Internal auditors, Objectivity

Abstract The article describes an experiment that examines the effect of three audit schemes on taxpayers' joint or related decisions about the level of labor to be supplied and the amount of income to underreport in the United States. Individuals failed to report between $70 and $79 billion in federal taxes due on legal income received in 1986. This amount is equivalent to approximately 20 percent of federal income taxes due and 40 percent of the federal deficit in that year. This problem can be countered by auditing self-reported income; An audit scheme is the approach by which a taxing authority chooses the self-reports to be audited. The three audit schemes differ principally in the information used by the taxing authority to determine which self-reports of income to audit: no information is used--reports are chosen strictly at random; reported income is the basis for choosing the reports to be audited; an estimate of true income is used in addition to reported income to select audit cases. The taxpayer's labor response to the tax system may not be determined solely by the direct effect of tax rates.

[Individuals failed to report between 70 and 79 billion in federal taxes due on legal income received in 1986. This amount is equivalent to approximately 20 percent of federal income taxes due and 40 percent of the federal deficit in that year. Including underreporting of organizations and of those who receive illegal income likely pushes the annual amount of taxes due, but not paid, above the $100 billion mark (Roth et al. 1989, 1). Thus, reporting income for tax purposes may be characterized by a high degree of inaccurate self-reporting with an immediate economic impact. This problem can be countered by auditing self-reported income. An audit scheme is the approach by which a taxing authority chooses the self-reports to be audited. This paper describes an experiment that examines the effect of three audit schemes on taxpayers' joint or related decisions about the level of labor to be supplied and the amount of income (if any) to underreport. The three audit schemes differ principally in the information used by the taxing authority to determine which self-reports of income to audit: (a) no information is used-reports are chosen strictly at random; (b) reported income is the basis for choosing the reports to be audited; (c) an estimate of true income is used in addition to reported income to select audit cases. Also examined is the impact of alternative tax rates and penalty levels on earned and underreported income. Traditional theoretical work shows that income taxes alter the amount of labor supplied (e.g., Flanagan et al. 1984, 143-5). However, predictions regarding the direction of the change in labor supply are ambiguous: the labor supplied may increase as the taxpayer tries to compensate for the income lost to taxes by working more (the income effect), or the amount of labor may drop as alternatives to work become more economically attractive (the substitution effect). Swenson (1988) experimentally examined labor supply in response to varying marginal tax rates, and the overall results are consistent with the substitution effect dominating the income effect. The taxpayer's labor response to the tax system may not be determined solely by the direct effect of tax rates. Once a tax system is imposed, those electing to underreport their actual earned income may also elect to increase their labor supply as a result of a diminished tax substitution effect in the presence of underreporting. If the reporting decision directly affects the labor supply decision, then any tax system parameter (e.g., penalty and audit) affecting the reporting decision will also impact the labor supply decision. Consistent with the reasoning above, Pencavel (1979) analytically portrays the taxpayer's response to the tax system (i.e., rates, penalty, and probability of audit) as a joint or related decision about labor supply and the income reported. In a similar vein, Atkinson and Stiglitz (1980, 27-8) refer to the impact of taxation (and evasion opportunities) on labor supply in terms of income, substitution, and "financial" effects. They explain that financial effects arise when "the same real activity can correspond to several different forms of payment, which are taxed at different rates." The most extreme example offered of the financial effect on labor supply is the underground or "hidden" economy. Taxpayers may restructure their activities or transactions so as to operate in an economic environment free of taxation. Recognition of the jointness of the labor and reporting decisions suggests that it is reasonable to incorporate both variable in empirical studies to test how the taxpayer responds to the tax environment. In another study, Collins et al. (1990) found evidence that a positive relationship exists between work effort and noncompliance opportunities. In general, subjects with a noncompliance opportunity worked harder than those without an underreporting opportunity. The effects of the tax environment (i.e., audit schemes, tax rates, and penalty levels) on income earned and underreporting of income are tested in a laboratory setting because well controlled real world setting counterparts are not available. The experimental design consists of three audit schemes and two levels of tax rate and penalty resulting in 12 between-subject conditions. The subject's task is a computerized letter decoding task. During the experiment, each subject participated in a practice work session and four five-minute actual work sessions. At the end of each work session, subjects self-reported the income earned and corresponding tax liability. One of the three audit schemes was followed to select reports to verify. The reports denoting whether audit selection had occurred were returned privately to the subjects before the beginning of the next work session. Subjects were compensated based on the actual income earned less the taxes self-reported and possible penalties (proportional to the tax deficiency) imposed as a result of the audit. The subjects' underreports of income and work effort are analyzed for each work session separately and across work sessions two through four together using a multivariate analysis of covariance (MANCOVA). The number of letters decoded by each subject in the practice work session is included as the covariate. This measure serves as a surrogate for ability. Subsequent analyses of covariance (ANCOVAs) and mean comparisons are performed for each dependent variable. Verification schemes that incorporate the preliminary information signal sent by the taxpayer are more successful overall in curbing underreporting than purely random audit models. Also, underreporting is generally greater when tax rates are high and penalty levels are rather low. Finally, underreporting and effort are positively related. Those subjects electing to underreport also produce significantly more income.]

Abstract ABSTRACT: Auditors' reliance on their memories vis-a-vis their reliance on external information sources such as workpapers is of practical as well as research interest. This study examined auditors' relative confidence in relying on accurate and Inaccurate recognitions of audit evidence. Each of 85 practicing auditors was asked to review a set of hypothetical audit workpapers, then after one day's delay, to respond to a recognition test and rate their confidence in their recognitions. They were asked to use the confidence rating to reflect their willingness to rely on their recognitions rather than on reviewing the workpapers or source documents again. Auditors were most confident in two cases: when they accurately recognized evidence that they had previously seen and when they confused their own Inferences with actually observed evidence. Auditors are often as confident in their Incomplete and inaccurate recognitions as they are in their accurate recognitions.

[Auditors' reliance on their memories vis-�-vis their reliance on external information sources such as workpapers is of practical as well as research interest. This study examined auditors' relative confidence in relying on accurate and inaccurate recognitions of audit evidence. Each of 85 practicing auditors was asked to review a set of hypothetical audit workpapers, then after one day's delay, to respond to a recognition test and rate their confidence in their recognitions. They were asked to use the confidence rating to reflect their willingness to rely on their recognitions rather than on reviewing the workpapers or source documents again. Auditors were most confident in two cases: when they accurately recognized evidence that they had previously seen and when they confused their own inferences with actually observed evidence. Auditors are often as confident in their incomplete and inaccurate recognitions as they are in their accurate recognitions.]

Abstract There is concern that rather than critically deliberating specific circumstances, auditors focus on selecting and documenting defensible audit positions. Currently, subordinate auditors perform tasks mindful that they will be accountable for their work both inside (e.g., partners) and outside (e.g., PCAOB) the firm and adopt “implementation intentions” based on previous review experiences to guide their performance. In the context of fraud‐detection planning, we consider an alternative approach in which subordinate auditors work under contingent reward agreements under which they will be compensated for effective fraud‐detection plans. Lacking an anticipated course of action, they invoke a “deliberative mindset” in order to create a task strategy. In an experiment, auditors completed a fraud‐detection planning task under contingent rewards, accountability, or anonymity. We find that auditors operating under contingent rewards used deliberative mindsets. They were better able to identify potential fraud, select more effective procedures, and plan more hours for effective procedures. Auditors under accountability completed the planning task based on implementation intentions. They focused on broadly increasing audit hours across procedures, including allocating significantly more hours to less effective procedures. Mediation analysis shows that improved planning performance resulted from the use of deliberative mindsets and not implementation intentions.

ABSTRACT Although lower-level auditors increasingly carry out mandatory analytical procedures (APs) in audits, they do not perform as well as partners and managers. In order to improve performance in APs by lower-level auditors, we investigated tasks requiring creativity, where training in metacognition—consciously thinking about one's thought process—improves task performance. As a result, we train lower-level auditors to use a sequential thought process comprised of two metacognitive skills: divergent thinking, where they generate explanations for unusual evidence, followed by convergent thinking, where they evaluate explanations generated and eliminate those judged infeasible. To test the efficacy of our training, we conducted an experiment with three conditions: both divergent and convergent thinking, divergent thinking only, and a control. We found that training auditors in only divergent thinking increases both the number and quality of explanations generated for an unusual situation. However, the combination of divergent and convergent thinking training leads to improved explanation generation over divergent thinking alone and, more importantly, leads to a greater likelihood of generating and choosing the correct explanation.