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Encouraging Professional Skepticism in the Industry Specialization Era

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Not ignorance, but ignorance of ignorance is the death of knowledge.

- Alfred North Whitehead.

Abstract

This paper provides theory and experimental evidence that, under common audit conditions, industry specialization inhibits some aspects of auditors’ professional skepticism. As auditors amass industry experience, they develop extensive knowledge of non-misstatement explanations for unusual financial statement fluctuations. This knowledge coupled with confidence in their ability to analyze audit evidence inhibits their inclination to be skeptical when there are no overt indicators of elevated misstatement risk. Although these conditions are, by definition, the conditions where misstatements are least likely, they are also the same conditions where the PCAOB has alleged pervasive insufficient professional skepticism and where well-concealed fraud is possible. These results pose an ethical dilemma for the PCAOB in terms of weighing its charge to protect the public interest against the fairness of its inspections to audit firms. Encouragingly, I also predict and find that audit firm efforts to promote professional skepticism are more effective for specialists as non-specialists are skeptical regardless of these efforts.

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Notes

  1. As all major audit firms organize themselves along industry lines, virtually all audits of public companies (i.e., those subject to PCAOB inspections) are performed by industry specialist auditors. To examine the pervasiveness of industry specialization, I interviewed a Big 4 partner. To his knowledge, all public companies within his firm are audited by industry specialists. With very few exceptions, at least one partner and one manager specialize in the client's industry, and typically at least on senior does as well. He also believes that the other major audit firms are similar in this regard. Thus, the PCAOB general reference to “the auditors” or “the audit team” in its inspection reports is calling into question the work of industry specialists in the vast majority of cases.

  2. Gunny and Zhang (2013) find that only 17 % of PCAOB inspection reports identify a GAAP deficiency (i.e., a misstatement). Also, in the Gunny and Zhang sample of PCAOB-identified deficiencies, 70 % were deemed solely GAAS-deficient (i.e., substandard audit procedures) whereas only 30 % were also deemed GAAP-deficient. I reviewed the 2010 PCAOB inspection report of a Big 4 firm and found that only 28 % of identified deficiencies involved the audit firm failing to react to red flags or other indicators of elevated misstatement risk. The remaining 72 % of deficiencies simply indicated that the audit work was insufficient. As the non-public portion of the inspection report may include more detail about red flags, I interviewed a partner who had spent time in the PCAOB inspections group of a Big 4 firm who indicated that PCAOB allegations of insufficient skepticism frequently are not associated with red flags.

  3. If I had seeded an overt indicator of elevated misstatement or fraud risk, my theory would no longer be applicable as specialists would be more likely to identify these indicators and elevate their professional skepticism (cf. Hammersley 2006). Further, engineering a normal audit setting with respect to the risk of material misstatement allows me to provide an explanation for the PCAOB’s findings of pervasive insufficient professional skepticism and Dyck et al.’s (2010) finding that the vast majority of frauds are concealed well enough to go undetected.

  4. Accounting firms designate auditors as industry specialists when they focus on audits of firms in a particular industry. Although the designation officially recognizes specialists, the knowledge and experience acquired from auditing within a particular industry (and from firm training) truly makes the auditor a specialist (Libby 1995; Solomon et al. 1999).

  5. In this section, I review the behavioral literature on industry specialization. See Gramling and Stone (2001) for a review of the related archival literature which also finds uniformly positive effects on audit quality.

  6. It is possible that industry specialists identify and quickly dismiss low probability (but still possible) misstatement explanations including well-concealed fraud. Such quick dismissal is inconsistent with professional skepticism and consistent with my theoretical development that industry specialists will not be overly concerned with misstatement explanations.

  7. Such efforts could include emphasizing professional skepticism in training, performance evaluation, decision aids, etc. or by creating an ethical culture (Martinov-Bennie and Pflugrath 2009). However, for expositional simplicity and to maximize generalizability, I develop Hypothesis 2 and design my experiment simply in terms of asking auditors to elevate their professional skepticism (i.e., prompting). As will be discussed, previous research has found such prompts to be largely ineffective in increasing professional skepticism (e.g., Peecher 1996; Brown et al. 1998; Turner 2001), and such inefficacy is consistent with my theoretical development when auditors are working outside of their area of specialization.

  8. A skepticism prompt involves counterexplanation, but is more complex as it affects how the auditor acquires, evaluates, and weights evidence about the material accuracy of the financial statements. Furthermore, the counterexplanation literature (e.g., Heiman 1990, Koonce 1992) has not documented that industry specialization affects (1) the extent/nature of counterexplanation and (2) efficacy of counterexplanation prompts.

  9. Although it does not affect my theoretical development, Nelson (2009) discusses that another key distinction is whether professional skepticism is equated with auditor neutrality or presumptive doubt although most recent studies adopt the presumptive doubt perspective.

  10. I do not pose a research question regarding which prompt will be more effective for non-specialists for two reasons. One, I expect both prompts to be largely ineffective for non-specialists as my theoretical development indicates that non-specialists will exhibit a high level of professional skepticism irrespective of prompting. Two, there are limited, if any, practical implications as almost all audits are currently conducted by industry specialists.

  11. There is a higher rate of specialists in the online responses (54 % of online responses are specialists; 16 % of paper responses are specialists). The online sample also has more experienced auditors (Online = 8.0 years; Paper = 3.7 years). A concern is that paper respondents are, in general, more skeptical than online-respondents rather than due to non-specialists’ industry unfamiliarity. This possibility is unlikely as online-respondents devote more time (2.4 more minutes; p < 0.01) and generate 1.40 additional explanations (p < 0.01). The inclusion of control variables for response mode, general experience, and closely related industry experience does not change the inferences from the results, and I am unaware of any theory suggesting an interaction with any of my independent variables. Furthermore, research has found online and paper results are similar (Birnbaum 2000). When using only online responses, inferences from H1 testing are unchanged. For H2, results are directionally consistent, but lose statistical significance (p > 0.10) which is not surprising given the exclusion of 53 % of my participants. I lack sufficient data to test my hypotheses within the paper responses as there are only 15 specialists spread across the 3 Prompting conditions.

  12. Hammersley (2011) reviews and criticizes studies that use seeded frauds with specific fraud indicators to assess the effectiveness and efficiency of fraud planning. Specifically, she discusses how (1) developing a comprehensive set of testable fraud hypotheses from the risk indicators is the ultimate goal of fraud planning, (2) the financial statements/ratios may not contain any specific fraud indicators, and (3) diagnosis of fraud is not possible during fraud planning as it is a function of performing and evaluating the results of the audit procedures (i.e., evidence evaluation). As such, efficiency is not a primary concern of fraud planning tasks.

  13. I reclassified seven participants who spend significant time on insurance clients (>25 % of their year) but reported no or another industry specialization and two participants who spend very little time on insurance clients (<25 % of their year) but who reported an insurance industry specialization. Inferences are unchanged by using their reported specialization or by omitting these participants. I interviewed a Big 4 partner who stated he would consider an auditor who spends over 25 % of their time within an industry to be a specialist.

  14. Two of the examples are shared across the Evidence and Self-Criticism manipulations because there is substantial degree of overlap between the evidence skepticism and self-criticism constructs. For example, auditors can direct self-criticism towards their skepticism of evidence. Tweaking one example permits me to examine the critical differences between the two constructs while still capturing the essence of the two constructs and holding manipulation strength between the prompts as constant as possible. As such, this design choice was based on maximizing manipulation cleanliness and equalizing manipulation strength at the expense of maximizing manipulation strength.

  15. Participants also report the lowest and highest possible risk of material misstatement. Inferences are unchanged using these alternative risk assessments measures. Thus, these measures are not further discussed.

  16. Consistent with specialists and non-specialists considering high-frequency errors irrespective of prompting (see Owhoso et al. (2002) for specialists and the development of H1 for non-specialists), I do not observe support for my hypotheses using either the number or probability of error explanations, and do not further discuss these variables.

  17. I collect two other measures in the two Prompting conditions using 11pt Likert Scales: (1) perception of the prompt as an accuracy goal as Kadous et al. (2003) found that perception may inhibit professional skepticism by amplifying the propensity to support management, and (2) the extent to which the prompt made them defensive. I control for Non-specialists’ insurance and closely related industry experience by adding the percent of their year spent on insurance and other financial services clients, and multiplying by an indicator variable set to 1 for non-specialists. I control for data collection mode with an indicator variable. Inclusion of any of these control variables in the main analyses does not affect the inferences from the results.

  18. I used planned comparisons for hypothesis testing as my predictions do not necessarily imply significant MANOVA main effects or interactions. I only predict a significant difference across Specialization within Prompting-Control. For Prompting, I am predicting that Prompting will be more effective for specialists than non-specialists. As such, if the prompts are largely ineffective for non-specialists and/or the two types of prompts exhibit similar efficacy, I would not observe a significant main effect. Finally, Buckless and Ravenscroft (1990) describe how ANOVA results may not reveal significant interactions, especially when there are more than 2 levels of an independent factor (i.e., my Prompting manipulation).

  19. The control conditions are subtracted to examine the relative efficacy of the prompts for specialists vs. non-specialists. The theory underlying H2 simply predicts that the prompts will be more effective for specialists than non-specialists, not whether specialists will end up being less, equally, or more skeptical than non-specialists after prompting. If H1 is supported (i.e., unprompted specialists are less skeptical than unprompted non-specialists), any of these three possibilities are possible while still supporting H2.

  20. I do not observe significant differences between unprompted specialists and non-specialists in the probability of management’s explanation or the probability of unknown non-misstatements. Consistent with professional skepticism being associated with increased attention to misstatements versus decreased attention to non-misstatements, I do not find significant effects of Prompting on any non-misstatement measure for either Specialists or Non-Specialists.

  21. This inconsistency with Taylor (2000) is potentially attributable to power issues considering the effect size and the significant results across all Prompting conditions.

  22. An example of a fraud explanation from a specialist is “Company has intentionally or inadvertently adjusted DAC amortization to reduce expense in the current year and/or company has intentionally or inadvertently accelerated unearned premium recognition.” An example of a fraud explanation from a non-specialist is “Fraud.”

  23. My decision to use accountability biases me against observing support for prompts being more effective for specialists than non-specialists. Logically, specialists should be less likely to respond to supervisor preferences as they are less likely to perceive themselves as being less knowledgeable than their supervisor. It is also important to note that simply being accountable to a supervisor cannot explain my results as Peecher (1996) found that auditors are less skeptical when accountable to supervisors who emphasize efficiency (i.e., his credence condition).

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Authors and Affiliations

  1. Department of Accountancy, Farmer School of Business, Miami University, 800 E. High Street, Oxford, OH, 45056, USA

    Jonathan H. Grenier

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  1. Jonathan H. Grenier
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Correspondence to Jonathan H. Grenier.

Additional information

This paper is based on my dissertation at the University of Illinois. I am indebted to my committee for their invaluable encouragement and guidance: Brooke Elliott, Mark Peecher (chair), Neal Roese, and Ira Solomon. I thank Chris Agoglia, Billy Brewster, Helen Brown-Liburd (discussant), Rob Evans, Annie Farrell, Sally Gunz (co-editor), Erin Hamilton, Jackie Hammersley, Kevin Jackson, Kathryn Kadous, Justin Leiby, Pam Murphy, Mark Nelson, Ed O’Donnell, Derek Oler, David Plumlee, Brad Pomeroy, Linda Quick, Sue Ravenscroft, Tammie Rech, Drew Reffett, Brett Rixom, Stephen Rowe, Chad Simon, Matt Stern, Linda Thorne (co-editor), Tom Vance, Scott Vandervelde, Brian White, attendees of the University of Illinois’ 19th Symposium on Auditing Research, AAA Auditing Midyear Meeting, and University of Waterloo’s 2nd Biennial Symposium on Accounting Ethics, and workshop participants at Iowa State University, Miami University, Texas Tech University, University of Illinois, University of Massachusetts-Amherst, University of Notre Dame, University of South Carolina, and University of Waterloo for constructive feedback. I thank Brian Rossman for his programming assistance, the auditors who participated in the experiment, and the American Accounting Association for awarding a previous version of this manuscript the ABO Section Outstanding Dissertation Award.

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Appendix 1

Appendix 1

Prompting Manipulation

Panel A: Evidence

Recent professional standards and the PCAOB stress the exercising of professional skepticism to prevent and detect fraud. The engagement partner is concerned that our auditors sometimes might not exercise sufficient professional skepticism. Specifically, the engagement partner is concerned that our auditors sometimes fail to approach management-provided explanations and other audit evidence with sufficient professional skepticism. This concern is based on evidence that auditors across a variety of engagements do not actively question management assertions or critically assess audit evidence. Other examples of auditors not being sufficiently skeptical of evidence include:

  • Failure to gather sufficient information.

  • Overweighting evidence that confirms expectations.

  • Reliance on management’s honesty and integrity.

Please ensure that you are sufficiently skeptical of evidence when performing this analytical review. In 2-3 sentences, describe an instance when you were not sufficiently skeptical of management-provided explanations or other audit evidence.

The partner on this task is primarily concerned…

  • with my judgment accuracy.

  • with me being skeptical of management-provided explanations and other audit evidence. (CORRECT ANSWER).

Actively questioning management’s assertions and critically assessing audit evidence increases the effectiveness of audits.

  • True (CORRECT ANSWER).

  • False.

Panel B: Self-Criticism

Recent professional standards and the PCAOB stress the exercising of professional skepticism to prevent and detect fraud. The engagement partner is concerned that our auditors sometimes might not exercise sufficient professional skepticism. Specifically, the engagement partner is concerned that our auditors, even when focused on accuracy, sometimes fail to actively consider the possibility of making incorrect judgments and decisions. This concern is based on pervasive evidence that experts in a variety of fields, such as medicine and law, tend to be overconfident in their judgments, and, on occasion, make incorrect judgments. Common expert errors include:

  • Failure to gather sufficient information.

  • Overweighting evidence that confirms expectations.

  • Overconfidence in own or others’ technical knowledge.

Please ensure that you are sufficiently skeptical when performing this analytical review in terms of considering the possibility of making incorrect judgments. In 2-3 sentences, describe an instance when you were overconfident precluding you from actively considering the possibility of making incorrect judgments.

The partner on this task is primarily concerned…

  • with my judgment accuracy.

  • with me being skeptical of my judgment and decision making and actively considering the possibility of making incorrect judgments. (CORRECT ANSWER).

Overconfidence sometimes leads to experts making incorrect judgments and, therefore, can be detrimental to the effectiveness of audits.

  • True (CORRECT ANSWER).

  • False.

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Grenier, J.H. Encouraging Professional Skepticism in the Industry Specialization Era. J Bus Ethics 142, 241–256 (2017). https://doi.org/10.1007/s10551-016-3155-1

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  • DOI: https://doi.org/10.1007/s10551-016-3155-1

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