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 managements incentives to intentionally
misstate their financial position, and in the quality of a firms audit committee. Internal
auditors are an integral part of an organizations 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 a nother
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.

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 (ORegan 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

For additional discussion on this role for internal auditors see Thomas and Clements (2002).

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, dont 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

(i.e., audit hours) to investigate the potential of such risk. Evidence on the extent to
which internal auditors are sensitive to factors that underlie the occurrence of fraud
provides insights into how well internal auditors discharge this component of their
function. Such evidence may be useful for external auditors, as well as audit committee
members, seeking to rely on internal auditors as partners in the prevention and
detection of fraudulent financial reporting.
Our experimental results indicate that internal auditors fraud risk assessments
are responsive to variations in management incentives and 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
not to variations in the quality of the audit committee. These results generally hold
whether the internal auditors are evaluating a potential acquisition target or the
company at which they are employed. Our findings imply that internal auditors are
typically aware of the importance of a strong audit committee to reducing the risk of
fraudulent financial reporting, but are nevertheless unwilling to reduce the scope of their
fraud related audit work as a result of the presence of a strong audit committee. This
result raises more of an efficiency concern than an effectiveness concern, which may be
good news to the many market participants and observers concerned with the quality of
financial reporting .
The remainder of the paper is organized into four sections. The next section
provides background information on the role of internal audit in the financial reporting
process, discusses literature relevant to fraud risk assessments, and presents the

of management incentives and audit committee quality on planning assessments and decisions. Thus, the issue we
examine herein remains an important issue for investigation.

research hypotheses. The research method and results follow in sections 3 and 4,
respectively. Section 5 concludes with a summary of the findings and a discussion of
the potential implications of these findings.
2.

Background and hypotheses

The role of internal audit in the financial reporting process

Financial audit related work comprises, on average, 25 percent of the work
typically performed by internal auditors (Felix et al. 1998). Through their monitoring
activities, internal auditors serve a vital function in ensuring the quality of financial
reporting (BRC 1999). Their role in financial reporting is further increased when external
auditors rely on the work of internal auditors in completing the financial statement audit
(e.g., see AICPA SAS No. 65; Maletta and Gramling 1999). Also, internal auditors are
oftentimes required to assess the reliability and integrity of financial information as part
of due diligence audits related to joint ventures, mergers, and acquisitions (Burke
2000).4
In planning and performing audits of the integrity and reliability of financial
information, internal auditors are directed to be alert to the potential indicators of fraud
(IIA, 1995 Section 280; IIA, 2001 Section 1210.A1). Two potentially important indicators
of fraudulent financial reporting identified in prior research are the incentives of
management to misstate their financial position (Loebbecke et al. 1989) and the quality
of corporate governance mechanisms, especially the audit committee, designed to limit
the opportunity for fraudulent financial reporting (Beasley et al. 1999b; BRC 1999,
4

A number of practitioner articles discuss the important role for internal audit in the mergers and acquisitions
process (e.g., Nygaard (2002), Aldhizer and Cashell (1999, 2000)). Further, the IIA recently published a monograph
to provide guidance to internal auditors who involved in merger and acquisition activities at their organizations

Chtourou et al. 2001). Further, the IIA standards stress the importance of ensuring that
the audit plan is appropriate, in light of the risk of fraudulent financial reporting (IIA ,
1995 Section 520.04.3b; IIA, 2001 Section 1220.A1).
Incentives for fraudulent financial reporting
The risk of fraudulent financial reporting is influenced by management incentives
to misstate financial information (Loebbecke, Eining, and Willingham 1989). Incentives
for this type of reporting behavior stem from a variety of sources, including a
commitment to analysts to achieve unrealistic forecasts, a management bonus plan that
is based on financial performance, and a perceived need to continue a sales growth
trend (AU 316.17 AICPA 2001; Duncan 2001; Jacksonh and Pitman 2001).
Archival research examining predictors of fraud has indicated that management
incentives to misstate are associated with the occurrence of fraud (e.g., Albrecht and
Romney 1986; Loebbecke et al. 1989; Bell and Carcello 2000). However, little research
exists to document whether auditors risk assessments, and related audit effort
decisions, appropriately incorporate management incentives.5
Prior research suggests that decision makers are sensitive to source credibility. 6
Source credibility is influenced by various characteristics of the information source
including integrity (e.g., Kaplan and Reckers 1984; Peecher 1996), competence (e.g.,
Messier and Schneider 1988) and, most important to this study, motivation (e.g.,
Jaspars et al., 1983; Eagly and Chaiken 1993). It is reasonable to assume that
(Davison 2001). Despite this important role, the academic literature in this area is sparse. Thus, examining the
judgments and decisions of internal auditors in this process provides important insights.
5
Prior survey research suggests that both external and internal auditors perceive that management incentives are an
important indicator of fraud risk (i.e., perceptions were provided, but no judgments were made) (e.g., Apostolou, et
al. 2001; Gramling and Myers, 2003; Heiman-Hoffman et al. 1996). However, no research has focused on whether
the fraud risk assessment task is sensitive to variation in management incentives and the quality of audit committees.

management incentives affect the motivation to fraudulently misstate financial

information, which, in turn, affects the credibility of the financial statements. 7 For
example, when management has high (low) incentives to fraudulently report their
financial position, the credibility of their assertions will be low (high).
An important issue then is whether internal auditors risk assessments are
contingent on the level of management incentives. Internal auditors are closely aligned
with management, often have the same incenti ves of management and, therefore, may
be unwilling to associate such incentives with higher fraud risk. To control for the
potential effect of this unique role of internal auditors, we first examine a setting where
internal auditors evaluate a potential acquisition and, and hence a management with
which they are not closely aligned. This setting allows us to present a clearer test of the
relation between internal auditors' fraud risk assessments and management incentives
that is less likely to be contaminated by internal audit being closely aligned with
management. To increase the generalizability of our findings and incorporate the many
unique aspects of internal auditing (e.g., incentives congruent with management,
familiarity with management), we then extend our investigation to a setting where
internal auditors evaluate the company at which they are employed.
Internal auditors assessing fraud risk in the financial statements should consider
the credibility of the source of that financial information (e.g ., Goodwin 1999; Hirst
1994). Specifically, in the settings we examine, internal auditors should recognize there
is a higher (lower) likelihood of fraudulent financial reporting when management has
6

The terms credibility and reliability are interpreted as having the same meaning and are used interchangeably (see
Goodwin 1999).
7
While we appeal to the source credibility literature as a theoretical basis for our hypotheses, other literatures in
psychology provide alternative theoretical frameworks. For example, attribution theory suggests that when an

high (low) incentives to misstate their financial position. Accordingly, we expect internal
auditors to incorporate management incentives into their risk assessments, as indicated
in the following hypothesis.
H1a: Internal auditors fraud risk assessments will increase more when management
incentives to misstate their financial results are high than when their incentives are low.
Internal audit plans should reflect the risk of fraudulent financial reporting (IIA,
1995 Section 520.04.3b; IIA 2001 Section 1220.A1). Accordingly, when management
incentives to misrepresent financial results are high (low), auditors should plan to exert
more (less) effort ascertaining whether, and to what extent, fraudulent financial reporting
has occurred. Prior archival and experimental research with external auditors has found
a tenuous relationship between risk assessments and audit programs (e.g., Mock and
Wright 1993, 1999; Wright and Bedard 2000). 8 These results may stem from external
auditors being fixated with the prior years audit program. Internal auditors do not
typically audit the same area on an annual basis, and thus would be less influenced by
a prior years audit program; therefore their audit plans may be more reflective of risk.
This expectation is formalized in the following hypothesis.
H1b: Internal auditors budgeted audit hours will increase more when management
incentives to intentionally misstate their financial results are high than when their
incentives are low.
Audit committees as a mechanism to limit the opportunity for fraudulent financial
reporting
Regardless of managements incentives to intentionally misstate their financial
results, opportunities to intentionally misstate are reduced in the presence of a high

information source has incentives to bias, evaluators of that information should perceive that information as less
persuasive (e.g., Eagly and Chaiken 1993).
8
We are not aware of any similar research examining internal auditors audit program decisions.

quality corporate governance structure (Loebbecke et al. 1989; Turner 1998; Beasley et
al. 2000, Chtourou et al. 2001). An important component of an organizations corporate
governance is its audit committee, which exercises oversight responsibility over the
financial reporting process (Beasley et al. 1999b). Recent stock listing requirements, as
well as other professional reports, recognize the important role that a quality audit
committee can have in ensuring quality financial reporting. 9
Archival research has shown an association between the quality (i.e., financial
expertise and independence) of the audit committee and fraud occurrence. With
respect to audit committee expertise, Beasley et al. (1999a) note that, for fraud
companies, only 35 percent of audit committee members had accounting or finance
expertise. McMullen and Raghunandan (1996) find that only 6 percent of companies
with SEC enforcement actions, earnings restatements, or both have audit committees
with at least one CPA, while 25 percent of non-problem companies had audit
committees with at least one CPA. Finally, Chtourou et al. (2001) find some evidence
for a negative relation between the financial competence of the audit committee and
earnings management.
Research documents similar findings related to audit committee independence.
Carcello and Neal (2000) posit that audit committees may perform their duties
inadequately if the committee members are not independent. Beasley (1996)
documents that relative to no-fraud companies, fraud companies have a lower
percentage of outside (i.e., independent) directors on the audit committee. McMullen

A forthcoming study asks internal auditors to rate the importance of various factors in assessing the risk of
fraudulent financial reporting (Gramling and Myers, 2003). The study finds that internal auditors assess governance
factors, including audit committee factors, as important for this assessment, albeit much less important than many
other factors.

and Raghunandan (1996) also document a similar difference between companies with
and without reporting problems. For problem companies, 67 percent had audit
committees comprised of only independent directors, while 86 percent of the no
problem companies had audit committees comprised of only independent directors.
Further, Beasley et al. (1999a) find that for a sample of fraud companies, only 40
percent had audit committees composed of entirely independent directors. In
comparing fraud companies in three industries with no-fraud industry benchmarks,
Beasley et al. (2000) find that, in all three industries examined, audit committees at
fraud companies were less independent than the corresponding no-fraud industry
benchmark.
While archival evidence supports a positive relation between audit committee
quality and quality of financial reporting, there is little evidence that auditors risk
assessments and related audit effort decisions are influenced by variations in audit
committee quality. 10 From a source credibility perspective, internal auditors should
recognize the relation between the quality of the audit committee and the likelihood of
fraudulent financial reporting. Further, parties interested in the internal audit profession
(e.g., AuditWire 1999; Beasley et al. 1999b) encourage internal auditors to consider this
documented archival evidence (e.g., Beasley et al. 1999a) when assessing fraudulent
financial reporting. However, it is also possible that internal auditors may have difficulty
assessing an audit committee as weak. That is, they may perceive the existence of an
10

Cohen and Hanno (2000) examine a somewhat related issue and find that the extent of substantive testing,
measured by number of locations to be tested, is affected by the quality of corporate governance, but that the extent
of testing to be performed at an interim date is not affected by corporate governance quality. Cohen and Hannos
(2000) definition of corporate governance is quite different from what we examine herein. Their independent
variable of corporate governance included characteristics of the board (e.g., level of board independence, importance
of board developed code of conduct) and activities and characteristics of the audit committee (e.g., meetings with

10

audit committee as prima facie evidence of managements commitment to strong

governance.11 On balance, there appears to be greater theoretical and archival support
for a predicted association between audit committee quality and fraud likelihood.
Accordingly, we would expect internal auditors to incorporate audit committee quality
into their risk assessments, as stated in H2a.
H2a: Internal auditors fraud risk assessments will increase more when the quality (i.e.,
expertise, independence) of the audit committee is low than when the quality is high.
Similar to our discussion related to the relation between management incentives
to misreport and planned budgeted hours (i.e., H1b), we expect that internal auditors
will adjust their audit plans in response to variations in the quality of corporate
governance. Accordingly, we present the following hypothesis.
H2b: Internal auditors budgeted audit hours will increase more when the quality (i.e.,
expertise, independence) of the audit committee is low than when the quality is high.
3.

Research method

Participants
The participants were 60 internal auditors who were recruited through either their
local Institute of Internal Auditors (IIA) chapter or through personal recruitment from one
of the co-authors.
The majority of the participants (54.1%) currently hold positions as internal audit
seniors or managers. Twenty-six (42.6%) auditors had experience as an external
auditor and have the CPA certification. Over the last two years the participants had

internal and external auditors). Thus, their design, unlike the design presented herein, does not allow for
unambiguous interpretation regarding the importance of audit committee quality.
11
We recognize that firms listed on the three largest exchanges (NYSE, AMEX, NASDAQ) must appoint an audit
committee, and thus the existence of an audit committee is not prima facie evidence of a committee to quality
governance, but rather evidence of adherence to regulatory requirements (Parker 1999).

11

spent, on average (), 17.4 (21.3) percent of their time conducting audits related to the
integrity and reliability of financial information.
Experimental task and procedure
Participants were asked to assume that they had been assigned to the internal
audit team that will be performing the audit of a hypothetical company, which is an
acquisition target of their current employer. 12 The participants were told that the audit
teams focus is on the reliability and integrity of the financial information for the year just
ended. As part of this examination, they had been assigned to plan the audit
engagement for the area of accounts receivable and related accounts (i.e., bad debts,
allowance for uncollectible accounts, cash discounts, sales returns). 13 Participants were
told that their planning would culminate in several risk assessments and audit effort (i.e.,
budgeted hours) decisions. Participants were reminded to make these judgments as if
they were on an actual audit where, for instance, their judgments would be subject to
supervisory review. 14
The first part of the case materials provided the participants with information
about the target company including comparative financial statements, key personnel,
and key accounting and internal control policies. The companys stock is traded on
NASDAQ. Internal controls are described as typical for a small to medium sized
manufacturing company. Moreover, because the company is relatively small, internal

12

The hypothetical firm is based on case materials modified from Zimbelman (1997). We use the context of
performing due diligence work on a potential acquisition since this is an area where internal audit can play an
important role in assessing the reliability of financial information (see footnote # 3 above, and Applegate 2000;
Burke 2000).
13
On average (),over the past two years participants had worked on 11.2 (19.7) audits where they performed
procedures related to the integrity of the accounts receivable balance.
14
Prior to running the experiment, preliminary versions of the cases were given to practicing internal auditors for
their review and completion. All agreed that the case was realistic and could be reasonably completed by internal
auditors.

12

controls are not extensive, though they are deemed adequate and cost beneficial.
Further, as part of this audit engagement, the participants were told that they would not
be relying on, or performing, tests of controls. Participants were also informed that
external audits of the target company had consistently resulted in unqualified audit
opinions. The year ended will be the third year that the same Big 5 external audit firm is
scheduled to audit the target company. Minor adjustments resulting from prior audits
have generally been related to the cutoff for accounts payable, the allowance for
doubtful accounts, and the inventory reserve.
After reading this introductory material, participants were then asked to indicate
the likelihood of an intentional material misstatement and an unintentional material
misstatement (e.g., error) existing in the net accounts receivable account. They made
these assessments on a scale whose endpoints were labeled minimum likelihood=0
and maximum likelihood=100. Participants were also asked to budget audit hours to
confirm receivable balances, as well as to perform other A/R work. They indicated total
budgeted hours, and provided an allocation of the total hours among staff, seniors,
managers, and director.
After providing these initial assessments, participants were informed that their
internal audit director had received additional information about the target company that
she believed they should know. The director provided information about revenue goals
of the target company, and the composition and activities of the audit committee and
board of directors. 15 This additional information served as the manipulations of

15

Information about the board was not manipulated. Accordingly, participants in all experimental conditions
received the same information about the Board of Directors. That information indicated The Board is comprised of
seven members. On average, the board members have served on Valley Manufacturings Board for five and a half
years. The Board typically has seven meetings a year. Less than half of the Board members are company insiders

13

management incentives to intentionally misstate their financial results and the quality of
the audit committee (manipulations are described below). Subsequent to these
manipulations, participants were asked to provide a revised risk assessment and update
audit effort decisions, as they deemed appropriate .
The case concluded with manipulation checks and demographic questions. On
average (), the participants spent 28 (12.4) minutes completing the case materials.
The participants reported a mean () of 7.43 (2.07), on a scale of 0=not at all
understandable to 10=very understandable, whe n asked to indicate the
understandability of the instructions and case materials.
Research design and manipulations
We use a 2x2 between-subjects research design. The two manipulated
independent variables are the level of incentives of management to fraud ulently report
their financial results and the quality of the audit committee. The dependent variables
are the revisions in fraud risk assessments and planned budget hours subsequent to
obtaining the between-subjects manipulated information.
The two management incentive conditions specifically focused on the incentive of
management to engage in inappropriate revenue recognition practices. Our focus on
revenue recognition stems from the growing problem in this area (Iwata 2000) and
regulators concerns over this issue (Turner 1998).16 Participants in the high incentive
to fraudulently report financial results condition were told:
(i.e., officers of Valley Manufacturing). All of the other Board members are senior executives at other companies.
Two of the Board members are outside directors on other boards. The Board has two committees - a Compensation
committee and an Audit committee.
16
Based on a sample of approximately 200 SEC AAERs from 1987 to 1997, Beasley et al. (1999a) find that the two
most common types of frauds are revenue and asset overstatements. Falsifying revenue is a growing problem.
Revenue recognition was mentioned in only 20% of the securities frauds filed in 1998, but was an issue in 50% of
the fraud lawsuits filed in the first half of 1999 (Iwata 2000). Common abuses include recording sales that never

14

Following last years net loss, the CEO established some very aggressive
revenue goals for 2000. The sales force has faced a great deal of pressure for
sales growth from senior management. In fact, achieving sales targets has
become a company-wide obsession. Much of this pressure stems from
managements commitment to analysts to achieve their goals. A significant
portion of senior managements compensation derives from a performance
based bonus plan tied to accounting earnings. The remainder comes from a fixed
salary.
Those in the low management incentive condition were told:
Following last years net loss, the CEO set moderate revenue goals for the
company for 2000. While these goals have provided motivation to the sales
force, these goals have not caused the sales force inordinate pressure from
senior management for sales growth. While analysts have used these goals in
setting their forecasts, management has not committed to the analysts that they
will achieve these goals. Senior managements compensation is derived primarily
from a fixed salary with only a small percentage derived from performance
bonuses tied to accounting earnings.
Audit committee quality was manipulated by varying the independence and
financial expertise of the audit committee. Specifically, in the high quality condition,
participants were told:
The audit committee is comprised of three members, who are all independent
directors (i.e., no disclosed relationship between the director and the company or
its officers). Two of the audit committee members are CPAs, while the third is a
CIA. All three have work experience in the same industry as Valley
Manufacturing. All three have past experience in accounting and finance
positions; in fact, one of the audit committee members is currently employed as a
senior officer with significant financial oversight responsibilities.
In contrast, the participants in the low quality condition were told:17
occurred, shipping products before customers agree to delivery, and booking revenue upfront from long-term
contracts, rather than over the life of the contract (Iwata 2000, Turner 1998). Recent cases involving improper
revenue recognition include California Micro Devices (MacDonald 2000) and Bausch and Lomb (Plunkett and
Rouse 1998), while other well-known, though somewhat older cases include MiniScribe (Wang et al. 1997) and
Mattel (Knapp 1996).
17
Effective June 14, 2001 (subsequent to the administration of our case) NASDAQ mandated new audit committee
structure and membership requirements. Our case profiles a client whose stock is traded on NASDAQ. The new
rules require that audit committees have a minimum of three members and be comprised of independent directors
only. All directors must be able to read and understand fundamental financial statements, including a companys
balance sheet, income statement, and cash flow statement. At least one director must have past employment
experience in finance or accounting, requisite professional certification in accounting, or other comparable
experience or background, including a current or past position as a chief executive or financial officer or other senior

15

The audit committee is comprised of three members, of whom one is an officer

of the company, and one is a former employee of the company, who recently
retired. The third audit committee member is an outside director (i.e., has no
disclosed relationship between the director and the company or its officers).
None of the three audit committee members are professionally certified in
accounting, as their work experience has been exclusively in areas outside
accounting and finance. All three have work experience in the same industry as
Valley Manufacturing.
To provide context for the audit committee manipulation, all participants were
informed:
The audit committee has adopted a formal written charter that indicates that the
audit committee has responsibility for exercising oversight of the financial
reporting process. As part of that responsibility, the committee appoints the
external auditors and serves as a liaison between top management and the
external auditors. The committee is charged with reviewing the financial reporting
process, including review of estimates made by management and review of any
complex transactions. To accomplish its objectives, the committee typically
meets three to four times each year.
4.

Results

Manipulation checks
After completing the case materials (i.e., providing risk assessments and audit
effort decisions) participants were asked to characterize managements incentive to
misstate the financial statements, the financial competence of the audit committee, as
well as the independence of the audit committee on 11-point scales (see Appendix A for
the scales used in obtaining manipulation checks). Participants in the high incentive to
misstate condition rated managements incentives to misstate the financials at a mean
() of 5.97 (2.15), compared to a mean of 3.24 (1.68) reported by those in the low
incentive condition (t=5.44, p = 0.0001). Participants in the high quality audit committee
officer with financial oversight responsibilities. In some circumstances, however, the new rules allow one nonindependent director to serve on the audit committee. Accordingly, we anticipate that variations in quality among
audit committees will continue to exist. Our focus on whether internal auditors recognize and respond to variations

16

condition rated the financial competence of the audit committee at a mean () of 7.77
(1.96), compared to a mean of 3.45 (1.80) for those in the low quality audit committee
condition (t=8.87, p = 0.0001). Finally, participants in the high quality audit committee
condition rated the independence of the audit committee at a mean () of 7.52 (1.96),
compared to a mean of 3.21 (2.04) reported by those in the low quality audit committee
condition (t=8.33, p = 0.0001). Together, these results provide evidence for the success
of the manipulations. 18
Hypotheses tests
Assessments of fraud risk Hypothesis H1a indicates that management
incentives will affect internal auditors assessments of fraud risk, while hypothesis H2a
indicates that audit committee quality will affect these assessments. The revision in
fraud risk assessment subsequent to the manipulations is the dependent variable used
in testing these hypotheses.
Descriptive statistics pertaining to the dependent variable are presented in Panel
A of Table 1. Internal auditors in the high management incentive condition increased
their risk assessments by a mean () of 13.23 (15.36), compared to a mean ()
decrease of 2.06 (10.81) for those in the low management incentive condition. Internal
auditors in the high quality audit committee condition increased their risk assessments
in audit committee quality remains an important issue and provides evidence on the potential value of mandated
changes to audit committee structure and membership.
18
We performed sensitivity analyses to determine whether our results, presented in the next section, are sensitive to
demographic or case perception variables. First, ANOVAs indicate that the means of the following variables are not
significantly different across the four cells: self-reported effort in completing the case; self-reported length of time
to complete the case; perception of similarity of case materials to those used in practice, internal audit experience
with manufacturing clients, and internal audit experience with public companies. Additionally, we performed the
analyses presented in Tables 1 and 2 with the following covariates: whether the participant had a CPA, whether the
participant had ever been employed as an external auditor, understandability of the case materials, experience
auditing the integrity of the accounts receivable balance, and percentage of time spent in the last two years

17

by a mean () of 0.97 (12.74), compared to a mean () increase of 11.03 (16.33) for

those in the low quality condition.
The hypotheses are tested with a GLM that employs management incentives and
corporate governance as 2 levels between-subject factors. Panel B of Table 1 shows
that the incentive variable (F=22.85, p= 0.0001) and the audit committee variable (F=
9.54, p=0.0031) are both significant. The interaction is not significant (F=0.98, p=
0.3273). These results provide support for both H1a and H2a. 19
[INSERT TABLE 1]
[INSERT TABLE 2]
Audit Effort Decisions: Hypothesis H1b relates to the relation between
management incentives to intentionally misstate and internal auditors audit effort (i.e.,
budgeted hours) decisions, while hypothesis H2b relates to the relation between audit
committee quality and internal auditors budgeted hours. Descriptive statistics
pertaining to the dependent variable (i.e., percentage change in budgeted hours
subsequent to viewing manipulations) are presented in Panel A of Table 2.20
Internal auditors in the high management incentive condition increased budgeted
hours by a mean () of 23.67 (31.13) percent, compared to a mean () decrease of 3.69
(17.16) percent for those in the low management incentive condition. Internal auditors in
conducting audits related to the reliability and integrity of financial information. The covariates were not significant
and the results in Tables 1 and 2 remain unchanged.
19
While incentives to misrepresent financial position are expected to be associated with fraud risk, there is not a
strong reason to believe that these incentives would be associated with the likelihood of unintentional misstatements
(i.e., errors). Since our research focuses on fraud risk, we do not formally present a hypothesis related to
unintentional misstatement. However, supplemental ANOVA results (not presented in tabular form) indicate that
management incentives are only marginally significant (p > .075) in explaining internal auditors assessments of the
risk of unintentional misstatements (i.e., errors). Further, we would expect the effect of audit committee quality on
risk of unintentional misstatement to be similar to its effect on intentional misstatement risk. ANOVA results
support this expectation and indicate that audit committee quality is significant (p > .009) in explaining assessments
of unintentional misstatements.

18

the high quality audit committee condition increased budgeted hours by a mean () of
4.73 (12.23) percent, while those in the low quality condition increased budgeted hours
by a mean () 15.68 (31.67) percent.
The hypotheses are tested with a GLM that employs management incentives and
corporate governance as 2 levels between-subject factors. Panel B of Table 2 indicates
that the incentive variable is significant (F=15.73, p= 0.0003), providing support for H1b.
However, neither the audit committee variable (F= 2.46, p=0.1238), nor the interaction
(F=1.40, p=0.2428) is significant. These results provide evidence that internal auditors
budgeted audit hours are sensitive to changes in management incentives to misreport
financial results, but they do not reflect changes in audit committee quality. 21
Experiment 2
The basic conclusion from the experiment just discussed is that internal auditors
risk assessments are sensitive to variations in management incentives and audit
committee quality, while their audit effort decisions are sensitive to management
incentives, but not sensitive to audit committee quality. This conclusion is based on a
setting where internal auditors evaluate a potential target acquisition. While this setting
is one in which many internal auditors are involved, it does ignore the potential effect of
the unique role of internal auditors. That is, internal auditors often conduct audits where
they are potentially closely aligned with management (i.e., have the same incentives of
management) and, therefore, may be unwilling to associate their managements

20

The sample size difference between Tables 1 and 2 results from some subjects not providing completing
information necessary for testing H1b and H2b (Table 2).
21
The analysis we present is based on a revision in total budgeted hours. Our results remain qualitatively
unchanged (i.e., management incentive is significant, audit committee quality and interaction are not significant) if
we use revisions in hours for either of the two budget categories (i.e., confirmation work, other accounts receivable
work) as the dependent variable.

19

incentives with fraud risk. Further, the internal auditors will often having greater
familiarity with an audit committee of their own company, than with the audit committee
of a potential acquisition.
Given that our experimental setting controlled for the potential effect of this
unique role of internal auditors, it remains an unanswered question as to whether
internal auditors are able to appropriately incorporate management incentives and audit
committee quality into their risk assessments and audit effort decisions when the
management and audit committee they are assessing would be considered to be their
employers. That is, a potential explanation associated with these results is that the
internal auditors may have been more skeptical of an audit committee and management
of a potential acquisition firm than for their own firm. Thus, these results may not
generalize to settings where internal auditors make risk assessments and audit effort
decisions related to the firm that employs them.
Accordingly, before we could assess the generalizability of these results we
conducted a second experiment. In this follow-up experiment a second group of 43
internal auditors 22 completed the same task as in the first experiment, with one
exception. The setting was described as relating to the company in which they were
employed, rather than as a potential acquisition target.

23 24

22

These participants were selected in the same manner as for the first experiment. That is, they were recruited
through either their local Institute of Internal Auditors (IIA) chapter or through personal recruitment from one of the
co-authors. Further, all 43 participants provided responses necessary for inclusion in analysis for all hypotheses.
23
Consistent with Experiment 1, the responses to our manipulation check questions indicate that the manipulations
were successful (all p-values < .000).
24
The time spent on the case (28 vs. 28.05 minutes) and the perceived understandability of the case (7.43 vs. 8.33)
did not differ between the two experiments. Further, the experience levels of the participants in Experiment 2 were
very similar to those in Experiment 1. Specifically, approximately 42% of the participants were either audit seniors
or managers; approximately 60% had worked as external auditors and held a CPA; and over the past two years
participants had spent approximately 27% of their time conducting audits related to the integrity and reliability of
financial information.

20

The results of this second experiment are generally consistent with the results of
our first experiment. Internal auditors in the high management incentive condition
increased their risk assessments by a mean () of 25.22 (20.19), compared to a mean
() decrease of 3.50 (10.89) for those in the low management incentive condition.
Internal auditors in the high quality audit committee condition increased their risk
assessments by a mean () of 10.00 (24.12), compared to a mean () increase of 14.00
(19.30) for those in the low quality condition. Thus, the directions of the changes are
consistent with expectations.
A GLM that employs management incentives and audit committee quality as 2
levels between subjects factors indicates that the management incentive variable (H1a)
is significant (F = 30.83, p < .000) and the interaction of management incentive and
audit committee quality is insignificant (F = 1.758, p = .193). These results are
consistent with Experiment 1, and suggest that auditors are able to associate their own
managements incentives with fraud risk. However, inconsistent with the results from
the first experiment we find that audit committee quality (H2a) is not significant (F =
0.530, p = .471). We offer two potential explanations for this differential finding in the
concluding section of the paper.
With respect to budgeted audit hours, we find that internal auditors in the high
management incentive condition increased budgeted hours by a mean () of 24.73
(40.84) percent, compared to a mean () increase of 0.18 (6.40) percent for those in the
low management incentive condition. Internal auditors in the high quality audit
committee condition increased budgeted hours by a mean () of 11.16 (27.45) percent,

21

while those in the low quality condition increased budgeted hours by a mean () 15.79
(37.77) percent. Thus, the directions of the changes are consistent with expectations.
A GLM that employs management incentives and corporate governance as 2
levels between-subject factors indicates that, consistent with Experiment 1, the
management incentive variable is significant (F=6.617, p= 0.014), providing additional
support for H1b. Further, also consistent with the results from experiment 1, neither the
audit committee variable (F= 0.176, p=0.677), nor the interaction (F=0.002, p=0.961) is
significant.
5.

Conclusions and discussion

Our results, based on two experimental settings requiring internal auditors to

complete hypothetical case materials , indicate that internal auditors fraud risk
assessments are, as predicted, significantly influenced by the level of management
incentives to misreport financial results and generally influenced by of audit committee
quality. While the results generally hold across our two experimental settings, we do
note that the significance of audit committee quality is greater when internal auditors are
evaluating a potential acquisition than when they are evaluating their own organization.
While this finding may be contrary to expectations, we offer two potential explanations.
One potential explanation is that the lack of significance in experiment 2 may be due to
reduced power because of a small sample size. However, it is interesting to note that
the overall mean change () in fraud risk assessment in Experiment 2 of 11.86 (21.85)
is similar to the mean change () in fraud risk assessment in Experiment 1 in the low
quality audit committee condition of 11.03 (16.33), rather than the high quality audit
committee condition (mean = 0.97; = 12.74). This finding suggests new skepticism

22

about the ability of audit committees to mitigate fraudulent financial reporting, and may
be due to changes in environmental conditions between the administration of
experiments 1 and 2. Experiment 2 was administered in early spring 2002 (i.e.,
February 2002 to April 2002), at a time when there was much concern about the quality
of financial reporting and the ability of the audit committee to enhance financial reporting
quality (i.e., the Enron financial reporting scandal was headline news during this time).
Further investigation is needed to assess auditors perceptions of the ability of the audit
committee to mitigate fraudulent financial reporting in a post-Enron environment.
Relatedly, our examination was conducted prior to the passage of Sarbanes-Oxley in
June 2002. Given the heightened focus on quality financial reporting, and on the
importance of management incentives and audit committee quality following the
passage of Sarbanes-Oxley, continued examination of the importance of these factors
is warranted.
Our results also indicate that i nternal auditors budgeted audit hours are sensitive
to variations in management incentives to misreport financial information, but are not
reflective of variations in the quality of audit committees. These results hold whether
internal auditors are assessing a potential acquisition target or the company for which
they work.
These results provide an enhanced understanding of internal auditors judgments
and role in the prevention and detection of fraudulent financial reporting and should
prove useful to those interested in corporate governance and quality financial reporting
(e.g., external auditors, audit committee members, regulators). Specifically, our findings
imply that internal auditors are aware of the significance of management incentives in

23

fraud risk assessments, and their level of planned audit effort reflects those incentives.
Hence, internal auditors appear to respond in an effective and efficient manner to the
level of management incentives, whether they are assessing management of a target
acquisition or their own management. Our results further imply that internal auditors are
generally aware of the importance of a strong audit committee to reducing the risk of
fraudulent financial reporting, but are nevertheless unwilling to reduce the scope of their
fraud related audit work as a result of the presence of a strong audit committee.
However, this finding raises more of an efficiency concern than an effectiveness
concern.
The nature of our investigation suggests several additional opportunities for
future research. Most importantly, we recognize that a great many audit committee
characteristics (e.g., experience, knowledge; see DeZoort and Salterio 2001) will affect
the quality of the audit committee. Greater analysis as to how these various
characteristics are perceived by internal auditors to affect audit committee quality, and
therefore audit assessments and plans, will provide useful insights into important
corporate governance issues. Additionally, the BRC (1999, pg 6-7) recognizes that the
effectiveness of an audit committee is likely contingent on the characteristics of the
overall board. That is, if the board is low quality (i.e., lacking in independence and/or
competence), the audit committee will likely find it difficult to effectively fulfill its
responsibilities. While our experimental approach does not incorporate variations in
overall board characteristics, research that assesses whether auditors recognize the
importance of the overall board is yet another important extension of research in the
area of corporate governance, and is especially relevant given recent discussions

24

regarding corporate governance. The focus on enhanced corporate governance in

todays markets provides unlimited opportunities for continued investigation.

25

APPENDIX A
EXCERPTS FROM CASE MATERIALS- MANIPULATION CHECKS
Based on the case materials, how would you characterize Valley Manufacturing
managements incentive to misstate the financial statements? (circle one number)

.___.___.___.___.___.___.___.___.___.___.
0
|
no
incentive

5
6
|
moderate level
of incentive

10
|
high level
of incentive

Based on the case materials, how would you characterize the financial competence of the
overall audit committee at Valley Manufacturing? (circle one number)

.___.___.___.___.___.___.___.___.___.___.
0
|
not at all
competent

5
|
somewhat
competent

10
|
very
competent

Based on the case materials, how would you characterize the independence of the audit
committee at Valley Manufacturing? (circle one number)

.___.___.___.___.___.___.___.___.___.___.
0
1
|
not at all
independent

5
6
|
somewhat
independent

10
|
very
independent

26

Table 1
Changes in Fraud Risk Assessments
Panel A
Means (standard deviations) by experimental condition

Low Quality Audit

Committee
High Incentives
to Misstate

High Quality Audit

Committee

Total

6.87
(12.50)
n=16

13.23
(15.36)
n=31
-2.06
(10.81)
n=29

20.00
(15.58)
n=15

Low Incentives
to Misstate

1.42
(10.99)
n=14

-5.33
(9.90)
n=15

Total

11.03
(16.33)
n=29

0.97
(12.74)
n=31

Panel B
Test of null hypothesis of no difference in change in Fraud Risk Assessments
Mean
Square
3544

df

F-value

p-value

22.85

0.0001

Audit Committee

1480

9.54

0.0031

Incentives x Audit Committee

151

0.98

0.3273

Incentives

Note:
Independent Variables (see text for additional discussion):
Incentives: Management incentive to intentionally misstate financial information; at a high or low
level
Audit Committee: Quality (independence and financial expertise) of the audit committee; at a
high or low level

Dependent Variable (see text for additional discussion):

Revision in assessed risk of intentional material misstatement subsequent to viewing
manipulations

27

Table 2
Percentage Changes in Total Budgeted Hours
Panel A
Mean percentage change in total budgeted hours (standard deviations) by experimental
condition
Low Quality Audit
High Quality Audit
Total
Committee
Committee
High Incentives
to Misstate

33.65%
(30.28%)
n=12

14.45%
(30.10%)
n=13

23.67%
(31.13)
n=25
-3.69%
(17.16%)
n=25

Low Incentives
to Misstate

-2.30%
(21.80%)
n=12

-4.98%
(12.23%)
n=13

Total

15.68%
(31.67%)
n=24

4.73%
(24.59%)
n=26

Panel B
Test of null hypothesis of no difference in mean percentage change in total budgeted hours
Mean
Square
0.957

df

F-value

p-value

15.73

0.0003

Audit Committee

0.149

2.46

0.1238

Incentives x Audit Committee

0.085

1.40

0.2428

Incentives

Note:
Independent Variables (see text for additional discussion):
Incentives: Management incentive to intentionally misstate financial information; at a high or low
level
Audit Committee: Quality (independence and financial expertise) of the audit committee; at a
high or low level

Dependent Variable (see text for additional discussion):

Percentage change in total budgeted audit hours subsequent to viewing manipulations

28

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