preferred activity with company than going alone to the preferred activity.

VAGUENESS AND AMBIGUITY

A casual word search of the Miller GAAP Guide (vague terms)

IDENTITY

Economists are becoming interested in identity. E.g., Akerlof, G., and R. Kranton, 2000, Economics and Identity, Quarterly Journal of Economics.

My take: Individuals have a need (intra- and interpersonal) to be consistent. Consistency is probably a major determinant of individual and group behavior.

Although: Ralph Waldo Emerson said that A foolish consistency is the hobgoblin of little minds.A foolish consistency is the hobgoblin of little minds

FINAL THOUGHT knowledge of these areas will be very helpful.