1. Experimental Economics Research in Auditing Steven Kachelmeier University of Texas at Austin … and some broader observations

2. NextPrevious Todays program Current auditing issues Research tools Analytical Experimental economics Empirical Behavioral Getting it published

3. NextPrevious Todays program, as reorganized Current auditing issues Research 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

4. NextPrevious What exactly differentiates the experimental economics paradigm? Wrong answer: Experimental economics studies are motivated by economic theories instead of psychology theories.

5. NextPrevious What exactly differentiates the experimental economics paradigm? A better answer (in my opinion): Experimental Economics Behavioral Judgment Dependent Variable ActionsJudgments and Hypothetical Decisions IncentivesDecision-based compensation No payments or fixed payments Nature of Decisions InteractiveIndividual

6. NextPrevious Does experimental economics warrant equal billing on todays program? - 30068005600

7. NextPrevious Total auditing studies published in JAR and TAR, 1980-2004

8. NextPrevious Total auditing studies published in JAR and TAR, 1995-2004

9. NextPrevious Takeaways thus far No, I probably dont 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 Im 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.

10. NextPrevious Total articles published in JAR and TAR: 1980-2004

11. NextPrevious Total studies in JAR and TAR: 1980-2004

12. NextPrevious Total studies in JAR and TAR: 1980-2004, by topic

13. NextPrevious Each topic as percent of total: 1980-2004

14. NextPrevious Total studies in JAR and TAR: 1980-2004, by method

15. NextPrevious Each method as percent of total: 1980-2004

16. NextPrevious Total studies in JAR and TAR: 2000-2004, by topic and method

17. NextPrevious Total studies in JAR and TAR: 1980-1984, by topic and method

18. NextPrevious Audit studies as % of total: 1980-2004 Highest year: 1982 (38%)Lowest year: 2002 (9.6%)

19. NextPrevious Frequency of audit issues investigated in JAR and TAR, 1980-2004 1.Strategic interactions between auditors and managers, including studies of fraud 67 2.Planning, screening, and risk assessment43 3.Internal controls37 3.Audit fees and the market for audit services37 5.Evaluation of substantive audit evidence35 6.Audit sampling34 7.Analytical review procedures31 8.Perceptions of and market reactions to auditing26 9.Going concern assessments and reports20 10.Effects of non-audit services on independence18 Freq.

20. NextPrevious Frequency of audit issues investigated in JAR and TAR, 1980-2004 11.Organizational issues involving CPA firms (e.g., evaluations, job satisfaction, staffing) 16 12.Audit review process15 13.Internal auditing9 14.Materiality8 15.Nontraditional services / assurance services7 16.Attribution of responsibility for failures6 Freq.

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

22. NextPrevious 2. Planning, screening, and risk assessment

23. NextPrevious 3 (tie). Internal controls

24. NextPrevious 6. Audit sampling

25. NextPrevious 10. Effects of non-audit services on independence

26. NextPrevious 11. Organizational issues involving CPA firms

27. NextPrevious 12. Audit review process

28. NextPrevious Where I see your future 1. Impact of SOX on auditor-manager interaction 2. Internal controls (back to the future) 3. Auditing estimates

29. NextPrevious Comparative 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

30. NextPrevious Comparative advantages of experimental economic methods 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 –

31. NextPrevious Recipe for a successful study following the experimental 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.

32. NextPrevious Recipe for a successful study following the experimental 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.

33. Three quick examples

34. NextPrevious Example 1 (Hobson and Kachelmeier, Accounting Review, 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.

35. NextPrevious Example 2 (Mayhew and Pike, Accounting Review, July 2004) Question: Does it make any difference whether the auditor is hired by management or is hired directly by investors? Economics: It shouldnt 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.

36. NextPrevious Example 3 (King, Accounting Review, 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.

37. NextPrevious Two other auditing studies that caught my eye upon scanning 25 years of JAR and TAR 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.

38. NextPreviousQuestions?