The occurrence and awareness of a misstatement effect in auditors' internal control severity judgments

• Author: Barbara Majoor,Arnold Wright,Stephen Kwaku Asare
• DOI: http://doi.org/10.1111/ijau.12093
• Published date: 01 November 2017
• Date: 01 November 2017

ORIGINAL ARTICLE

The occurrence and awareness of a misstatement effect in

auditors’internal control severity judgments

Stephen Kwaku Asare

1

|Barbara Majoor

2

|Arnold Wright

3

1

University of Florida, Gainesville, FL, USA

2

Nyenrode Business University, Netherlands

3

Northeastern University, Boston, MA, USA

Correspondence

Stephen K. Asare, University of Florida,

Warrington College of Business, Fisher School

of Accounting, PO Box 117166, Gainesville, FL

32611‐7166, United States.

Email: kwaku@ufl.edu

We define a misstatement effect as a tendency for auditors to take the non‐detection of a mis-

statement as evidence of the absence of a material weakness and test the hypothesis that it

occurs unconsciously in their internal control severity judgments. In a between‐participants

design, which is analogous to the practice setting, we find that auditors evaluate an internal con-

trol deficiency less severely when it has not led to a misstatement. However, in a within‐partici-

pants design, where the misstatement manipulation (detected or not detected) is more salient, we

find that auditors evaluate the deficiencies as equally severe, suggesting that the misstatement

effect in the between‐participants design is not intended. The findings suggest the need to con-

sider the use of decision aids that align auditors’heuristics and knowledge. For instance, auditors

may be required to document possible misstatements that could occur when evaluating control

deficiencies that have not led to misstatements.

KEYWORDS

Internal control decisions, material weaknesses, misstatementeffect, severity of control

deficiencies

1|INTRODUCTION

Auditors are required to evaluate the severity of internal control

deficiencies to determine whether the deficiencies, individually or in

combination, are material weaknesses as of the balance sheet date

(PCAOB, 2007, para. 62). This requirement has a global reach as it

applies to auditors who audit companies that are listed or cross‐listed

on US exchanges (see also IAASB, 2009, 2016).

1

The evaluation of

control deficiencies is of immense importance as it determines whether

an adverse report is issued on the client’s internal controls over

financial reporting (ICOFR) with its consequential effects, such as a

higher cost of capital or negative market reaction (e.g., Asare & Wright,

2012; Ashbaugh‐Skaife, Collins, Kinney, & Lafond, 2009; Beneish,

Billings, & Hodder, 2008; Hammersley, Myers, & Shakespeare, 2008).

Auditing standards note that the evaluation of the severity of a

deficiency is not to be based solely on the presence or absence of

misstatements (IAASB, 2016; PCAOB, 2007). That is, the presence of

a misstatement is not to be taken as evidence of a material weakness.

Nor should the absence of a misstatement be taken as evidence of the

absence of material weakness. Nevertheless, PCAOB inspection

reports suggest that auditors may inappropriately base their material

weakness evaluations solely on the materiality of identified

misstatements in the financial statements (PCAOB, 2009).

2

We label

this tendency for auditors to take the non‐detection (detection) of a

misstatement as evidence of the absence (presence) of a material

weakness as a “misstatement effect.”Prior studies have found this

misstatement effect in auditors’internal control severity judgments

(e.g., Gramling, O’Donnell, & Vandervelde, 2013; Kinney, Martin, &

Shepardson, 2013; PCAOB, 2009). These studies, however, do not

provide insights as to whether this effect reflects auditors’beliefs

about how the presence of a misstatement should affect their

judgments. Anecdotal evidence suggests that auditors’internal control

severity judgments may not necessarily reflect their underlying

knowledge about control deficiencies (e.g., Gramling et al., 2013;

Kozuch & Nichols, 2011). It is, therefore, important to examine the

extent to which the heuristics that auditors use to evaluate control

deficiencies reflect their knowledge.

The purpose of this study is to examine the extent to which a

misstatement effect reflects auditors’beliefs about how the detection

(or non‐detection) of a misstatement should affect their evaluation of

the severity of internal control deficiencies. This is an important issue

because auditors’lack of insight into their control severity judgments

can lead them to issue unintended control reports, which, in turn,

suggests the need for decision aids and/or guidance that align their

knowledge and heuristics (see Kahneman & Tversky, 1996; Libby,

Bloomfield, & Nelson, 2002; Tan, Libby, & Hunton, 2002).

Received: 30 March 2016 Revised: 1 January 2017 Accepted: 17 January 2017

DOI: 10.1111/ijau.12093

Int J Audit. 2017;21:225–236. © 2017 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 225