Auditors’ self-perceived abilities in conducting domain audits

Critical Perspectives on Accounting 20 (2009) 3–21

Auditors’ self-perceived abilities in conducting domain audits Vincent Owhoso, Andrea Weickgenannt ∗ Northern Kentucky University, United States Received 21 December 2006; received in revised form 25 February 2007; accepted 10 April 2007

Abstract This study investigates the extent to which auditors’ ratings of self-perceived abilities correspond with their actual performance, and whether these perceptions are influenced by audit experience and effectiveness when conducting audits within their domain of specialization. One hundred forty-four (144) industry-specialized audit seniors and managers reviewed two sets of audit working paper cases, one in banking and one in healthcare. At the end of the review, the auditors rated their ability to perform an audit in their domain. The analysis of these ratings shows that auditors significantly inflated their perceived abilities relative to actual performance. The results indicate that differences in auditor rank are insignificant in terms of this propensity to overestimate self-perceived abilities relative to actual performance; however, above median effective auditors are far less overconfident than below median effective auditors. These results have implications for the audit profession in terms of training, assignments, performance evaluation, and the use of decision aids to mitigate the propensity toward overconfidence. © 2007 Elsevier Ltd. All rights reserved. Keywords: Self-perceived ability; Confidence; Review process; Risk reduction; Error detection; Ability; Audit performance; Auditor perceptions; Auditor overconfidence; Domain audits

1. Introduction Concerns about audit quality have always been a major issue for the public accounting profession. This has lead the American Institute of Certified Public Accountants (AICPA) to issue SQCS No. 2 (AICPA, 1996), which requires public accounting firms to assign ∗

Corresponding author. Tel.: +1 859 572 5499; fax: +1 859 572 6177. E-mail addresses: [email protected] (V. Owhoso), [email protected] (A. Weickgenannt).

1045-2354/$ – see front matter © 2007 Elsevier Ltd. All rights reserved. doi:10.1016/j.cpa.2007.04.005

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only personnel with the appropriate levels of technical training and proficiency to audit engagements. More recently, the AICPA also issued SAS No. 99 (AICPA, 2002) which mandates that auditors assigned to “significant audit responsibilities should possess the knowledge, skill, and ability” to effectively complete those tasks. Consequently, the ability of an auditor to perform an audit task is a major factor in assigning audit team members to specific tasks in order to ensure quality in the conduct of the audit engagement. To control audit quality, public accounting firms can hire, train, and provide advancement opportunities to individual auditors they want to retain and whom they believe possess the characteristics that will enable them to perform their audit assignments in a competent manner. Further, during audit engagements, public accounting firms assign experienced or senior members of an audit team to observe, supervise, and review the work of subordinate auditors (Owhoso et al., 2002). Finally, through the firm’s formal evaluation process, a public accounting firm can acquire knowledge of the capabilities of the auditors it retains (Hunt, 1995; Jiambalvo, 1982; Wright, 1982). These measures can lead firms to control audit quality, reduce audit risk to acceptably low levels, and directly influence subordinates’ ability to learn and develop expertise (Hunt, 1995). Despite these quality controls, several recent and very public audit and business failures1 suggest a breakdown in the process of controlling audit quality. The common thread among these audit failures is that control of audit quality was not sufficient to facilitate the recognition and/or disclosure of the underlying accounting problem (Cullinan, 2004, p. 857–60). While there are various likely explanations for these audit breakdowns, one must assume that the affected public accounting firms would have assigned the audit tasks to auditors they believed possessed the capabilities to perform those tasks based upon information provided by the firms’ formal personnel and performance records. In addition to the outrage over the significant economic costs associated with these recent audit failures, questions have been raised about the abilities of auditors, as well as their perceptions of their abilities and the expectations of their firms regarding their performance. Specifically, are these auditors and their firms overconfident in the auditors’ abilities? If evidence had been available to suggest that the affected auditors might have over- or understated their own abilities to perform similar audit tasks relative to their actual performance in the past, this information could have aided audit firms in effectively assigning auditors to tasks they could more effectively perform, in designing training programs and decision aids, and in allocating resources to the audit. 1

Enron, WorldCom, Waste Management, and Sunbeam are a few of the company names known for corporate failures which were linked to improprieties within accounting and financial reporting practices, including the audit function. In the case of Enron, a complex organizational structure facilitated the abusive reporting of profits despite the existence of hundreds of millions of dollars in losses on the sales of underperforming assets. Improprieties at both WorldCom and Waste Management involved misclassifications of billions of dollars in operating costs so that their effect could be spread out over many years rather than recognized immediately. At Sunbeam, the erroneous financial statements were a result of the use of overstated revenues involving bill and hold transactions and other improprieties. In each of these instances, it appears that the corporate auditors failed to detect and/or report the underlying problems. These are a few of the most widely publicized cases of audit failures that lead many investors and regulators to question auditor performance and reliability. Although there are other points of view regarding explanations for these audit failures, especially in the case of Enron, this study focuses primarily on audit performance issues.

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Although research has shown that auditors do not detect all errors (Johnston et al., 2003; Waggoner, 1990), we know of no other study that has examined the role of individual auditors’ self-perceived abilities in effectively conducting an audit. If there is a weak relationship between auditors’ perceived abilities and their actual performance, this could suggest that auditors and their firms may be overconfident in the auditors’ expected level of performance and in their assignment to specific audit tasks. Such overconfidence can result in an incorrect match of abilities and assignments, inefficient allocation of audit resources and use of audit technology, and worse ineffectiveness in terms of substandard audit output. These deficiencies can lead to potential legal problems for the audit firm, as well as potential losses for investors and other stakeholders who rely on an auditor’s opinion. Thus, information about auditors’ self-perceived abilities relative to actual performance might be incorporated into public accounting firms’ training programs and formal performance evaluation processes to produce a better alignment of auditors’ abilities and the assignment of audit tasks, potentially leading to better actual audit performance. In this study, auditors’ self-rated perceived abilities in conducting audits are compared to their actual performance in detecting errors during working paper reviews within their domain of specialization and for another industry (not the auditor’s domain of specialization). In addition, the roles of auditor rank (manager and senior) and level of auditor effectiveness (above median and below median) are also examined with respect to their impact on auditors’ self-perceived ability ratings. Prior studies have reported mixed results regarding auditors’ confidence in their judgments. A segment of these studies has shown that auditors are overconfident in co-variation judgments in assessing their own technical knowledge/abilities (Waller and Felix, 1984) and the abilities of subordinates (Kennedy and Peecher, 1997). Another segment of prior studies suggests that auditors are under-confident in their judgments (Dilla et al., 1991; Mladenovic and Simnett, 1994; Tomassini et al., 1982). The current study builds on a prior study that examined audit managers’ and seniors’ abilities to detect mechanical and conceptual errors during the review process (Owhoso et al., 2002) and it adds to the body of literature on auditors’ self-rated abilities in the following important ways. First, the study examines whether there is a correlation between auditors’ perceived abilities and actual performance. Second, it explores whether auditors overestimate their perceived abilities relative to actual performance and whether the overestimation of self-perceived ability, if any, is independent of auditor rank. Third, it investigates whether the level of auditors’ effectiveness explains any observed overconfidence in self-perceived abilities. We anticipate that providing answers to these questions will shed more light on the notion of auditors’ propensity toward overconfidence and identify the relevant implications for audit practice in terms of the opportunities for reducing audit risks, including effectively assigning personnel to audit tasks and understanding personnel from the point of view of the firm’s training decisions, use of decision aids, and resource allocations. This study utilized the self-ability ratings data of 72 pairs of audit managers and seniors from the healthcare and banking industries from the Owhoso et al. (2002) study that have not been previously analyzed. The participants reviewed audit working paper case materials in their own industry of specialization and in an industry outside their specialization.2 At 2 Only within industry results were analyzed and presented in this study. Prior studies show that auditors performed poorly in detecting errors outside their industry of specialization.

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the end of the review, each auditor rated his or her ability to perform an audit in his or her own industry of specialization and in the other industry. The study is fully described in Owhoso et al. (2002) and is summarized in Section 3. Self-perceived ability ratings are tested as a function of actual performance, auditor rank, and auditor effectiveness within industry of specialization. The study finds that auditors’ self-perceived abilities are not significantly correlated with actual performance. The findings also show that audit managers and seniors are both overconfident and the magnitude of their overconfidence is similar. In addition, the results indicate that above median effective auditors, regardless of auditor rank, are significantly less overconfident in their self-perceived abilities relative to actual performance than below median effective auditors. The importance of the findings is discussed in Section 5. The rest of the paper is organized as follows: the next section provides a theoretical development of the research hypotheses; a section presenting the methodology then follows; the last sections present the results and a critical discussion of the findings, as well as their implications for audit practice and research.

2. Background literature and hypotheses development It is customary for public accounting firms to assign only auditors whom the formal evaluation process has identified as competent or capable in performing audit tasks. In fact, generally accepted auditing standards (GAAS) require that auditors possess competence in the form of technical training and proficiency (AICPA SAS No. 1, 1972). In addition, research has shown that auditors score high relative to other business professionals on such traits as self-acceptance, psychological-mindedness, flexibility, measures of achievement (DeCoster and Rhode, 1971, p. 659), and cognitive processing (Gul, 1984, p. 265). Since auditors possess these attributes, specialized auditors assigned to complete audit tasks by their firms should be able to accurately assess their own abilities in conducting audits in their audit domain relative to their actual performance.3 Libby and Luft (1993, p. 428) define ability as the capacity to complete information encoding, retrieval, and analysis. They propose a model (reproduced in Fig. 1) of relationships among experience, knowledge, and ability. According to the model, ability manifests itself through performance, that is, auditors’ abilities should lead to performance either directly (link 3) or when combined with knowledge (link 2). They also note that experience combined with knowledge should lead to performance (link 1). Auditors’ perceived abilities are related to auditors’ performance in that self-perceptions are individual auditors’ beliefs or views of their capacity to effectively perform specific audit tasks based on the task-specific knowledge acquired previously, either directly or indirectly.4 While perceived ability is not the same as ability, it can be said that perceived 3 For example, audit seniors and managers assigned to review subordinates’ working papers should be able to assess whether or not they were capable of reviewing the work and to rate their ability to review subordinate’s working papers during an audit. 4 Auditors acquire knowledge directly or indirectly through performing specific industry tasks over time and/or from participating in related audit training programs designed to increase the auditors’ task knowledge.

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Fig. 1. Model of relationship between experience, knowledge and task performance.

ability mimics the expectations of ability, taking into account the determinants of ability. Taken together, it appears that the ability to self-perceive one’s performance depends upon the extent of relevant experiences and task-specific knowledge (Davis et al., 2000).5 A correspondence between self-perceptions and performance has also been noted in the psychology literature. For instance, in prior psychology research, self-perceived ability is defined as perceived self-efficacy, the belief an individual associates with his or her ability to perform and complete tasks successfully (Bandura, 1997). According to Bandura, this belief influences actions, effort, realization of goals, and it determines outcomes before any action occurs. As individuals understand how their beliefs might affect outcomes, they are likely to increase their self-perceived ability, which will in turn increase the likelihood that the individual will perform a given task successfully. Bandura (1997) also indicates that individual experiences and feedback from peers or supervisors are key factors that positively influence an individual’s self-efficacy. In the accounting profession, the profile of an auditor, as mandated by GAAS and the AICPA Code of Professional Conduct, leads us to believe that auditors’ self-perceptions should correlate with actual performance. This is because the nature of auditors’ work is focused on competence and diligent performance of services, as guided by standards and ethical principles. For example, auditors should only accept tasks that they are competent to perform. In fact, the first standard under GAAS states that audits are to be performed by persons having adequate training and proficiency (AICPA, 1972, SAS 1). Furthermore, the Code of Professional Conduct states that, in carrying out their professional responsibilities, auditors are expected to strive to improve their competence and observe technical and ethical standards in determining the scope and nature of services to perform (AICPA, 2006, ET210). Prior accounting research also supports the notion that auditors’ self-perceptions should correlate with actual performance. For instance, DeCoster and Rhode (1971) use the California Psychological Inventory (CPI) index to analyze psychological test scores of CPAs in comparison with other occupational groups, and finds that CPA firm employees are better predictors of self-described characteristics than professionals in other business disciplines 5 For example, when auditing bank loan loss reserves, auditors should know the categories to which an error relates in order to gain the relevant task-specific knowledge for auditing loan loss reserves in banking.

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(such as salesmen, bankers, and other business executives). DeCoster (1971, p. 660) also demonstrates that CPAs are more apt to possess characteristics of self-acceptance, independent achievement, and psychological-mindedness when compared to other professionals. These findings suggest that auditors are likely to make more accurate self-predictions of their performance. Furthermore, Gul (1984, p. 274) and Pratt (1980, p. 504) describe instances of possible positive correlation between personality and cognitive style with decision-making ability or performance among accountants. These studies each create the expectation that auditors are good predictors of their own abilities. The nature of audit practice is also consistent with the notion that auditors’ selfperceptions should correlate with actual performance. Auditors receive feedback from supervisors through the review process and also from their peers, either directly or indirectly. For example, audit seniors who review staff auditors’ working papers would also have their work reviewed by an audit manager, while an audit partner would review the work of the manager until the final product is accepted (Bamber and Ramsay, 1997; Owhoso et al., 2002). In addition, even audit engagement partners have their work reviewed by another independent partner on almost all large engagements. Through this review process and successive audit performance in similar audit tasks, subordinate auditors should gain experience, knowledge, and skills to effectively rate their abilities in conducting an audit. Taken together, the literature on self-perceived ability in auditing and psychology and the nature of audit practice suggests that auditors should be able to self-assess their own effectiveness and abilities over time in conducting audit tasks, especially in their own domain. Hence, the following hypothesis: Hypothesis 1. Auditors’ self-perceived abilities to perform audits in their domain will be positively correlated with their actual audit performance. 2.1. Auditor over- or under-confidence in self-perceived ability Prior evidence in psychology suggests that individuals are overconfident in their abilities. Zammuto et al. (1982) reported that subordinate nurses viewed themselves more positively than their supervisors on many dimensions of performance evaluation. Likewise, corporate managers’ self-ratings of their own human relationship with others exceeded their supervisors’ rating of the managers on the same dimension (Yammarino and Waldman, 1993). Further, Scullen et al. (2003) indicate that subordinates’ self-ratings on managerial performance in one corporate setting were more significantly positive than the judgments of their supervisors or peers. Other studies also noted the general tendency of humans to be overconfident (Alba and Hutchinson, 2000; Chung, 1995). It is unclear whether the notion that individuals generally overestimate confidence in their own abilities generalizes to auditors’ assessments of their self-perceived abilities, since auditors are governed by GAAS and are trained to be competent and skilled in performing audits. However, a number of empirical studies in auditing research suggest that auditors are also likely to overstate their perceived abilities relative to actual performance. For example, Waller and Felix (1984) indicate that auditors are overconfident in co-variation judgments while Kennedy and Peecher (1997) report that audit supervisors are overconfident in their own technical knowledge and those of their subordinates when assessing the technical

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abilities of subordinates in performing an audit task. Auditors are also said to be usually overconfident in knowledge tasks (Stankov and Crawford, 1997). Consequently, it appears that auditors would also be likely to overstate their self-perceived abilities, relative to their actual performance in auditing tasks; hence, the following hypothesis: Hypothesis 2. Relative to overall actual performance, auditors will overestimate their self-perceived abilities in conducting an audit. 2.2. Impact of auditor experience on self-perceived ability Prior studies indicate that auditors’ abilities to process information or to take subsequent actions increase with experience (Gibbins, 1984). For example, Libby (1995) notes that experienced auditors have well-developed relevant memory structures for audit issues and events and these memory structures allow them to effectively perform their audit tasks and to make effective decisions. Frederick and Libby (1986) suggest that when faced with judgment decisions, experienced auditors tap into their memory structures and make more accurate judgments than inexperienced auditors who do not possess such well-developed memory structures as their more experienced audit counterparts. Consequently, the ability of auditors to effectively assess their own abilities in performing an audit task should require an understanding and manifestation of their competence and skills. Ideally, when reviewing working papers, audit managers should be less likely than seniors to overestimate their ability to perform an audit task, such as working paper review, because audit managers should have acquired more experience reviewing working papers than audit seniors. However, since both managers and seniors face similar environmental factors related to their work and since empirical evidence in the field of psychology suggests that all individuals are likely to be overconfident in assessing their own abilities, it is unclear whether or not audit managers would be as equally biased as audit seniors in overstating their self-perceived abilities relative to their actual performance. Thus, the following hypothesis is tested: Hypothesis 3(a). Relative to overall actual performance, audit managers and seniors will both overestimate their perceived abilities in conducting an audit. Furthermore, the tendency to overestimate abilities may not depend upon the experience level of the auditor. For example, Libby and Luft (1993, p. 428–30) recognize that even though more experienced auditors are paid more and assigned to greater responsibility, and thus their performance is expected to be better than their less-experienced counterparts, there is little basis to expect experience-related differences regarding such qualities as self-insight. Therefore, if auditors are generally biased in their self-ability ratings, the magnitude of the difference between the self-perceived abilities and actual performance should not be significantly different for audit managers and seniors. Consequently, the following hypothesis is tested: Hypothesis 3(b). The difference in audit managers’ self-perceived abilities and their actual performance will not be significantly different from that of audit seniors.

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2.3. Impact of auditors’ effectiveness on self-perceived ability During the normal course of an audit, a public accounting firm would assign auditors considered to be effective to specific audit tasks and supervise assistants that are also assigned to that audit in order to ensure audit quality. However, prior studies examining auditors’ overconfidence made no distinction between overconfidence ratings for different levels of auditor effectiveness, such as above median and below median effective auditors. In this study, effectiveness can be defined as the auditor’s ability to detect seeded errors in the audit working papers. It may be that above median effective auditors are less overconfident than their peers who are below median. Kruger and Dunning (1999) reported that less competent individuals are more likely to overestimate their abilities to perform domain-specific tasks than individuals possessing the relevant domain-specific knowledge, because less competent individuals lack the task-specific knowledge to understand the errors in their own judgment or decisions. Kruger and Dunning (1999) also noted that competent individuals tend to choose the most reasonable and likely options when making judgments, because they possess the ability to know how well they are performing and when they are likely to be accurate in their judgments. In contrast, Metcalfe (1998) noted that less competent individuals lack the metacognitive skills to make accurate self-assessment of their abilities. Consistent with Kruger and Dunning (1999), prior studies in auditing also show that industry-specific knowledge allows individual auditors to effectively perform an audit task better than those who do not possess the industry-specific knowledge (Owhoso et al., 2002; Taylor, 2000). In these studies however, competence is generally equated to the possession of industry-specific training and not the level of auditor’s performance. In the current study, competence is defined as the level of the auditor’s effectiveness in detecting errors based on whether the amount of errors detected by the auditor is above or below the median of all detected errors. Auditors with detected errors greater than the median are classified as above median effective auditors while auditors with detected errors below the median are classified as below median effective auditors. Based on this classification, it is expected that above median effective auditors, regardless of industry of specialization, will possess a more accurate understanding of industry-specific task details necessary to better perform an audit task and would therefore be able to better assess their self-perceived abilities than below median effective auditors. As a result, the following hypothesis is tested: Hypothesis 4. Above median effective auditors will be less overconfident than below median effective auditors in their self-perceived abilities relative to actual performance. The next section describes the methodology used to test the hypotheses.

3. Research methods 3.1. Participants The study analyzes the self-perceived ratings of 72 audit managers and 72 seniors from 42 offices of one Big 4 firm that were not previously examined in Owhoso et al. (2002). The

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average experience of the managers is 7.3 years and the average experience of the seniors is 3.8 years. The subjects were all industry specialists, half of whom specialized in healthcare (hospital) audits and the other half specialized in banking audits. They were classified as experienced and inexperienced based on the rank of manager or senior, respectively. The Big 4 audit firm that helped with the study supplied the auditor rank information and also provided the subjects for the study in several specially arranged sessions for conducting the experiment. For each location where special sessions could not be organized, the Big 4 firm designated an audit partner who was responsible for receiving the instruments from the author, administering them to the subjects, and forwarding the completed instruments to the author. Seventy-two pairs of audit teams of a manager and a senior were constructed from the 144 subjects participating in the study, with half of the pairs (36 teams) in banking and the other half (36 teams) in healthcare. Within each pair, each auditor reviewed one case in his or her industry of specialization and one case outside the industry of specialization. More specifically, each auditor in the team reviewed one case individually (which was not reviewed by the manager in the team), and one case as part of an audit team (which was also reviewed by the manager in the team). For instance, if a healthcare audit senior reviewed a healthcare case individually (this would not be reviewed by the manager on the team), this senior would also review a banking case as part of the team (whereby the senior reviewed the case and then presented it to the manager for further review). The healthcare manager in that team would also review a healthcare case individually and then review the banking case work that had been completed by the senior as part of the team. Likewise, if the healthcare audit senior reviewed a banking case individually, the senior would then review the healthcare case as part of the team. The audit manager would also review the healthcare case as part of the team and then complete the banking case individually. This process is counterbalanced for both the healthcare and banking teams.6 3.2. Case material Two audit working paper cases, one in banking and the other healthcare, were developed and presented for review to the audit managers and seniors who participated in this study. The cases were presented to the seniors first. From the completed cases, one was presented to an audit manager who was randomly assigned as part of the dyad team for review; the other was not further reviewed. The banking case involved loan receivables and loan loss reserves, and the healthcare task involved hospital patient service receivable, related accounts receivable, and the allowance for bad debt accounts. The case materials were developed and pilot tested with the assistance of one Big 4 accounting firm. The background information in the case included an overview of the company’s accounts receivables or loans receivables, audit plans, and the company’s financial data (the balance sheet and income statement for 2 years). The cases also included working papers that the subjects reviewed. The cases were also seeded with relevant industry-specific errors that vary in their mechanical and conceptual error dimensions. The banking case was seeded with 11 errors and the healthcare case was seeded with 13 errors. 6

The auditors in this study were told that a senior member of the audit team might review their work.

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Each senior and manager auditor was asked to do three things: (1) to assume the role of an in-charge senior or engagement manager, respectively, (2) to be familiar with each company’s background information, and (3) to review individually two sets of audit working papers. Finally, at the end of the review task, each subject was asked to make an assessment of his or her ability to perform an audit (1) in the healthcare industry and (2) in the banking industry, using a percentage scale that was provided. The scale ranges from 0% (very low ability) on the lower extreme to 100% (very high ability) on the upper extreme. This type of scale is commonly used in behavioral auditing research for simulating subjects’ likelihood assessments (Libby, 1985). The subjects each made their self-perceived ability assessments only at the end of the review task, after they had familiarized themselves with the client’s background information and reviewed the auditor’s working papers. This was intentional because it allowed the reviewers to be fully aware of the client’s economic and internal control issues and to consider whether they identified (or failed to identify) errors in the working papers before estimating their ability to perform an audit in the industry. The errors seeded in the working papers reviewed by the audit seniors and managers were from another study involving audit partners in the banking and healthcare industries. The partners each rated errors in their industry on the following dimensions: (1) the relative frequency of occurrence of each error in their industry, (2) the relative importance of each error, (3) the member of the audit team who would detect each error, and (4) the nature of the error, i.e., mechanical or conceptual. Mechanical errors were defined as those that require very little or no judgment on the part of the auditor and conceptual errors as those that require significant judgment on the part of the auditor.7 3.3. Dependent variable The dependent variable reported in this study is the audit manager’s and senior’s selfperceived ability in performing an audit in the domain of specialization relative to actual performance. Each subject rated his or her ability to perform an audit in the banking industry and in the healthcare industry after reviewing a subordinate’s working papers. More specifically, healthcare and banking auditors assessed their abilities to perform an audit in their industry of specialization and in an industry outside their industry of specialization immediately after completing reviews of subordinates’ working papers on two audit cases. Individual auditors’ perceived ability ratings were compiled separately within and outside the industry of specialization. 3.4. Independent variable Auditor Rank is the primary independent variable for Hypotheses 1–3(b). Rank is manipulated at two auditor levels: manager and senior. The subjects’ ranks were previously identified by the Big 4 audit firm that helped with the development and testing of the case materials. For Hypothesis 4, auditor effectiveness is the primary independent variable and it is a constructed variable. Auditor effectiveness is manipulated as above median and below 7 The data from the prior study was updated recently in 2005 as part of another study. The data generated by these studies are being used to develop an ongoing database of audit errors in the banking and healthcare industries.

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median auditors at both the manager and senior levels. Above median effective auditors are those whose detected errors average is greater than the median; below median effective auditors are those whose detected errors average is below the median.

4. Results 4.1. Descriptive statistics Panel A of Table 1 presents the descriptive statistics for audit managers’ and seniors’ selfperceived abilities versus actual audit performance in terms of detected errors. The results indicate that overall, auditors significantly inflated their self-perceived abilities relative to their overall actual performance in detecting errors. The means of the self-perceived abilities are much larger than the means of actual performances. 4.2. Correlation of auditors’ self-perceived abilities and actual performance Hypothesis 1 predicts that auditors’ self-perceived abilities should be positively correlated with their overall actual performance. To test Hypothesis 1, a correlation analysis was conducted on the pooled self-perceived abilities and actual performance for both managers and seniors. The results are presented in Table 1(Panel B). The results show that overall, there was no significant positive correlation between auditors’ self-perceived abilities and actual performance (r = 0.07064, p < 0.4320). When the correlations were analyzed separately for managers and seniors, a negative but insignificant correlation was observed between selfperceived abilities and actual performance for both managers (r = −0.1127, p > 0.5145) and Table 1 Auditors’ perceived abilities in conducting domain audits Auditor rank

n

Self-perceived ability rating

Panel A: mean perceived ability rating and actual performance Managers 36 90.472 Seniors 72 79.986 Overall 108 83.481

S.D.

Actual performance

S.D.

10.472 19.331 17.613

48.287 34.294 38.958

19.287 12.098 16.209

Self-perceived ability Panel B: correlation of auditors’ self-perceived ability and detected actual errors (S.D. in parentheses) Seniors: actual detection −0.2263 (0.8503) Managers: actual detection −0.1127 (0.5145) Overall actual detection 0.07064 (0.4320) Auditor rank

Self-perceived ability rating

Actual performance

Predicted (actual)

t-Value

p-Value

Panel C: audit managers and seniors self-perceived ability versus actual performance (S.D. in parentheses) Managers 90.472 (10.472) 48.287 (19.287) 42.185 (23.094) 15.61 <0.0001 Seniors 79.986 (19.331) 34.294 (12.098) 45.692 (23.036) 16.83 <0.0001 Overall 83.481 (17.613) 38.958 (16.209) 44.523 (23.007) 20.11 <0.0001

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seniors (r = −0.2263, p > 0.8503). This result implies that there is no discernible credible relationship between audit seniors’ and managers’ self-perceived abilities and their actual performance, contrary to our expectation. Because the result was unexpected, we further analyzed the data (results not shown) by partitioning the detected errors into mechanical versus conceptual errors as if the auditors had rated their self-perceptions along these dimensions. The results show that auditors’ self-perceived abilities are positively correlated with detected conceptual errors (r = 0.25; p < 0.0101) but negatively correlated with detected mechanical errors (r = −0.28, p < 0.0035). The results suggest that auditors who detected more mechanical errors tended to rate their self-perceived abilities lower while auditors who detected more conceptual errors tended to rate their self-perceived abilities higher, suggesting that the nature of errors do moderate auditors’ self-perceived ability ratings. Hypothesis 2 predicts that relative to actual performance, auditors will overstate their self-perceived abilities in performing an audit in their domain of specialization. To test this hypothesis, a paired t-test was conducted on the difference in the auditors’ self-perceived abilities and their overall actual performance. The results indicate a significant difference in the auditors’ self-perceived abilities in conducting audits versus their actual performance. From Table 1(Panel C), it is shown that auditors inflated their self-perceived abilities compared to their actual performance, consistent with expectation. The difference between auditors’ self-perceived abilities and actual performance is 44.523, which is very large and significant (t = 20.11, p < 0.0001). Hypothesis 3(a) predicts that relative to actual performance, audit managers and seniors will overstate their self-perceived abilities in performing an audit in their own domain. To test this hypothesis, a paired t-test was conducted on the difference in the auditors’ perceived abilities and their overall actual performance. The results indicate a significant difference in both audit managers’ and seniors’ self-perceived abilities in conducting audits versus their actual performance. From Table 1(Panel C), it is shown that audit managers and seniors both inflated their self-perceived abilities compared to their actual performance, consistent with expectation. The difference between audit managers’ perceived abilities and actual performance is 42.185, which is very large and significant (t = 15.61, p < 0.0001). Likewise, the difference in audit seniors’ self-perceived abilities and their actual performance is 45.692. The difference is also very large and significant (t = 16.83, p < 0.0001). These results show that audit managers and seniors are equally biased in estimating their perceived ability in conducting an audit relative to their actual performance. Hypothesis 3(b) predicts that on average, the difference in the managers’ ratings of their self-perceived abilities relative to actual performance and audit seniors’ rating of self-perceived abilities and actual performance would not be significantly different. The results show that audit experience or rank does not differentially moderate audit managers and seniors’ self-perceptions of ability versus actual performance. As shown in Table 1(Panel C), there is no significant difference in the prediction spread of audit managers’ self-perceived abilities versus their actual performance when compared to that of audit seniors. The difference in the managers’ self-predicted abilities and actual performance is 42.185 and is not significantly different than 45.692, the difference in the seniors’ perceived abilities versus actual performance. Thus, Hypothesis 3(b) is supported.

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Hypothesis 4 predicts that above median effective auditors will be less overconfident than below median effective auditors in their self-perceived abilities relative to actual audit performance. To test Hypothesis 4, the categorization of above median and below median effective auditors was determined first by dividing the sample of detected errors into two halves using the median score. Auditors whose error detection average was above the median were classified as above median and those whose error detection average was below the median were classified as below median effective auditors. No attempt was made to denote the below median auditor group as “less effective” auditors, since it is unlikely that audit firms would to hire ineffective auditors. Next, a prediction spread score was calculated for each auditor’s perceived ability rating and actual performance. The means of the two groups were compared using the t-test statistic. Consistent with expectation, the results presented in Table 2 show that, overall, the above median effective auditors were far less overconfident than the below median effective auditors (t = 23.19, p < 0.0001). The prediction spread between the above median effective auditors’ perceived abilities and actual performance was 33.289. This difference is much smaller than 51.667, the prediction spread for the below median effective auditors’ perceived abilities and actual performance. With respect to above median effective audit managers, the prediction spread between perceived abilities and audit performance is 32.040. This is much smaller than 68.548, the prediction spread for the below median effective audit managers. This difference is largely significant (F = 36.19, p < 0.0001). Similarly, for the above median effective audit seniors, the prediction spread between their self-perceived abilities and actual performance is 35.319. This is smaller than 48.654, the prediction spread for the below median effective audit seniors. The difference is significant (F = 4.37, p < 0.0403). Thus, Hypothesis 4 is supported. The results are discussed in the next section.

5. Summary analysis and future research This study examines whether auditors’ self-perceived abilities assessed after completing an audit task in their industry domain corresponds with their actual performance and whether it is influenced by auditor rank and auditor effectiveness. The results show that overall, auditors’ self-perceived abilities do not significantly correlate with their actual performance (Hypothesis 1); however, auditors are overconfident in their perceived abilities relative to their actual performance (Hypotheses 2 and 3(a)). The results further show no significant difference between managers’ and seniors’ self-perceptions versus actual performance (Hypothesis 3(b)); however, for industry-specialized auditors, above median effective auditors are much less overconfident than below median effective auditors (Hypothesis 4). There are a number of insights into these findings. First, they point to the need for additional audit resources and improvements in training and performance evaluation systems. Second, they suggest a need for an examination of the influence of personality traits and corporate culture variables on auditors’propensity to be overconfident relative to performance—variables that the profession and researchers may not traditionally have considered to have impact on auditors’ behaviors.

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Auditors effectiveness

n

Perceived ability rating

Actual performance

Predicted (actual)

t-Value

p-Value

All above median effective auditors All below median effective auditors Above median effective managers Below median effective managers Above median effective seniors Below median effective seniors

42 66 26 10 16 56

88.095 (11.298) 80.545 (20.192) 89.192 (12.218) 93.800 (3.910) 86.312 (9.714) 78.178 (21.016)

54.806 (12.032) 28.877 (8.705) 57.152 (13.470) 25.250 (11.209) 50.994 (8.241) 29.52 (8.134)

33.289 51.667 32.040 68.548 35.319 48.654

23.19

0.0001

36.19a

0.0001

4.37a

0.0403

a

These are F-values from ANOVA with the difference score as the dependent variable and effectiveness and rank as the independent variable.

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Table 2 Self-perceived ability vs. actual performance for above median vs. below median auditors (S.D. in parentheses)

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The findings that auditors’ self-perceived abilities do not correspond to their actual performance and auditors are overconfident in their perceived abilities relative to their actual performance, regardless of auditor rank, demand a critical analysis. For example, (1) What do the findings mean for audit practice? (2) Could it be that auditing technology and resources are being misallocated whenever auditors are overconfident? (3) What level of audit quality do we have when auditors are overconfident? (4) Is the auditors’ personality or the audit firms’ corporate culture contributing to the auditors’ propensity to be overconfident? (5) What potential remedies are likely to mitigate auditors’ propensity to overstate ability relative to performance? (6) How might audit firms incorporate these potential remedies? In an auditing context, overconfidence could lead the auditor to engage in risky behaviors and hence conduct ineffective audits by overlooking the obvious. For example, the overconfident auditor might systematically underestimate the risk of an audit engagement and/or overstate the effectiveness, adequacy, and sufficiency of an audit procedure or evidence. An overconfident auditor might fail to properly gauge the effectiveness of a client’s systems and procedures, believing that he or she has the capacity to discover whatever weaknesses the client may have. An overconfident auditor might also erroneously accept new but risky clients and justify his or her actions based on the reliance on some stateof-art audit techniques or technology, even when it is clear that the client should not be accepted. The overconfident auditor might not seek consultation when it is mostly needed because he or she believes that the chosen approach or solution to the problem is a better one. Further, the overconfident auditor might focus more on either financial data and less on non-financial evidential data or vice verse because he or she might believe that his or her technical knowledge could overcome deficiencies in a client’s financial statements. The outcome of such overconfident decisions may take the form of substandard audits and the misallocation of audit resources. This could lead to legal problems, inappropriate staffing, inefficient use of technology, and misallocation of audit resources. For a reputation-driven profession like auditing, these outcomes can have tremendous economic impact. Accordingly, accountants must recognize the economic incentive to become more accountable by mitigating the propensity toward overconfidence and other characteristics of auditor risk (Fuerman, 2004). Notwithstanding the numerous professional training programs auditors undergo, the codes of conducts by which they abide, the auditing standards – general, fieldwork, and reporting – with which they must comply, the regulatory bodies to whom they are accountable, and the bodies of auditing and financial accounting pronouncements with which they must be familiar, it is ironic that auditors are still overconfident in their abilities relative to performance. This phenomenon is very counterintuitive and it begs the question of why auditors are overconfident in spite of their extensive exposure to resources designed to enhance effective and efficient task performance. Could it be that auditors are overconfident because of egocentric reasons and/or corporate culture environmental pressures? Egocentric bias can be defined as the tendency for humans to inflate their self-ratings in order to create a different view of themselves than held by other people (Thornton, 1968). Egocentric bias leads to defensiveness, that is, the tendency to inflate self-ratings to enhance the evaluation. An example of this bias might be when auditors justify their decisions or actions, as they constantly do as part of their day-to-day job performance. For example,

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auditor have to justify such judgments as why a client is a going concern risk, why a client’s accrual for additional allowance for bad debts should or should not be accepted, or why a certain transaction should be capitalized or expensed. Auditors also justify actions that may lack definitive applicable authoritative guidance Kennedy et al. (1997, p. 105). Thus, it appears that once auditors take actions, they are bound to justify the correctness of their decisions. Peecher (1996, p. 126) defines justification as the act of providing evidence to support decisions. Thus, auditors’ practice of justification is positive in that it enhances confidence as well as the auditor’s responsibility for accumulating evidence. However, auditors may also suffer egocentric bias due to high self-esteem. Persons with high self-esteem are likely to defend their actions, even if the performance is inaccurate. DeCoster and Rhode (1971) noted that auditors are more apt to be psychologically minded and posses characteristics of self-acceptance and independent achievement, suggesting that they are likely to have high self-esteem. With high self-esteem, auditors are likely to be overconfident in their justification of actions, and may not be aware when their justifications are inaccurate. Egocentric bias might also occur when inaccuracies are explained away as someone else’s fault (Harris and Schaubroeck, 1988, p. 45) For example, auditors may attribute good performance to their own actions; whereas, poor performance may be blamed on what the engagement partner, audit manager, or reviewer wanted. As long as auditors believe these tendencies, they are likely to overestimate their abilities. The expectations of the audit firms’ corporate culture are also likely to promote confidence and justification for decision-making. Auditors are expected to be promoted to higher ranks in the future. For example, an audit manager expects to become a partner, and an audit senior expects to become a manager. These promotions are expected to be the results of putting forth continuously successful efforts. Overconfidence in judgments and responses may result, as some auditors may be reluctant to admit failure in this success-driven environment. Likewise, some auditors may neglect to seek consultation on routine issues if they believe that their superiors and peers would expect them to be knowledgeable on the subject. Similarly, the contradictory forces of a professional marked both by compliance with standards and autonomous judgment (MacLullich, 2003, p. 808) may further facilitate overconfidence in decision choices. To reduce these deficiencies, public accounting firms might consider dedicating additional resources to their audit practices, such as information regarding self-perceived abilities, in addition to more hours, more qualified personnel, and improved training programs. In addition, the firms’ methods of evaluating subordinate auditors for retention, performance, and audit task assignments could be enhanced by including information on self-perceived abilities to mitigate subordinates’ propensity to overestimate their abilities relative to actual performance. Furthermore, the fact that above median effective auditors are less overconfident may alleviate some effectiveness issues and open avenues for using decision aids to help auditors mitigate the propensity to be overconfident. Thus, audit firms may be able to reduce audit risk through these improvements in their audit processes and resources. According to Baker and Owsen (2002, p. 783) and Fuerman (2004), the role of auditing needs to be increased in order to facilitate better corporate governance, which will benefit all stakeholders and society in general. Given the significant economic costs that are associated with audit failures, such improvements are critical.

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There are inherent limitations in this study since it was conducted in a laboratory setting. Accordingly, we cannot be certain that the auditor subjects encoded the survey documents as they would have done in a fieldwork setting. Since the auditors knew that there were no real consequences for their judgments, it is also possible that they may not have completed this exercise with the same degree of scrutiny or rigor as they would have exercised in an actual fieldwork setting. This limitation, as well as the results, provide various avenues for future academic research. Future research could consider the accountability variable by creating a scenario that would make auditors more accountable for their judgments. One interesting issue might be to consider whether auditors’ self-perceived abilities are influenced by the expectation that their working papers will be further scrutinized by a superior. For instance, they might address the extent to which auditors’ self-perceptions of effectiveness rely upon the multitiered structure of working paper reviews in public accounting firms by examining whether such perceptions differ when the auditors are told definitely that their working papers will or will not be further reviewed. Similarly, research could take into consideration that one potential driver of auditor overconfidence is the individual auditor’s self-perceptions of audit effectiveness in performing audit tasks. As noted earlier, above median effective auditors are less likely to overestimate their perceived abilities than below median effective auditors. Although overconfidence is a general phenomenon, future studies could examine whether overconfidence is a function of effectiveness among novices. Another possibility for future research is to investigate the association between auditors’ self-perceived abilities and actual detection of mechanical or conceptual errors. Although not specifically tested in this study, it was noted that auditor performance varied based on the effective detection of mechanical errors versus conceptual errors. It would be interesting to further examine the relationship between auditor overconfidence and auditors’ actual performance in terms of error detection, differentiated by the type of error (mechanical versus conceptual). Finally, concerning each of these areas for future research, it is important to recognize the culture of the auditing profession and its impact on self-perceptions. Power (1995, p. 333, 334) suggests that future research should acknowledge the reality of audit work rather than the imagery created by the many rules with which auditors must comply. Academic research may provide relevant insights into self-perceived abilities and how related data can assist the practice of auditing only if the research accurately reflects the multiple dimensions of this profession.

Acknowledgements The authors gratefully acknowledge the comments received from participants at the American Accounting Association northeast regional meeting, the Scholarly Activities Committee workshop at Bentley College, the brown bag research session at Northern Kentucky University, and the Association of Global Business conference, as well as three anonymous reviewers. We also thank the Big 4 firm which provided the subjects for this study.

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