Experimental Economics Research in Auditing

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

2. Today’s program • Current auditing issues • Research tools • Analytical • Experimental economics • Empirical • Behavioral • Getting it published

3. Today’s 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. What exactly differentiates the “experimental economics” paradigm? Wrong answer: Experimental economics studies are motivated by economic theories instead of psychology theories.

5. What exactly differentiates the “experimental economics” paradigm? A better answer (in my opinion):

6. Does experimental economics warrant equal billing on today’s program? - 300 6800 5600

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

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

9. Takeaways 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.

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

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

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

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

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

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

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

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

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

19. Frequency of audit issues investigated in JARand TAR, 1980-2004 Freq.

20. Frequency of audit issues investigated in JARand TAR, 1980-2004 Freq.

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

22. 2. Planning, screening, and risk assessment

23. 3 (tie). Internal controls

24. 6. Audit sampling

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

26. 11. Organizational issues involving CPA firms

27. 12. Audit review process

28. Where I see your future • Impact of SOX on auditor-manager interaction • Internal controls (back to the future) • Auditing estimates Tenure ?

29. 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. 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. 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. 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. 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. 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 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.

36. 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. 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. Questions?