An investigation of auditor's perceptions and decision processes regarding evaluation of material internal accounting co...

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An investigation of auditor's perceptions and decision processes regarding evaluation of material internal accounting control weaknesses
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xi, 217 leaves : ill. ; 28 cm.
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Mayper, Alan G., 1952-
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Thesis (Ph. D.)--University of Florida, 1981.
Bibliography:
Includes bibliographical references (leaves 209-216).
Statement of Responsibility:
by Alan G. Mayper.
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Typescript.
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Vita.

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Full Text















AN INVESTIGATION OF AUDITOR'S PERCEPTIONS AND
DECISION PROCESSES REGARDING EVALUATION OF
MATERIAL INTERNAL ACCOUNTING CONTROL WEAKNESSES











BY

ALAN G. MAYPER


A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL
OF THE UNIVERSITY OF FLORIDA IN
PARTIAL FULFILLMENT OF THE REQUIREMENTS
FOR THE DEGREE OF DOCTOR OF PHILOSOPHY



UNIVERSITY OF FLORIDA

1981


































Copyright 1981

by

Alan Gale Mayper


















ACKNOWLEDGEMENTS


I thank my committee members: Charles McDonald, Douglas Snowball,

William Messier, and Richard Griggs, for their invaluable guidance,

contributions and encouragement. I am also indebted to Dennis Patz

and Gary Holstrum who provided helpful suggestions and criticisms

at all stages in the research.

I also wish to thank the auditors who generously provided their

time and attention in participating in this research.

Finally, my greatest debt is to my close friends,

Tracie Erin Lee and Robert Thompson. Without their encouragement

and "ears" this dissertation (and my doctoral studies) would never

have been done.

















TABLE OF CONTENTS

PAGE

ACKNOWLEDGMENT . . ... .iii

LIST OF TABLES . . ... .vii

LIST OF FIGURES . . ... .viii

ABSTRACT . . ... . .ix

CHAPTER I INTRODUCTION TO THE STUDY . 1

Nature of Study . . ... 1
Professional Judgment . . 1
Materiality Judgments . . 2
Significance of the IACW Materiality Judgment . 3
Statement on Auditing Standards Number 20 . 4
The Cohen Commission . . 4
Foreign Corrupt Practices Act of 1977 . 5
The SEC . . ... 6
Statement on Auditing Standards Number 30 . 6
Significance of Changing Responsibilities . 7
Nature of the IACW Materiality Judgment . 7
Elements of the Judgment . . 7
Auditor's Decision Process . . 8
Statement of the Problem . .. 10
Research Questions Addressed . ... 13
Judgment Factors . .. 14
Descriptive Models of the Judgment Process ... 15
Consensus . .... 15
Auditor's Self-Insight into the Judgment Process ... .16
Methodology . .. 16
Pre-Experimental . .. 17
The Field Experiment . .. 17
Scope Limitations . ... . 18
Organization of the Study . .. 19
Notes . . ... . 20

CHAPTER II MATERIALITY OF INTERNAL ACCOUNTING CONTROL
WEAKNESSES: POTENTIAL FACTORS .. .. 21

Introduction . .... . 21
Factor Criteria . .... . 22
Chapter Methodology . .... 22
Auditors' Evaluation of Internal Accounting Control ... .24
Properties of Internal Control ... .. 24
Personnel . .... . 25











Segregation of duties . ... 25
Authorization of procedures . .. .26
Adequate documents and records . .. .27
Proper procedures for record keeping .. .27
Physical control over records and assets .. .27
Independent checks on performance . ... .28
The Materiality of Internal Accounting Control
Weaknesses . . ... 29
Concept of Materiality . . ... 32
Definition . . ... 32
Financial Accounting Materiality Versus Auditing
Materiality . . ... 39
The Internal Accounting Control Weakness
Materiality Decision . ... 42
Categorization of Materiality Factors . ... .43
Materiality Factor Description and Application of
the Factor Selection Criteria . ... 48
Environmental Factors . ... 48
Description . . ... 48
Criteria application . ... 49
Enterprise Related Factors . ... 50
Description . . ... 50
Criteria application . ... 53
Accounting Policy Related Factors . ... .58
Description . . ... 58
Criteria application . ... 59
Uncertainty of the Existing State of Nature .. .60
Description . . ... 60
Criteria application . ... 61
Surrounding Circumstances Associated with the
Existing State of Nature . ... 62
Description . . ... 62
Criteria application . ... 64
Dollar Effects . . ... 66
Description . . ... 66
Criteria application . ... 69
Summary of Factors Satisfying the Factor
Selection Criteria . ... 70
Summary of Interview Results Concerning Factors
in the IACW Materiality Judgment . ... .72
Summary and Conclusions . ... 75
Notes . . ... . 76

CHAPTER III METHODOLOGY . . ... ... .79

Introduction . . ... 79
The Model . . ... ....... 80
ANOVA . . ... 80
Pairwise Comparison Measure . ... 81
Complete pairwise comparison procedure .. .82
Incomplete pairwise comparison procedure ... .83
Experimental Design . . ... .. 85
Experimental Setting and Subjects . ... 85











Independent Factor Selection . .
Background Data . .
Dependent Variables and Tasks .
Pairwise comparison task . .
Single rating task . .
Description of the Auditor's Judgment Process
Auditors' Consensus . .
Auditor's Insight into His Judgment Process
Additional Analyses . .
Administration of the Experiment .
Pilot tests . .
Primary study . .
Limitations of the Experiment .
Summary . . .
Notes . . .

CHAPTER IV RESULTS OF THE EXPERIMENT .

Introduction . . .
ANOVA Models--Individual Analyses .
ANOVA Models--Group Analyses . .
Judgment Consensus . .
Correlation Analyses . .
Percentage Consensus Analysis by IACWs .
Self-Insight . . .
Subjective Weights . .
Self-Insight Index . .
Additional Data . . .


Specific Comments and Additional
Desired by Ss .
Task Evaluation .
Summary . .
Notes . .


Information
.o o. o o
. .o .
. o o o o.
. o .o


85
87
87
89
94
95
101
101
102
103
103
105
107
109
110


. 113


113
113
124
131
132
135
140
141
145
149

149
150
150
152


CHAPTER V SUMMARY, IMPLICATIONS AND SUGGESTIONS FOR
FUTURE RESEARCH . .

Summary of Problem, Research and Experimental
Results . . .
Implications . . .
Future Research . .
Notes . . .

APPENDIX A PRE-EXPERIMENTAL INTERVIEWS .


. 153



. 153
. 157
. 161
. 164

. 165


APPENDIX B EXPERIMENTAL MATERIALS . .. .186

REFERENCES . . .. .. 209


BIOGRAPHICAL SKETCH . .


. 217


















LIST OF TABLES


TABLE PAGE

2.1 A SUMMARY OF RESEARCH ON THE FACTORS WHICH
AFFECT MATERIALITY JUDGMENTS . ... 45
2.2 FACTORS WHICH SATISFIED THE THREE SELECTION
CRITERIA . . ... 71
2.3 SUMMARY OF PRE-EXPERIMENT INTERVIEWS . .. 73
(Perceived Important Factor Responses)

3.1 DOMINANCE RANKINGS OF SELECTED STANDARD SETS ... 91
3.2 COMPARISON OF PAIRWISE SCALE TO SINGLE RATING SCALE .. 106
(Correlation Criterion for Subject Retention)
3.3 SUMMARY OF Ss BY FIRM, CITY AND EXPERIENCE LEVEL ... .107

4.1 SUBJECT'S SIGNIFICANCE LEVELS AND R-SQUARES--
MODEL 1 AND MODEL 2 . ... .114
4.2 SUMMARY OF ANOVA RESULTS . ... .116
4.3 SELECTED EXAMPLES OF DIFFERENCES IN THE IMPORTANCE
OF FACTOR USAGE TO THE VARIOUS Ss . .. 118
4.4 RELATIVE IMPORTANCE OF THE IACW MATERIALITY
FACTORS AND INTERACTIONS . ... .119
4.5 DISTRIBUTION OF Ss BY TOTAL VARIANCE EXPLAINED .. .123
4.6 AVERAGE OMEGA-SQUARE VALUES OF SIGNIFICANT
EFFECTS BY VARIOUS SUB-GROUPS . .. 125
4.7 JUDGMENT CONSENSUS AMONG Ss BY FIRMS, EXPERIENCE
LEVELS, CITIES, STANDARD SET AND ORDER GROUP .. .134
4.8 SUBJECT MATERIALITY AGREEMENT ABOUT INDIVIDUAL
IACWs . . . 136
4.9 IACW MATERIALITY JUDGMENT AGREEMENT BY FIRM ... .137
4.10 IACW MATERIALITY JUDGMENT AGREEMENT BY CITY .. .138
4.11 IACW MATERIALITY JUDGMENT AGREEMENT BY EXPERIENCE
LEVEL . . ... 138
4.12 VALUE OF SUBJECTIVE WEIGHTS BY Ss . ... .142
4.13 SELECTED EXAMPLES OF DIFFERENCES BETWEEN Ss'
SUBJECTIVE AND STATISTICAL WEIGHTS . .. 143
4.14 VALUE OF SUBJECTIVE WEIGHTS BY VARIOUS SUB-GROUPS ... .144
4.15 SELF-INSIGHT INDICES FOR INDIVIDUAL Ss ... .146
4.16 SELF-INSIGHT BY VARIOUS SUB-GROUPS . ... .148

















LIST OF FIGURES


FIGURE PAGE

1.1 OVERVIEW OF THE AUDITOR'S DECISION PROCESS .. 11

2.1 AUDITOR'S EVALUATION OF IACWs . 3C
2.2 THE CONCEPT OF MATERIALITY . ... 35
2.3 APPLICATION OF THE CONCEPT OF MATERIALITY TO
FINANCIAL ACCOUNTING AND TO AUDITING CONTEXTS ... 40

3.1 EXPERIMENTAL DESIGN . . .. 88
3.2 PAIRWISE COMPARISON CALCULATIONS . .. 93
3.3 SUMMARY OF EXPERIMENTAL ANALYSES . .. .104

4.1 GRAPHS OF TYIAC X AS INTERACTION EFFECTS .. .121
4.2 FIRM X FACTOR EFFECTS . ... 127
4.3 EXPERIENCE AND RISK X FACTOR EFFECTS . .. 130


viii


















Abstract of Dissertation Presented to the Graduate Council
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy



AN INVESTIGATION OF AUDITOR'S PERCEPTIONS AND
DECISION PROCESSES REGARDING EVALUATION OF
MATERIAL INTERNAL ACCOUNTING CONTROL WEAKNESSES

By

Alan G. Mayper

March 1981

Chairman: Charles L. McDonald
Major Department: Accounting

This dissertation explored the auditor's judgment process in

making an internal accounting control weakness (IACW) materiality

decision. The auditing literature clearly has indicated the im-

portance of judgment to this type of decision. The two general

objectives of this study were 1) to develop a conceptual framework

which related the concept of materiality to the auditor's evaluation

of IACWs, and 2) to empirically test some implications of this

framework using a human information processing methodology.

The development of the conceptual framework required an ex-

tensive review of both the internal control literature and the

materiality literature. A simple, yet rigorous, definition of

materiality formed an important part of this framework. The concept

of materiality was defined as

The perceived importance of a difference between
an existing state of nature and some other (generally
a standard or ideal) conceived state of nature.











The auditor's evaluation of the materiality of an IACW was presumed

to consist of the following two components: 1) the auditor's es-

timation of the expected dollar exposure due to the IACW, and

2) the auditor's evaluation of the importance of the expected dollar

exposure (i.e., the comparison of the expected dollar exposure to

the auditor's materiality threshold). The conceptual framework

led to the selection of a set of factors considered potentially

relevant to the auditor's IACW materiality judgment. The factors

were relevant to estimating either the probability or dollar exposure

of errors due to an IACW. Three of the selected factors (two

probability oriented factors and one dollar exposure oriented

factor) were incorporated into an experiment relating to auditors'

IACW materiality judgments.

The experiment provided a mechanism by which the study could

evaluate the importance of the materiality factors to the auditors'

IACW materiality judgments, examine the extent of judgment consensus,

and assess the extent of auditors' self-insight into their judgment

process. Thirty-eight auditors participated in the experiment. The

auditors evaluated the materiality of 12 IACWs using a pairwise com-

parison procedure and a single rating procedure.

The major results of the experiment indicated 1) the ANOVA

models explained a high proportion of variance in the auditor's IACW

materiality judgments, 2) individual differences existed among the

auditors concerning the importance of each materiality factor,

3) substantial configural processing in regards to the two probability

oriented factors, 4) a moderate degree of consensus among the auditors,

and 5) a low degree of self-insight. The above results are subject to

the many limitations discussed throughout the study.











In summary, this research has provided some insights into the

IACW materiality decision and the concept of materiality. This

dissertation has shown that abstract judgment situations can be

examined empirically, with some rigor. Since this dissertation

was only an exploratory study, no conclusion was made in regard

to the need for guidance in the auditor's IACW materiality judgment.

It is hoped only that this study will provide some assistance to

future research that examines the concept of materiality and the

auditor's judgment process in IAC evaluation.

















CHAPTER I
INTRODUCTION TO THE STUDY


Nature of the Study

This study concerns a particular type of professional judgment

exercised by auditors: the assessment of the materiality of internal

accounting control weaknesses (IACWs). This opening chapter is

intended to show that the materiality judgment:

1) is of current significance and is growing in importance;

2) is one for which there is little authoritative guidance
provided the auditor; and

3) is one where empirical research (hitherto not performed)
could aid the development of effective authoritative
guidelines.


Professional Judgment

The auditor relies heavily upon his personal judgment in the

collection and evaluation of evidence in an audit engagement. This

is referred to as the application of professional audit judgment.

Professional judgment represents the decision process the auditor

uses in the evaluation of evidence and in analyzing the effect of

internal accounting controls (IACs) on the audit. It is generally

agreed that professional judgment plays a major role in auditing and

deserves academic inquiry. This is supported by Bernstein [1967,

p. 90] when he says:











Judgment is, of course, a vital part of any professional
work. In accounting it plays an important role every
step of the way. But that does not mean that it is a
mysterious process, undefinable and inexplicable. We
know that the processes that feed judgment are varied
and complex, yet it does not follow that we cannot
make some progress in their analysis and description.

Recent empirical research concerning professional judgment has

examined the auditor's judgment process (e.g., Ashton [1973]; Joyce

[1976]; Messier [1979]). Common purposes underlying these studies are

to determine if auditors can make consistent judgments and to describe

what cues (factors) are important in the auditor's decision process.

By addressing these issues, researchers have sought evidence as to the

need for guidance in specific professional judgments made by auditors.

The prior studies have used a methodology that models the auditor's

judgment process and indicates the consistency of auditor's judgments.

The underlying assumption has been that if inconsistencies are found

in auditors' judgments, then more authoritative guidance is needed to

eliminate the inconsistencies. It is assumed also that the judgment

models obtained may help policy makers establish this authoritative

guidance. The present study constitutes a continuation of empirical

efforts to enhance understanding of professional audit judgment.


Materiality Judgments

Numerous and important professional judgments by the auditor

frequently concern the determination of the materiality of an event.

This is borne out by the American Institute of Certified Public Account-

ants' [AICPA, 1973) codified Statement on Auditing Standards Section

150.04 (SAS), which states, "[T]he concept of materiality is inherent

in the work of the independent auditor." The materiality concept is

normally thought of in relation to the average user; that is, an











event is material if knowledge of that event would cause some dif-

ferential action to be taken by an average user. However, it is

not the user who makes the materiality judgment, but the auditor

(or preparer), who must make it for the user.

The most common materiality judgment examined concerns the

auditor's evaluation of an item related to the current year's audit

of the financial statements. Specifically, researchers have examined

the auditors' materiality judgments related to a disclosure of an event

or a correction of an error related to the financial statements of the

current period. Several empirical studies have been performed in these

"financial reporting" contexts and these will be summarized in Chapter

II (e.g., Boatsman and Robertson [1974]; Hofstedt and Hughes [1977]).

However, their findings clearly cannot be generalized to other auditing

contexts. Factors related to the general concept of materiality have

not been put into a coherent framework and the judgment has been

categorized merely as within the realm of subjective professional

judgment [Financial Accounting Standards Board (FASB), Discussion

Memorandum, 1975]. A major purpose of this study is to rectify the

lack of precision with which the materiality concept has been addressed.


Significance of the IACW Materiality Judgment

Recent developments have created a renewed interest in the

auditor's evaluation of internal accounting controls and especially

IACWs. Traditionally, the auditor's primary purpose in the study and

evaluation of IACs was to establish a basis for reliance on the IACs

in order to assist him in determining the nature, timing, and extent

of auditing procedures to be performed in the examination of financial

statements. Thus the auditor was required to review an IAC system and











perform compliance tests only if he planned to rely on the internal

control as it related to the audited financial statements. The fol-

lowing section highlights current developments which appear to expand

the traditional responsibilities of auditors in the study and

evaluation of IACs.


Statement on Auditing Standards Number 20

In 1977 the purpose of the IAC review was extended by the AICPA's

Statement on Auditing Standards Number 20, "Required Communication of

Material Weaknesses in Internal Accounting Controls" (SAS No. 20).

SAS No. 20 established a requirement that:

the auditorcommunicate to senior management and the
board of directors or its audit committee material
weaknesses in internal accounting control that come to
his attention during an examination of financial state-
ments made in accordance with generally accepted
auditing standards. [emphasis added--AICPA, 1977, p. 1]

Prior to this statement, it was common for auditors to issue management

letters which contained their reservations and recommendations con-

cerning IACWs discovered during the audit engagement. The signifi-

cance of SAS No. 20 lies in the explicit requirement to consider

material weaknesses and communicate them to the board of directors.


The Cohen Commission

The proposals concerning the auditor's responsibility in relation

to IACs as presented by the AICPA's Cohen Commission go beyond SAS

No. 20. The Commission was one of the first advocates of public

reporting on the IAC system and of disclosure of material weaknesses.

In the Commissions' Report, "The Commission on Auditor's Responsi-

bilities: Report, Conclusions, and Recommendations" they recommended:










1) that management should include an assessment of all internal

accounting controls in the financial statements and 2) the independent

auditor should state in his report whether he agrees or disagrees

with management's description, and should describe any material

uncorrected weaknesses not disclosed by management [AICPA, 1978a,

pp. 60-63].


Foreign Corrupt Practices Act of 1977

The public sector recently became involved in the issue of

evaluation of IAC through the Foreign Corrupt Practices Act of 1977.

Although this Act does not directly concern the auditor's evaluation

of IAC and IACWs, it will most likely influence the auditor's

judgments. The Act requires publically held companies to maintain

adequate IACs to provide "reasonable assurances" that the following

objectives are met:

1) transactions have management's general or specific
authorizations.

2) transactions are properly recorded to permit preparation
of financial statements and accountability of assets.

3) access to assets have proper authorization.

4) the recording of assets and accountability of assets
are verified and differences are reconciled.

The above objectives are specified without materiality limits or guide-

lines being provided to judge compliance with the Act. It is reasonable

to assume that the independent auditor will assist management in

complying with the Act; indeed, the above objectives are identical with

the definitional objectives of "Accounting Control" as stated in the

AICPA's SAS No. 1, section 320.28. The primary difference is that

these objectives now have the force of law, under the jurisdiction of

the Securities and Exchange Commission (SEC).










The SEC

In response to the Foreign Corrupt Practices Act the SEC

advocated public reporting on IAC systems--by management, but with

direct involvement of auditors. Initially the SEC sought to require

management to issue a report concerning the adequacy of IACs and to

require the auditor to issue an opinion on management's statement on

IACs. In late 1979, however, the SEC withdrew a proposal concerning

these requirements. Among the reasons for withdrawing the proposal

included 1) that there were no materiality standards included in

the proposal; and 2) the SEC was presently satisfied as to the number

of companies issuing voluntary management reports that included a

statement about IACs [Business Week, 1979 and Ernst and Whinney, 1980].

Nevertheless, the SEC have stated that they expect the outside auditor

to eventually become involved with IAC reports and that management or

auditors will be responsible for the public reporting of material

IACWs [Ernst and Whinney, 1980].


Statement on Auditing Standards Number 30

In 1980 the AICPA issued Statement on Auditing Standards Number 30

(SAS No. 30), "Reporting on Internal Accounting Control." This

statement described the procedures to be applied by the auditor when

issuing reports concerning IACs for either special reports or normal

audit engagements. Included in the procedures were the requirements

that auditors identify IACWs in the accounting system and evaluate the

materiality of the individual IACWs. The auditor also is to include a

description of the material IACWs in his report. These reports are not

considered to be public reports but are intended solely for management,

specified regulatory agencies or other specified third parties.











Significance of Changing Responsibilities

The foregoing indicates that auditors' judgments related to IAC

and IACWs extend beyond the traditional responsibilities described

earlier. The evaluation of IACWs has become a much more explicit

task for the auditor. The determination of whether IACWs, once

identified, are material or not represents an increasingly important

task for auditors; both because of the requirements imposed by

SAS No. 20 and SAS No. 30, and because of the possibility that public

disclosure will become a reality.


Nature of the IACW Materiality Judgment


Elements of the Judgment

The particular judgment of interest brings together two basic

auditing concepts, IACWs and materiality. An IACW is defined as the

"absence of controls" which may lead to an error or irregularity

[Arens and Loebbecke, 1976, p. 177]. Materiality, from the auditor's

view, typically deals with dollar significance to the financial

statements. In combining these two concepts SAS No. 1 describes a

material IACW as follows:

.a condition inwhich the specific control procedures
or the degree of compliance with them do not reduce to
a relatively low level the risk that errors or ir-
regularities in amounts that would be material in
relation to the financial statements being audited may
occur and not be detected within a timely period by
employees in the normal course of performing their
assigned functions.
[section 320.68]

Given this description, then, it follows that the judgment requires

the auditor to assess the probability of an error or irregularity

occurring, that would (a) not be corrected on a timely basis in the











normal course of business, and (b) would materially affect the

financial statements. Both the probability assessment and the

assessment of the materiality to the financial statements are

unlikely to be direct and explicit judgments. Instead from available

evidence it seems likely that the auditor uses both quantitative and

qualitative factors as surrogates for the concepts contained in the

material IACW description. Furthermore, the description highlights

that two important factors in judging the materiality of an IACW are

probability and dollar exposure of the potential errors and ir-

regularities.


Auditor's Decision Process

In order to understand the likely decision process followed by

auditors in evaluating material IACWs, the auditors' evaluation of the

IAC system must first be understood. A review of the authoritative

literature (e.g., SAS's) and descriptions of the auditor's decision

process in recent auditing textbooks (e.g., Arens and Loebbecke,

[1976 and 1980); Robertson [1979]) provide some guidance in this

respect. The general perception seems to be that the auditor's

evaluation of IAC is made to satisfy the second standard of field-

work as provided in SAS No. 1 (a proper study and evaluation of IAC)

and to satisfy the objectives previously mentioned in the Foreign

Corrupt Practices Act section of this chapter. The essence of these

objectives is that the auditor should be satisfied that the IAC system

provides reasonable assurances that: 1) transactions are authorized

and properly recorded; and 2) assets are safeguarded, properly

accounted for, and that access to the assets are authorized.










In order to satisfy these objectives the auditor will partition

the IAC system into different cycles (e.g., sales and receivables,

cash disbursements and inventory). For each cycle the auditor will

go through a three-step evaluation process:

1) preliminary evaluation--understanding the system as
given by the client.

2) compliance testing and re-evaluation--assessing
whether the system works as given to the auditor.

3) audit tests of account balances (substantive tests),
re-evaluation if needed, and reporting of final
recommendations.

The preliminary evaluation may consist of IAC questionnaires,

decision tables, flowcharts and/or a walk-through of the system. The

auditor will evaluate this evidence to see how well the system con-

forms to the overall IAC objectives. At this time the auditor will

identify weaknesses in the IAC system and any strengths that may

compensate for these weaknesses (i.e., compensating controls).

Once the auditor obtains an understanding of how the IAC system

should be operating, there are three courses the auditor may pursue.

First, if the auditor perceives that he may rely on the IAC system

for the audit, he will then perform compliance tests to determine if

the IAC system is functioning as described to him. Second, if the

auditor concludes the system is too unreliable or weak, but that the

client is still capable of being audited, the auditor then will go

directly to the audit tests of account balances. Finally, if the

auditor judges that the system is too unreliable to meet any of the

objectives of IAC and the client is incapable of an audit, he will

issue a disclaimer or withdraw from the engagement.










If the first or second courses on the previous page are taken,

the auditor will develop his audit tests of account balances based on

the reliability placed on the IAC systems. During these tests the

auditor may obtain additional insight into the IAC systems and re-

evaluate any weaknesses originally documented. Finally after com-

pleting the account balance tests and issuing an opinion, the auditor

will summarize the material IACWs identified during the audit and

suggest any recommendations and improvements to management or other

interested parties in compliance with SAS No. 20.2

In this process the auditor may become aware of material IACWs

"through his initial review of the system, ... by performing such

tests of compliance with [the clients] prescribed procedures, ... and

by performing substantive tests" [AICPA, 1577, pp. 2-3]. The

evaluation of material IACWs clearly constitutes a sequential process

that takes place throughout the audit: the process is summarized in

Figure 1.1 (adapted from Robertson [1979, p. 190]).

Given the sequential judgment process described above, the final

materiality judgment of an IACW represents a complex task which would

be difficult to study in a single experiment. Accordingly, this study

attempts only to examine the auditor's IACW materiality judgment in

the context of the auditor's preliminary IAC evaluation (i.e., his

initial review).


Statement of the Problem

Auditors normally are accustomed to dealing with materiality as

it relates to account balances and some specific dollar value

criteria. When themateriality concept is applied to an IACW it

becomes additionally abstract. Mautz and Sharaf [1961] state:









11




























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FIGURE 1.1
OVERVIEW OF THE AUDITOR'S DECISION PROCESS


Phases of


Source
1972. Copy
Reprinted











Materiality, as applied to irregularities, is thus an
abstract and difficult concept. .First, cur idea
of materiality with respect to irregularities may be
somewhat different from our idea of materiality with
respect to financial condition and results of
operations. Second, it seems apparent that even
within this idea of materiality there may be some
irregularities that are sufficiently immaterial to
be of little significance to anyone.
[p. 119)

Unfortunately Mautz and Sharaf never directly address the problem of

how the auditor is to judge the materiality of an IACW. They

postulate that the judgment deals with probabilities that the internal

control system will fail to detect material irregularities, but this

still leaves us with the problem of judging materiality. They con-

clude that the evaluation of material IACWs remains the individual

auditor's professional judgment of the meaning of materiality.

The description of materiality given in SAS No. 1 (previously

mentioned) is ambiguous in that it does not establish clear boundaries

or guidelines within which to evaluate a material IACW. SAS No. 20

relies on this description in the requirement that auditors must

communicate material IACWs to senior management and the board of

directors. The auditor, as one committee member noted in his

qualification to the standard, is left with a major problem: that

the existing literature does not provide sufficient guidance or

criteria "for the auditor to measure objectively and uniformly the

materiality of weaknesses in systems of internal accounting control"

[AICPA, 1977, p. 10]. SAS No. 30 also relies on this description of

a material IACW and the statement does not provide further specific

guidance to the auditor in his materiality judgment.











As the previous indicates, the identification of a Lmaterial IACW

requires a subjective professional judgment and one for which the

professional literature presently provides little guidance.

Furthermore, since this judgment process has not been empirically

explored to date, the variables that auditors consider important to

the judgment are unknown. That is, it is not known what judgment

factors (cues) are used by auditors, the relative importance of

the cues, or with what consistency they are applied across auditors

and audit engagements. Considering the present audit environment

(e.g., SAS No. 20) and legal environment (e.g., Foreign Corrupt

Practices Act), auditors may need a specific set of criteria to

guide them in their evaluation of material IACWs. In order to assess

this need, empirical insight into the auditor's judgment of material

IACWs is called for, and indeed, the major objective of this

dissertation is to obtain this insight. This study of the auditor's

judgment is carried out in the same vein as recent empirical studies

concerning auditor's judgments (e.g., Ashton [1974]; Joyce [1976];

Messier [1979]), although the specific task context to be examined

differs markedly from those examined in earlier work.


Research Questions Addressed

The overall objective of this study is to obtain insight into the

auditor's IACW materiality judgment. In order to meet this objective,

answers are obtained to the following specific descriptive research

questions:

1) What factors are likely to be perceived by the auditor
to be important in the IACW materiality judgment?

2) Can the auditor's judgment of the materiality of IACWs
be described by a mathematical model?











3) Is there consensus across auditors (consistency across
auditors)?

4) How well does the auditor perceive his judgment
process?

Answers to these questions should provide a basis from which to

evaluate the need for formal criteria in this judgment and may

indicate the type of criteria presently used by auditors.


Judgment Factors

Factors that the auditor may use in the IACW materiality decision

have not been clearly defined. Because of the lack of clear

definitions this would allow considerable individual discretion on

the part of the auditor. Greater progress may be possible if the

specific judgment situation is incorporated explicitly within the

framework of the general concept of materiality, rather than being

viewed as an isolated issue. Placing the judgment of the materiality

of an IACW within a broader framework may itself lead to the

identification of factors to be considered in that judgment. However,

the major benefit of the framework will be that it will facilitate

the process of describing, evaluating and relating the various

factors.

Identifying the factors perceived to be important in the

material IACW judgment will facilitate assessment of the practicality

of establishing formal criteria for this judgment. A prerequisite in

establishing formal criteria for any judgment is that the identified

factors are understandable to auditors and have the capability of

being used by them. Identifying the factors perceived to be important

and used by auditors will indicate the feasibility of establishing

clearer guidelines in this professional judgment.










Descriptive Models of the Judgment Process

This study follows the lead of a well established body of

literature in judgment research (see Slovic and Lichtenstein

[1971]). Individual linear models are developed for auditors'

judgments of material IACWs. These models do not purport to

explain an individual's real cognitive processes; rather they

describe a linear relationship between the judgments and the

factors. That is, the models will indicate (a) whether the auditor's

decisions can be explained by an additive linear model, (b) the

significance of the factors in his judgment and (c) how the factors

were weighted and inter-related.

These individual models are important in two aspects. First,

the individual models developed may be useful in explaining why

there were differences between the auditors' judgments. These

differences would be reflected in the models by the different

weights the auditors may place on the various factors. Second,

they may provide direction for future research, in that if a set

of factors is determined to be explanatory of this process, then

future research can concentrate on how the auditor functionally

relates the different factors and integrates them into a final

judgment. This may indicate how to establish normative standards

in order to optimize this decision process.


Consensus

In this study consensus is defined as the agreement across

auditors for a given judgment task. If inconsistencies (i.e.,

disagreement between auditors) show up in auditors' judgments, this

may be harmful to the profession. Mautz and Sharaf [1961, p. 4]











point out that "inconsistencies have no place in auditing in the

long run" and that "if we are to have a profession worthy of the

name we must work to eliminate them." Ashton [1973, pp. 23-25]

indicates that users who rely on auditors' judgments should at

least expect auditors to make consistent judgments. He also

mentions that if inconsistent judgments are made this "will cause

the cost and/or quality of the audit to fluctuate--assuming that

all other factors are equal." Therefore, if inconsistencies are

found, this supports the proposition that clearer guidelines need

to be established in this judgmental area.


Auditor's Self-Insight into the Judgment Process

The last research question examines the extent to which auditors

have insight into their judgment policies. If low self-insight is

found, this may indicate thatauditors have a difficult time

communicating the importance of factors they use in the materiality

judgment of an IACW. Messier [1979] has suggested low self-insight

has two possible ramifications: 1) the auditor will have a more

difficult time intraining subordinates regarding this type of

judgment; and 2) the auditor may mislead any authoritative body

which attempts to establish guidelines for this judgment, due to his

inability to communicate the important factors related to the

judgment.


Methodology

In order to find the answers to the research questions, the

dissertation study involved 1) a thorough review of the general

materiality and IAC related literature to identify and synthesize










the factors that may be of relevance to judgments of the materiality

of IACWs; 2) interviews with a small sample of CPAs to determine

factors that they perceive important to judgments of the materiality

of IACWs; and 3) a field experiment to assess the impact of factors

on materiality judgments by auditors.


Pre-Experimental

The pre-experimental work provided an answer to the first

research question about the factors perceived to be potentially

important to the auditor in an IACW materiality judgment. This was

accomplished by a thorough review of the literature which merged

the judgment of a material IACW into the general concept of

materiality (see Chapter II). The review generated a list of

factors which were incorporated into an interview instrument. The

results of detailed interviews with a small sample of auditors

enabled a final list of factors to be developed. These factors

were then considered in the design of the field experiment.


The Field Experiment

In order to answer the last three research questions, a field

experiment was designed to enable the use of a well established

research methodology. The design was based on a pairwise comparison

procedure in which subjects (auditors) made comparative judgments of

the materiality of several IACW cases. The factors manipulated in

the cases were those derived from the pre-experimental portion of

the study. Each individual auditor's judgments were then modeled

using analysis of variance (ANOVA). The ANOVA results apply to the

second research question, for they 1) represent the auditors'











judgment processes, 2) showed how much of the variance of the

auditors' judgments could be explained, and 3) gave the factor

weightings for the auditor's judgment (i.e., objective weightings).

The remaining two research questions were concerned with the

consensus among the auditors' judgments and the self-insight auditors

had into their judgment processes." The consensus measure indicates

the extent of agreement the auditors display in the materiality

ratings of the IACW cases. This was measured by a rank correlation

measure (i.e., Kendall's Coefficient of Concordance W). The final

measure, self-insight, is the amount of insight each auditor has

into the factors he used in making the materiality judgment of an

IACW case. This measure was obtained by correlating the subjective

weightings the auditor placed on the experimental factors to the

auditor's model weightings on these factors.


Scope Limitations

Any empirical research must limit the amount of information

obtained due to subject, time, cost, and other experimental con-

straints. Also, considering this study was exploratory in nature,

only an initial insight into the auditor's judgments of the

materiality of an IACW can be expected. In order to make the ex-

periment operational, the auditor's environment surrounding the

judgment was simplified. Specifically, two simplifications were

made concerning the auditor's decision environment. First, each

IACW case was considered independent of each other, with no com-

pensating strengths offsetting the weakness. The primary reason

for this was that there is no way to separate the effect of











compensating strengths from the materiality factors in the auditor's

judgment process. A secondary reason was that the cases would

otherwise be too complex for the auditors to handle in a reasonable

amount of time. The second scope limitation was that the cases were

presented only from the standpoint of the auditor's preliminary

evaluation and do not reflect results of compliance or account

balance testing. This may not represent a serious limitation of

the study, for as SAS No. 20 indicates, the auditor can make a

materiality evaluation at any of these three points in the audit

process.


Organization of the Study

The remainder of the dissertation is divided into four chapters.

In Chapter II a review of the pertinent literature is presented, the

purposes of which are to 1) identify, define, and synthesize the

factors contained in the general materiality concept literature;

2) denote the relationship between the general materiality concept

and the specific IACW materiality judgment; and 3) generate the

input data for the interview instrument and report the interview

results.

Chapter III provides detaileddescription of the methodology

which was used to answer the research questions posed in this chapter.

Chapter III is divided into two sections. The first section presents

the methods used for describing the auditor's judgment process and the

measures applied in the field experiment. The final section of

Chapter III describes the experimental design used in the field

experiment. This presentation includes a description of the










experimental variables (dependent, independent and moderating), the

experimental tasks and setting, the data analysis procedures and

the limitations of the experiment.

In Chapter IV, the results of the field experiment are presented

and summarized along the lines of the latter three research questions

posed here in Chapter I. The final chapter of the present study,

Chapter V, summarizes the overall research effort and findings,

particularly with regards to the current implications of the

findings and implications for future research.


Notes


This conceptualization of the judgment is equally consistent
with Mautz and Sharaf's [1961, p. 47] postulates of auditing which
asserts that a good system of IAC "eliminates the probability of
irregularities."
2
SAS No. 20 provides the auditor an option concerning the
communication of material IACWs to management. The auditor
"should consider" reporting material IACWs to management at interim
dates during the audit; however, the auditor can wait until the end
of the audit to communicate the material IACWs to management.
Nevertheless, the timing of the communication does not affect
the discussion presented in this section.
SAS No. 30 [AICPA, 1980] states that the auditor should consider
the amount of errors that may occur (defined as a range of zero to
the gross amount of assets) and the risk or probability of errors
occurring. These factors are not defined precisely (i.e., not
operational definitions). Therefore, the auditor may need additional
guidance (specific factors to be considered in his judgment) in his
evaluation of the materiality of IACWs.

















CHAPTER II
MATERIALITY OF INTERNAL ACCOUNTING CONTROL WEAKNESSES: POTENTIAL FACTORS


Introduction

To assess the four specific research questions identified in

Chapter I, it is necessary to develop an understanding of the relation-

ship between the concept of materiality and the evaluation of IACWs.

The emphasis of this chapter is upon the first research question: what

factors are likely to be perceived by the auditor to be important in

the IACW materiality judgment? An organized framework for the IACW

materiality judgment, derived from the general materiality literature

and the IAC evaluation literature, is developed in this chapter. This

framework will be used in the identification of a set of factors

potentially relevant to the materiality judgment at issue; the factors

subsequently will be refined through pre-experiment interviews in

order to ensure a representative experimental design.

The literature dealing with materiality discloses numerous factors

that auditors may, should, or appear to rely on in various materiality

decision settings. The IAC evaluation literature describes IAC

objectives and properties and how these objectives and properties

relate to the evaluation of an IAC system. These two sources of

literature thus provide a basis for deriving, by means of pre-

established selection criteria, the preliminary set of materiality

factors relevant to the IACW materiality decision.











Factor Criteria

The selection criteria employed were that a selected factor must

contain characteristics which are consistent with 1) the AICPA's def-

initional elements of a material IACW, 2) the current extant litera-

ture on how auditors evaluate material IACWs and 3) the specificity

required by auditors to make audit judgments and obtain evidential

matter. The first criterion is based on the assumption that the

auditor is familiar with the profession's definition of a material

IACW, and that the factors used in his judgment of the materiality

of an IACW are related to the elements contained in the definition.

The second criterion simply means that a factor should not be incon-

sistent with the current literature on how auditors should or do make

IACW materiality judgments. Note that under this criterion a factor

does not need explicit literature support, but must not be rejected

by the current literature. The final criterion is invoked because

auditors are likely to consider specific, not general, factors in

their evaluation of IACWs. That is, the ". .auditor must determine

whether specific weaknesses exist, [and] the irregularities thereby

permitted. ." and this determination would require the application

of factors that relate directly to the IACW and the auditor's

evaluation of IAC [Mautz and Mini, 1966, p. 290]. The criterion

assumes the auditor provides explicit justification in the audit

workpapers for his evaluation of an IACW and considers the ramifi-

cations of his evaluEtion on the rest of the audit.


Chapter Methodology

It is assumed that if factors meet the above criteria, they are

likely to be perceived by an auditor as important in his judgment of a











material IACW. The following approach will be taken toward applying

these criteria. First, the auditors' approach to the evaluation of

IACs is reviewed in considerable detail. The objectives of IAC are

reviewed and the properties of IAC that auditors apparently consider

important in the evaluation of IAC are identified.2 This section

also considers how the properties and objectives used in the

auditor's evaluation of IAC are associated with the materiality of

an IACW. The auditor's evaluation of the materiality of an IACW is

then briefly discussed.

The concept of materiality is considered in the succeeding

section. First, the materiality concept is defined, and then its

relationships to financial accounting and to auditing are discussed.

This discussion also considers the relationshiD between financial

accounting materiality and auditing materiality, and the relevance

of both views of materiality to this study.

In the next section of the chapter a framework for materiality

factors is developed. The framework is then used to describe the

materiality factors and to derive the factors associated with the IACW

materiality judgment which would seem to be important to the auditor.

This involves assessing each potential factor identified in the frame-

work, in terms of the three criteria described earlier. The final

section of the chapter summarizes the chapter and the conclusions as

to the factors that appear potentially important to the IACW materiality

judgment are presented. The conclusions are based on the agruments

presented within the chapter and on interviews conducted with a small

sample of auditors.











Auditors' Evaluation of Internal Accounting Control

As Chapter I indicated, two purposes underlie the auditor's

evaluation of IAC. These are:

1) to satisfy the "Second Standard of Fieldwork," and

2) to evaluate a client's IAC system (see SAS No. 1) in
terms of the following four objectives of IAC:

i) transactions are properly authorized.

ii) transactions are recorded in a manner such that
financial statements may be accurately prepared
and all assets may be accounted for properly.

iii) assets are adequately safeguarded.

iv) recording of assets and accountability of assets
are verified and differences between what is re-
corded and what exists are reconciled.

The second purpose is of most relevance to this study since it in-

dicates what auditors would associate with an adequate IAC system.

Note, however, that these objectives of IAC are very general and

hence the auditor may find it difficult to directly evaluate the

extent to which an IAC system has achieved these objectives. Ac-

cordingly, the auditor should evaluate specific properties of IAC

that indicate whether or not the IAC objectives have been achieved.


Properties of Internal Control

Arens and Loebbecke (A&L [1976]) suggest seven properties that

need to be present in an IAC system in order to achieve the above

objectives. These properties are:

1) competent, trustworthy personnel with defined respon-
sibilities and authorities;

2) adequate segregation of duties;

3) proper procedures for authorization;

4) adequate documents and records;











5) proper procedures for record keeping;

6) physical control over records and assets; and

7) independent checks on performance.

Since the absence of any one of these properties would imply one or

more IACWs, the properties themselves are described in greater detail

below.


Personnel. The quality of personnel is a very important property

of any system of IAC. It is the responsibility of management to es-

tablish an effective IAC environment and the effectiveness of the IAC

environment is-dependent upon the quality of personnel [AICPA, 1978b,

p. 10]. If personnel are incompetent or dishonest, an IAC system can

become nonfunctioning [A&L, 1976, p. 161]. Thus, in evaluating inter-

nal control, the auditor must consider "...the varying capacities and

responsibilities of client personnel involved in the execution of the

client's internal control procedures [Broeker, 1967, p. 77]. This

judgment is considered difficult, however, since objective means are

not used to evaluate personnel (e.g., the auditor does not administer

aptitude tests to employees). The auditor may assess the quality of

personnel by evaluating the types of controls used by the company to

promote reliability of personnel (e.g., adequate supervision, defined

job responsibilities, hiring policies) and may also judge the quality

of personnel based upon his experience with their past work, the em-

ployees' experience in the job, or by the results of his compliance
4
tests.


Segregation of duties. A strong IAC system requires adequate

division of functions or duties, as opposed, for example, to cases











where a single employee should handle all aspects of a transaction.

By separating the functions of accounting, authorization, and asset

custody, the probability of an error occurring (either intentionally

or unintentionally) can be greatly reduced. It is also desirable to

have a separation of duties within the accounting function, in order

that cross-checks can prevent clerical errors from remaining undetected.

Research by Ashton [1974] has highlighted the importance of seg-

regation of duties. Of the five IAC properties considered within his

study, Ashton found segregation of duties to be the primary influence

(accounting for 51.4% of the variance) on his subjects' (auditors)
5
evaluative judgments of payroll systems. However, it should be noted

that his study concerned one precisely defined system in the IAC area

(i.e., payroll) and thus does not necessarily indicate that a lack of

segregation of duties always represents a material IACW.


Authorization procedures. All transactions of a firm should have

some type of authorization, if IAC is to be considered satisfactory by

the auditor [A&L, 1976, p. 163]. Without proper procedures for author-

ization, a firm's assets would not be properly safeguarded because un-

authorized persons could acquire or expend assets. This authorization

may be general, as when following prescribed policies of management for

a common group of transactions (e.g., set credit limits for customers),

or specific if management feels a need to review each individual trans-

action of a certain type. Finally, the presence of authorization pro-

cedures indicates the involvement and commitment of top management to

maintaining a strong IAC system. Managements' involvement in the auth-

orization of transactions should be commensurate with the nature and

significance of the transaction.











Adequate documents and records. Documents and records of the

client provide a major source of audit evidence. They represent the

"physical objects" used to transmit information "throughout the

client's organization and between organizations" [A&L, 1976, p. 165].

If the documents and records are designed and used properly, the

auditor should have reasonable assurance that the assets are controlled

and all transactions correctly recorded. Proper design and usage

implies that documents and records should be simple enough to under-

stand, multi-purpose, constructed to encourage correct preparation

(e.g., blank spaces for approvals), pre-numbered, and prepared on a

timely basis [A&L, 1976, p. 165]. If the auditor perceives the

documents and records to be adequate, he should reduce his estimate

of the likelihood of occurrences of material errors.


Proper procedures for record keeping. Well defined procedures

(preferably outlined in procedures manuals) help ensure that all trans-

actions are recorded properly. Proper procedures imply that there are

explicit rules concerning the flow of documents throughout the organi-

zation, and provide for adequate communication of information to

facilitate accurate record keeping and the maintenance of proper control

over assets. This property is closely associated with the other prop-

erties (in particular, the adequacy of documents and records). It

should be noted that a firm can have complex and numerous documents and

records, yet little or no control may exist because the absence of de-

fined procedures on how the documents should flow through the system.


Physical control over records and assets. Physical precautions

should be taken to ensure the safeguarding of assets and records.











Examples of these precautions or protective measures include inventory

storerooms with limited access, fireproof safes for accounting records

and currency, and backup records for redevelopment of lost or de-

stroyed records.


Independent checks on performance. The final property to be iden-

tified helps to ensure that the expected benefits associated with the

previous six properties will be achieved. The integrity of the system

over time is enhanced by frequent review of an IAC system in the form

of internal checks. An example of a strong internal check is the use

of internal auditors who are independent of accounting and operating

personnel. The presence of adequate internal checks should enable the

auditor to be more confident of the IAC system's ability to detect

material errors on a timely basis (given that the other six properties

are adequate).

Arens and Loebbecke [1976, p. 161] have stated that the above

seven properties are necessary for an adequate IAC system (i.e., a

system that achieves the four objectives of IAC). Once the auditor has

considered the seven properties in his IAC review, he should then be

able to make some preliminary judgments concerning the adequacy of the

IAC system. First, if he concludes that the properties are present

within the IAC system, the auditor should 1) assume that the IAC ob-

jectives have been achieved and that there are no significant IACWs and

2) proceed with compliance tests and development of the rest of his audit

procedures. On the other hand, if the auditor determines that one (or

more) of the properties of IAC is not present in a client's IAC system,

he may be expected to conclude that 1) one or more of the IAC objectives

have not been achieved and 2) there are one or more IACWs within the

client's IAC system.











The Materiality of Internal Accounting Control Weaknesses

If the auditor evaluates the properties of IAC and has determined

that one of the properties of IAC is absent, this implies that the

auditor has identified one or more IACWs resulting from the missing

controls. After the identification of the specific IACWs, the auditor

must consider the types of errors and irregularities that may occur

due to the IACWs. Finally, the auditor needs to assess the materiality

of the IACWs by evaluating the potential dollar exposure permitted by

the IACWs. The auditor's IACW evaluation process is summarized in

Figure 2.1.

Decision point 1 was discussed in the preceding section by

describing the properties of IAC. The identification of the missing

IAC properties by auditors is not considered to be a serious judgment

problem. For example, Mautz and Mini [1966] have indicated that:

the circumstances under which two auditors would
disagree as to the presence or absence of weaknesses
in a given system of internal control should be rare.
Personal standards could undoubtedly affect an
auditor's assessment of the seriousness of a given
weakness. but not his conclusion as to the presence
of that weakness.
[p. 2911

The second decision point, the identification of potential

errors and irregularities resulting from the IACWs, has received

little attention within the literature. Since most auditing firms

have detailed IAC manuals which describe the various errors and

irregularities that normally result from IACWs, it is considered

that this identification also poses no serious judgment problem for

the auditor. It is assumed in this study that auditors can adequately

identify the errors and irregularities that may result from IACWs.

















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The final decision point is the auditor's assessment of the

materiality of the identified IACWs. The auditor should explicitly

determine the materiality of the identified IACWs in order to de-

termine how they will affect his audit procedures and to comply with

SAS No. 20 [AICPA, 1977]. The materiality of an IACW should be

judged by considering the expected dollar exposure due to the IACW.

The expected dollar exposure is defined, in a broad sense, as the

expected economic loss due to the IACW (this considers both the

dollar magnitude and probability of errors permitted by the IACW).

This economic loss may be suffered by accounting users', auditors,

management or the firm. In this study it is assumed that a material

IACW implies a larger potential economic loss, for all the above

parties, than an immaterial IACW.

From the above discussion it may appear the auditor's evaluation

of the materiality of an IACW is simplistic. However, a direct

assessment of the expected dollar exposure by the auditor is not

possible. The expected dollar exposure is an expected value; there-

fore the auditor needs to consider the full probability distribution

of the dollar exposure, given the existing facts. This distribution

generally is not known to an auditor making an IACW materiality

decision. The auditor must rely on surrogate factors related to

the expected dollar exposure. The surrogate factors used by the

auditor are associated with the probability and the dollar exposure
8
of the errors due to an IACW. Examples of surrogate factors that

may be used by the auditor include the most likely amount of

dollar errors due to an IACW and the error rate due to an IACW.










In order to have a clear understanding on how the expected dollar

exposure relates to the auditor's materiality judgment the next

section of this chapter considers the concept of materiality.


Concept of Materiality


Definition

The concept of materiality has not been adequately defined by

accountants [Thomas and Krogstad, 1979]. Accountants have

attempted to describe the effects of materiality but have not

developed a genuine definition of the concept. An example of

accountants' descriptions of the concept of materiality is as

follows:

Materiality commonly is thought of in terms of whether
the disclosure of a matter or the accounting treatment
of it is either necessary for a reasonable overall
understanding of an enterprise's financial statements
or likely to influence the conduct of a prudent
investor.
[FASB, 1975, p. 7]

Other writers have offered similar "definitions" of the concept of

materiality.

An important purpose of this chapter is to present a general

definition of the concept of materiality that is applicable to

accounting (i.e., applicable to both financial accounting and to

auditing). The concept of materiality will be defined as

The perceived importance of a difference between an
existing state of nature and some other (generally
a standard or ideal) conceived state of nature.

The above definition has two major components. The first component

is the difference between two states of nature. In accounting

contexts, the existing state of nature represents the expected











dollar exposure given the perceived current set of facts (e.g.,

expected dollar exposure due to a specific IACW or due to noncom-

liance with GAAP). The standard state of nature represents the

minimum dollar exposure given an ideal accounting information

system. An example of an ideal accounting information system is

an IAC system which minimizes the probability that significant

errors will occur. Such a system presumably minimizes the dollar

exposure which can be assumed to be equivalent to a zero (minimum)

dollar exposure. Under this assumption the dollar exposure dif-

ference between the two states of nature then is equivalent to the

expected dollar exposure under the existing state of nature. It

is clear, therefore, that assessing the existing state of nature

represents a major task for a decision-maker in making a materiality

judgment. Since the existing dollar exposure cannot be measured

directly, the decision-maker must rely on surrogation.

The second component of the definition is the perceived

importance of the difference between the states of nature. This

implies that a decision-maker derives some amount of utility

(disutility) from the decision that the difference between the two

states of nature is important (or not important). This amount of

utility (disutility) can be expected to differ between decision-

makers since each decision-maker likely will have a different

utility function. The decision-maker's utility due to the difference

between the two states of nature can be observed only indirectly and

after the materiality decision is made (that is, if the decision was

that the dollar exposure difference was material, the decision-maker

may be presumed to have derived more utility by deciding the difference











was material versus deciding that the difference was immaterial).

An indirect means of describing when the decision-maker will derive

utility or disutility from the dollar exposure difference is to

locate the decision-maker's materiality threshold. The materiality

threshold represents the amount of dollar exposure the decision-

maker is willing to accept beyond his perceived standard state of

nature. Therefore when dollar exposure (or more precisely, sur-

rogates for dollar exposure) differences exceed the materiality

threshold the decision-maker will consider the dollar exposure

material; conversely, if dollar exposure (or a surrogate) is

less than the materiality threshold the decision-maker will con-

sider the dollar exposure immaterial. Note that the materiality

threshold would need to be assessed along the same scale as the

existing state of nature and accordingly, the same type of factors

that relate to the existing state of nature may be expected to

relate to the materiality threshold.

Figure 2.2 presents the above description of the concept of

materiality in diagram form. The definition presented is considered

applicable to materiality judgments in both financial accounting and

auditing contexts. The following example, which is intended to

clarify the definition further, is drawn from a financial accounting

context in view of its ease of understanding and in view of the fact

that the experiment undertaken in the present study will illustrate

the definition's applicability in an auditing context.





















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Assume that a company uses the percent of sales method to es-

timate bad debts. The net value of accounts receivable at year end

is $70,000. An aging of the accounts receivable at year end in-

dicates the net receivables should be $65,000. A materiality de-

cision is therefore called for in that the decision-maker (auditor

or manager) must determine whether the $5,000 difference should be

deemed sufficiently important to require an adjustment of the net

accounts receivable. The standard state of nature is the amount

considered to be the minimum dollar exposure. It is assumed that

the decision-maker perceives minimum dollar exposure (assumed to be

equal to zero) to exist when the accounts receivable is valued in

accordance with generally accepted accounting principles and where

the financial statements are fairly presented. The existing state

of nature is the expected dollar exposure (as perceived by the

decision-maker) associated with the status quo (i.e., the expected

dollar exposure associated with valuing the net receivables at

$70,000). The primary problem for the decision-maker is to estimate

this expected dollar exposure. The decision-maker needs to 1) es-

timate the full probability distribution of the dollar exposure as-

sociated with stating the net receivables at $70,000, and 2) calculate

the expected value of this distribution. The probability distri-

bution, however, is not known to the decision-maker. Therefore the

decision-maker must rely on surrogation. A reasonable surrogate for

the expected dollar exposure would be the expected dollar effect.

The expected dollar effect is the expected value of the probability

distribution of the observable dollar differences associated with











the existing state of nature (e.g., the $5,000 difference in this

example is one point in the distribution). However, it is unlikely

that a decision-maker will assess the full distribution of dollar

effects. It may not be cost beneficial for the decision-maker to

assess the full distribution (due to the costs of accumulating ad-

ditional information). Furthermore, several alternative surrogates

exist which are assumed to be easier (although they may be sub-

optimal) for tle decision-maker to derive. These include the

maximum dollar effect (i.e., the worst possible error permitted by

the existing state of nature) or the most likely dollar effect

(i.e., the most probable dollar amount of error permitted by the

existing state of nature). There is no empirical evidence indi-

cating what surrogates are actually used by decision-makers. However,

the FASB [1976] in their interpretation of FASB No. 5, Accounting for

Contingencies, considered a similar type of problem. Their problem

concerned the estimation of potential losses due to a contingency.

The FASB indicated that the decision-maker should choose the most
10
likely amount of loss when accruing for a contingency. Therefore

if the decision-maker does not use the full distribution of dollar

effects, it is reasonable to assume that he/she will use the most

likely dollar effect as an estimate of the expected dollar effect

(henceforth to be used interchangeably). In this example the es-

timate of the expected dollar effect is presumed to be the $5,000

difference. This is because the $65,000 is presumed to be the most

likely net receivables as compared to the $70,000 existing state of

nature. The probability associated with this estimate may be asses-

sed by considering factors such as 1) the probability that an











additional $5,000 of receivables is uncollectable, or 2) economic

factors that may influence the collectability of the accounts re-

ceivable. It is assumed that a larger expected dollar effect im-

plies a larger existing dollar exposure for any type of materiality
11
decision-maker. Once the existing dollar exposure is estimated,

the dollar exposure difference between the two states of nature is

derived. The difference is equivalent to the expected existing

dollar exposure since it is assumed that the standard state of nature

is equivalent to zero dollar exposure. The final step for the

decision-maker is to determine the importance of the dollar ex-

posure difference. This presumes that the decision-maker has

conceived a materiality threshold. An example of a materiality

threshold is the dollar amount representing 5% of net income. The

decision-maker then compares the expected dollar effect (the sur-

rogate for expected dollar exposure) to his materiality threshold

(e.g., 5% of net income) and will conclude one of the following:

1) the expected dollar effect (the absolute value)
is less than the materiality threshold; there-
fore the writedown of net receivables is un-
necessary since he perceives that the expected
dollar exposure is immaterial.

2) the expected dollar effect (the absolute value)
is greater than the materiality threshold;
therefore the writedown of net receivables is
necessary since he perceives that the expected
dollar exposure is material.

If the first conclusion is made, this implies that the decision-

maker derived a greater amount of utility by valuing the net re-

ceivables at $70,000 and not $65,000, and vice versa if the

second conclusion is made.1











In the next section of the chapter it is shown how the concept

of materiality is applied in different accounting contexts and that

the general definition of materiality is applicable to both the

financial accounting context and to the auditing context.


Financial Accounting Materiality Versus Auditing Materiality

The difference between financial accounting and auditing

applications of materiality lies in the type of decisions involved.

Financial accounting materiality decisions are described as

.the materialitydecisions which relate to accounting
matters such as consistency, classification, valuation,
and disclosure in financial statements. The main concern
is with the point at which errors and distortions in a
set of financial statements are serious enough to destroy
fairness of presentation.
[Leslie, 1977, p. 84]

Auditing materiality decisions, on the other hand, are described as the

.. .materiality decisions related to planning, executing,
and evaluating an audit with view to determining the
extent of audit evidence to be gathered. The main
concern is with the point at which audit procedures may
be curtailed and the audit objective considered
achieved.
[Leslie, 1977, p. 84]

However, both types of decisions involve the same concept of

materiality (i.e., the perceived importance of the difference between

two states of nature) and both have the same ultimate objective.

Figure 2.3 describes the application of the concept of materiality

from a financial accounting context and an auditing context and

shows -that both contexts eventually lead to the same objective--

the fair presentation of financial statements.

Financial accounting materiality decisions are directly concerned


































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with the fair presentation of financial statements. That is, the

conceived standard state of nature for all financial accounting

materiality decisions is the ideal fair presentation of the

particular accounting event (e.g., transaction, account balance)

involved in the decision.3 Auditing materiality decisions, on the

other hand, are concerned with audit planning, audit procedures, and

audit evidence. The link between the two is that in order for the

auditor to form an opinion on the fairness of presentation of

financial statements, he needs sufficient audit planning, audit

14
procedures and audit evidence.4 Therefore, the auditing materiality

decisions ultimately have the same objective as financial accounting

materiality decisions, as Thomas and Krogstad [1979, p. 77] have

pointed out:

Remember that materiality decisions related to internal
control deficiencies, audit procedures and sufficiency
of evidence underlie the ultimate materiality decision
regarding the fairness of presentation.

Most academic materiality studies have focused upon financial

accounting materiality (e.g., Woolsey [1954a; 1954b; 1973b];

Boatsman and Robertson [1974]; Newton [1977]). The important factors

associated with financial accounting materiality decisions have

received considerable attention in the materiality literature (see

FASB [1975]). Given the relationship between auditing materiality

and financial accounting materiality it is reasonable to expect that

factors considered important in financial accounting materiality

decisions will be closely related to factors that auditors consider

important in auditing materiality decisions. In fact, the sole

empirical auditing materiality study [Moriarity and Barron, 1979] used

several factors that were also assumed to be relevant in financial











accounting materiality decisions. Hence, the materiality literature

as a whole must be considered relevant in a search for important

factors in the judgment of material IACWs.


The Internal Accounting Control Weakness Materiality Decision

The materiality decision concerning an IACW is an audit materiality

decision. The evaluation of IAC and the identification of material

IACWs should influence the type and quantity of evidence that is

collected in performing an audit (see Chapter I and Figure 2.3). Of

course, materiality decisions relating to IACWs may involve factors

that are more abstract or subjective than factors associated with

financial accounting materiality. Carmichael [1970] states:

Weaknesses in internal control can have a potential
material impact on operations, but their materiality
cannot be evaluated in the same manner that a known
dollar amount of error can be with respect to the
financial statements taken as a whole.
[p. 49]

Nevertheless, IACW materiality decisions are concerned with the same

concept of materiality relevant to all materiality decisions. That

is, IACW materiality decisions are made by considering the importance

of the difference between a perceived standard state of nature and the

perceived existing state of nature. Therefore, a reasonable starting

point in identifying the important factors relevant to an IACW

materiality decision is to review the literature pertaining to the

financial concept of materiality.


Categorization of Materiality Factors

Existing research dealing with the concept of materiality is both

normative and empirical, with primary emphasis being placed upon

financial accounting materiality decisions. A multitude of factors











have been mentioned in this literature as having a potential impact on

materiality decisions made by auditors.

A useful summary and discussion of the majority of the

materiality literature were presented by the FASB in FASB Discussion

Memorandum: An Analysis of Issues Related to the Criteria for

Determining Materiality [FASB, 1975]. The FASB prepared this

Discussion Memorandum based upon interviews with auditors and other

interested parties and upon an extensive review of the materiality

literature. The FASB's Discussion Memorandum was primarily concerned

with financial accounting materiality and the factors that affect

financial accounting materiality decisions. The Discussion Memorandum

did not include the relationship of the factors to auditing materiality

decisions. Thomas and Krogstad [1979] state: "The FASB's DM should

help the profession move toward a definition of materiality in an

accounting sense, but many of the auditing dimensions of the concept are

not considered [p. 74]. However, one aspect of the FASB's Discussion

Memorandum that may be applied to various types of materiality

decisions was the FASB's categorization of potential materiality

factors into several general factors. This categorization both shows

the multidimensionality of the materiality concept and helps sort

specific factors into a workable framework [Thomas and Krogstad, 1979,

pp. 75-76]. The FASB suggested seven general factors which may be

considered by an auditor in a materiality decision. These factors are:

1) Environmental---economic, business practices

2) Enterprise related---management, risk, etc...

3) Accounting policies

4) Uncertainty of the existing state of nature











5) Surrounding circumstances associated with the existing
state of nature

6) Magnitude and financial effect

7) Aggregation effects

The last factor category suggested by the FASB, aggregation effects,

will not be considered a factor category for this framework. An

example of an aggregation effect is:

An auditor discovers two errors in the accounts of a
client, where the first error overstates net income by
$10,000 and the second error understates net income by
$6,000. The auditor determines that the first error is
material, whereas the second error is not material. If
the auditor aggregates the two errors he does not con-
sider the net effect to be material. The alternatives
for the auditor are: 1) to require the client to correct
the first error, or 2) to not require any adjustment by
the client. If the auditor chooses alternative one, he
then judges each materiality event individually; whereas,
if the auditor chooses alternative two, he accumulates or
offsets several materiality events in order to make a
single materiality judgment.

As the example shows, aggregation effects are not a set of factors that

determine materiality per se, but it reflects how the auditor accumu-

lates or offsets several materiality decisions. Since this study is

interested in how auditors evaluate materiality for individual IACWs

(i.e., one materiality decision at a time) and not how auditors

evaluate materiality for a group of IACWs, aggregation effects will

not be considered further.

The resulting six general factor categories provide a framework of

organization within which specific factors may be defined and described

as necessary. Table 2.1 identifies the specific factors (as identified

in the literature) grouped within the general factor categories and

cross references the specific factors to the literature. The next

section of this chapter utilizes this framework in describing specific





































































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factors, identifying the literature in which the various factors have

been cited and applying the criteria for factor selection.


Materiality Factor Description and Application
of the Factor Selection Criteria

The objective underlying the selection criteria is to derive the

factors which are associated with the IACW materiality judgment and

which are likely to be significant to the auditor. It will be re-

called that the selection criteria (introduced and defined in the

beginning of this chapter) for the factors are:

1) The selected factors should be consistent with the
definitional elements of a material IACW. The
definition of a material IACW includes two elements.
These elements are the probability and the dollar
exposure indicated by an IACW. Therefore a factor
needs either to be relevant in estimating the
probability of an error (or irregularity) occurring
due to a specific IACW or to be a surrogate for
estimating the dollar exposure of the errors
permitted by the IACW.

2) The selected factors should not be inconsistent with
the current literature on how auditors should or do
evaluate material IACWs.

3) The selected factors should be accessible to the
auditor and should be specific enough to relate to
an individual IACW. This means that the relation-
ship between the factor and the properties of an
IAC system should be clear, allowing the auditor
to assess the impact of the weakness.


Environmental Factors


Description. The environmental factors describe the external

environment in which a business firm must operate. The external

environment can be described in terms of political events, economic

events and business practice events. Environmental factors generally

are uncontrollable by the firm. The auditor should apply these











factors to his materiality judgments by determining how a specific

environmental event will affect the normal operations of a business

firm [FASB, 1975, p. 70]. Some specific factors the auditor may

consider are the broad range of economic indicators (e.g., money

supply, interest rates), whether or not a company is regulated, and

government spending patterns. A specific example of an environmental

factor that could affect an auditor's materiality decision would be a

government decision to cut defense spending significantly (a political

event) when the auditor's client depends largely on defense contracts

as a source of business. If the future of this company as a going

concern may be threatened, some form of disclosure may be deemed

necessary. This situation raises two materiality related questions---

Is the effect of the political event on the client material enough

that the auditor should qualify his audit opinion or at least require

some form of disclosure?

It has been advocated that auditors should apply the environmental

factors in making their-materiality judgments. FASB [1975] and Thomas

and Krogstad [1979] for example, both indicate that auditors should

consider the environmental factors when setting their materiality

guidelines for individual clients.


Criteria application. The environmental factors satisfy the first

and second criteria. However, they fail to meet the third criterion.

The environmental factors are too general for an auditor to apply to

any materiality judgment of a specific IACW. In financial accounting

materiality studies these factors either have been ignored or have been
15
held constant.1 Presumably, the researchers considered that these

factors could not be directly related to the individual materiality











decisions examined. It is also difficult to imagine how any of these

factors would have a direct relationship with the objectives or the

properties of IAC.


Enterprise Related Factors


Description. The enterprise related factors are those factors

which describe the business. Most of these factors are qualitative

in nature, with no objective rules available for their measurement.

Specific factors included within this category are:

Quality of management and personnel---this includes managements'

motives and credibility as well as the competence of all employees.

With regard to motives and credibility an auditor could classify these

factors only along a favorable-unfavorable dimension; in any

materiality decision then, the auditor should assess the relationship

of these qualities to the existing state of nature. With regard to

competence, the auditor may evaluate the experience of the personnel

in their jobs and his past relations with them; given inexperienced

personnel, the auditor should increase the probability of dollar

exposure occurring. The use of the quality of management and

personnel factors in materiality decisions has been recommended by

several authors (e.g., FASB [1975] and Messier [19791), and Pattillo

[1975] reported survey results that indicated these factors do affect

auditor's financial accounting materiality decisions.

Business Risk---Business risk is defined as the exposure to

financial loss due to specific characteristics of the enterprise.

Examples of such characteristics are policies of management (e.g.,

credit policy) and legal liability history. Indicators of business











risk for a particular firm may be measured quantitatively or quali-

tatively. An example of a quantitative measure of business risk is

"beta" (common stock volatility). An example of a qualitative measure

of business risk is to presume that newer firms have higher risk than

established firms. In their financial accounting materiality study,

Boatsman and Robertson [1974] found that the business risk factor

(measured by common stock volatility) was a statistically significant

factor in disclosure decisions by a group of auditors. However, the

risk factor explained only 2% of the variance in auditors' disclosure

decisions.

Enterprise operating characteristics---specific factors

included in this category are the level of competition associated

with the firms' products, the economic characteristics of the firms'

products (e.g., price elasticity), and the financial structure of a

firm. It is difficult to identify a specific group of materiality

decisions within which enterprise operating characteristics would be

considered, but it is conceivable that they would influence the

auditor in a specific materiality decision (e.g., decisions relating

to disclosure of anti-trust suits or of threats to the going concern

status of the firm).

Type of firm---this includes the size of the firm and whether

it is a private or public company. The size of the firm is one factor

that can be quantitatively assessed (although there may be disagreement

as to the appropriateness of the particular measure of size). In

Frishkoff's study [1970], size of the firm was measured as the dollar

magnitude of stockholder's equity. Frishkoff found size of the firm

to be a significant factor in materiality decisions concerning changes











in accounting methods. However, his sample size of large firms was

small, and thus the true significance of the size factor may be

questionable (see Stringer [1970]). The other type of firm factor,

private vs. public ownership, has not been empirically examined in a

materiality decision context, but examples of the effect of this

factor on materiality decisions may be offered. For example, public

companies have formal rules and regulations to follow (e.g., SEC

regulations), that include rules governing certain materiality

decisions (e.g., materiality judgments relating to capitalization of

leases, disclosure of leases, reporting of replacement data), yet

private firms may not be bound by those rules. Thus, a private firm

may make a different materiality judgment than a public firm even if

the circumstances associated with the judgment are identical.

Cost/Benefit considerations---simply described, these factors

are the costs (indirect and direct) and benefits that accrue to the

enterprise and stockholders because of materiality decisions. For

example disclosure of a piece of information may be desirable, but

the cost to gather the information may be considered excessive. The

benefits related to the materiality decision are said to be "difficult

to measure" and in some cases are ignored [FASB, 1975; AICPA, 1978b].

The costs in this decision may include:

and direct incrementalcosts such as the cost of
gathering and reporting additional information, any
indirect costs such as increased liability exposure
and legal fees, and any competitive implications.
[FASB, 1975, p. 75]

As the above shows, this factor overlaps with other enterprise related

factors (e.g., enterprise operating characteristics), but differs in

terms of explicit quantitative (dollar value) considerations. Beaver











[1978] has advocated the use of cost/benefit factors for making dis-

closure type materiality decisions. Ward [1976] investigated auditor's

perceptions of the relative importance of materiality related factors,

and included two cost type factors in his study: 1) losses suffered by

stockholders and clients due to an incorrect materiality decision by

the auditor, and 2) losses by the client and stockholders due to

lawsuits or court action. Neither of these factors was significant in

the auditors materiality judgments. These results could be due to the

fact that auditors recognize the difficulty in measuring cost/benefit

considerations, and thus consider them impractical and unimportant to

materiality decisions.

Firm's image---this relates to the credibility of the enterprise

among the financial community and the public in general. An example of

this is potential embarrassment to the firm from the discovery of an

error subsequent to the issuance of the financial statements, where

hindsight indicates the error is material. Another example occurs

when a firm makes disclosures, that are not necessary for the fair

presentation of financial statements, in order to draw favorable

praise from the financial community. Reininga [1968] indicated

auditors should consider this in a materiality decision, but the

auditors in the study by Ward [1976] considered this factor to be

insignificant to their materiality decisions.


Criteria application. The first enterprise related factor

concerns the quality of management and personnel. This factor does

satisfy all three selection criteria, for the auditor's evaluation

of personnel in an IAC area where a weakness is located should have an

impact on his materiality judgment. With regard to the first criterion,











the quality of management and personnel can provide an indication of the

probability of material errors occurring due to an IACW. The following

scenario illustrates how the quality of personnel can affect the

auditor's probability judgment:

A company has only one employee to receive and to record
cash receipts. This would definitely be an IACW because
of a lack of segregation of duties. However, if the auditor
judges that the employee is extremely competent and
honest, he may discount the seriousness of this weakness
due to a smaller likelihood of a material error occurring.

Hence, this factor satisfies the first criterion since it can be

relevant to estimating the probability of the errors due to a specific

IACW.

In reference to the second criterion, no explicit literature

reference indicates that the auditor does not need to judge the quality

of personnel in his evaluation of the materiality of an IACW. Therefore,

this factor is not inconsistent with the second criterion.

Although it may be difficult for the auditor to apply the quality

of management and personnel factor to a specific IACW, this factor

satisfies the third criterion. The auditor may judge the quality of

personnel by the experience he has had in working with the personnel

or by judging the experience of the personnel in a particular type of

job. However, there is no hard evidence that the auditor can use to

make this judgment. The quality of personnel factor is directly

related to the personnel property of a strong IAC system and therefore

is directly related to the auditor's evaluation of IACWs.

The second enterprise related factor discussed was business risk.

The risk factor does satisfy the three selection criteria. In the

IACW materiality judgment the risk factor should be evaluated by

determining the type of exposure that is a consequence of the IACW.











The risk factor satisfies the first criterion because it may be

relevant to estimating the probability of an error occurring due to

an IACW. An IACW in an area of high business exposure (i.e., high

risk) may indicate a higher probability of errors occurring.

The risk factor also satisfies the second criterion. According

to Fisher [1978] business risks need to be analyzed (ranked from high

risk to low risk) in the development and evaluation of IAC systems.

If a serious IACWis present within a high risk area, IAC objectives

may not have been attained and management would need additional

controls in that area to prevent material errors [Fisher, 1978, p. 359].

Martin and Johnson [1978] also refer to business exposure (i.e., risk)

as a guideline in evaluating the materiality of IACWs.

The risk factor does meet the conditions of the third criterion.

Martin and Johnson [1978] relate the risk factor to the evaluation of

the materiality of an IACW by considering the nature of the items

(assets or type of transactions) that may be affected by the IACW.

That is, where an IACW exists in an area that is highly susceptible

to fraudulent conversion (e.g., cash as opposed to fixed assets),

the probability of a material- error occurring is increased. The

auditor should also consider the nature of the item in evaluating

IAC objectives and properties as they apply to that particular IAC

area [Ernst and Ernst, 1978a].

Type of firm is the next enterprise related factor that meets the

criteria for factor selection. The size of the firm, in particular,

may affect the auditor's IACW materiality judgment. With regard to the

first criterion, it can reasonably be argued that the larger the firm

the lower the probability that material errors will occur due to an











IACW, since larger firms should have greater resources to devote to

establishing IACs. This may be especially true when it comes to

IACWs involving separation of duties. It is generally more feasible

for a larger firm to provide for adequate segregation than for a

smaller firm to do so. Furthermore, where a small firm and a large

firm have the same IACW, it is more probable that the large firm will

have another IAC that will either partially or fully compensate

(offset) for the specific IACW.

With respect to the second criterion, the literature on how

auditors evaluate the materiality of IACWs provides no indication

that auditors should not consider the size factor in their IACW

materiality judgment. Hence, this factor is not inconsistent with

the second criterion.

The size factor also satisfies the third criterion of factor

selection. The size factor is also directly related to the IAC

properties and to the IAC objectives evaluated by the auditor. A

small firm will likely find it more difficult to achieve all the IAC

properties of a strong IAC system (e.g., achieving adequate

segregation of duties). Nevertheless, the IAC objectives are equally

important to a small firm, and the auditor should still evaluate any

IACW as to its effect on achieving the IAC objectives.

The cost/benefit factor is the final enterprise related factor

that satisfies all three criteria for factor selection. Simply put,

the factor implies that the aggregate cost of correcting the IACW

should not exceed the benefit to be derived, if the IACW is to be

considered material. This does not mean, however, that an IACW is

necessarily material if it is cost beneficial to correct. Fisher [1978]











supports this statement by pointing out that a firm has a limited

amount of resources to spend on IACs. A firm may have an IACW that

is cost beneficial to correct, but the correction would not reduce

the firm's exposure significantly enough to use the firm's resources

to correct the weakness. In short, a necessary but not sufficient

condition for a material IACW would be that it is cost beneficial

to correct. Since the cost/benefit factor is relevant to estimating

the dollar exposure from an IACW, it satisfies the first criterion.

The cost/benefit factor satisfies the second criterion since

the current literature [Fisher, 1978; AICPA, 1978b; Ernst & Ernst

1978a]includes advocacy of the use of a cost/benefit analysis in the

evaluation of IACs and IACWs. The cost/benefit analysis has been

discussed in its relationship with audit evidence and the concept of

reasonable assurance [AICPA, 1978b]. That is, in the evaluation of

the materiality of an IACW, the auditor should obtain evidence that

provides reasonable assurance as to the achievement of the IAC ob-

jectives. It follows that the auditor also should have reasonable

assurance that an IACW is or is not material. Reasonable assurance

is obtained by applying a cost/benefit analysis. The discussion of

cost benefit analysis and materiality presented within the AIPCA

committee report on IAC [AICPA, 1978b] included the assertion that

Measuring the cost-benefit relationship is an important
subject for research. For the present, final decisions
relative to an evaluation of internal accounting control
requirements in areas where exposure could be material
should be carefully reviewed and approved by appropriate
levels of management.
.there is generally some materiality limit below
which it may be impractical to institute control pro-
cedures and techniques. These limitations should be
considered when management analyzes the cost-benefit
relationship between a control procedure and the
benefits expected to be derived. [ 151











From the above it may be concluded that auditors should review

managements' cost/benefit analysis in their evaluation of the

materiality of an IACW, but that it may be difficult for management

to provide such an analysis. Nevertheless, the cost/benefit factor

does satisfy the third criterion since 1) the factor should be

considered in evaluating the necessity of instituting an IAC for

correcting a specific weakness, and 2) in applying a cost/benefit

analysis to the materiality of an IACW, the auditor should include

the effects of the weakness on IAC properties and objectives.

The two remaining enterprise related factors, enterprise operating

characteristics and firm's image, do not meet the criteria for factor

selection. Neither of these factors can be used to estimate the

probability effects or dollar exposure associated with errors due to

an IACW. Neither factor, being unrelated to the IAC objectives or to

the IAC properties, is significant to materiality decisions concerning

specific IACWs.


Accounting Policy Related Factors


Description. These are the factors that are relevant to the

application of generally accepted accounting principles (GAAP). Some

materiality decisions may deal with a known error in applying GAAP;

a management choice in applying alternative GAAP or an inconsistent

application of GAAP over time. They directly concern the auditor's

opinion of the company's financial statements (i.e., an opinion as to

the fair application of GAAP on a consistent basis), and hence a

stricter materiality judgment would normally be required (i.e., the

auditor should lower his materiality threshold---[FASB, 19751). The











judgment may consider specific circumstances associated with the

application of GAAP; for example, whether it is a liberal or a

conservative use of accounting principles, whether it is a dis-

cretionary or nondiscretionary change in accounting principles,

the nature of the management motives behind the transactions (e.g.,

to "manage" earnings), the extent of likely misstatement over

future periods [FASB, 1975, pp. 76-78], and so on.

In his search for important factors in the materiality judgment,

Pattillo [1975] considered materiality decisions involving accounting

policy changes and disclosure of accounting policies. He found that

auditors lowered their materiality threshold in materiality decisions

concerning unusual accounting policies; however, the dominant factors

in these decisions were the percent effect on net income and impact

on earnings per share. Boatsman and Robertson [1974] also included

accounting changes as a factor in their materiality policy-capturing

study; they concluded that accounting changes were an insignificant

factor since they explained less than 1% of the variance in the

specific judgments examined.


Criteria application. The accounting policy related factors do

not satisfy the criteria for factor selection. Accounting policy

related factors are only indirectly related to IACW materiality

decisions. These factors pertain to how the firm uses accounting

policies and not to the IAC system used in implementing the policies.

IACWs would involve accounting policies only to the extent that the

firm's IAC systems failed to properly record or to properly value

a certain transaction in conformity with GAAP. Although this is











important, the IACW would still exist under any accounting policy the

firm may use. In addition, there is no reason to believe that the use

of one accounting policy versus an alternative accounting policy would

influence the probability or dollar exposure of errors due to an IACW.


Uncertainty of the Existing State of Nature


Description. Many materiality decisions involve estimating

future effects and thus require consideration of the uncertainty

factor. The FASB [1975] "defined" the uncertainty factor in terms

of the auditor's ability to assess the future effects related to a

materiality judgment. The FASB stated that in the evaluation of

uncertainty the auditor should:

seek to assess the probability of the occurrence of
a future event and of the amount and timing of its
potential financial effect. Experience and familiarity
with the type of matter involved, imminence of
occurrence and risk to the enterprise are all factors
which would be considered in any given situation.
[p. 78]

Given the materiality definition used in this study, the un-

certainty factor refers to the uncertainty associated with the

auditor's perception of the existing state of nature. The uncertainty

factor is concerned with the likelihood that the expected dollar ex-

posure will be a significant amount. The more certain the perception

of the significance of the existing state of nature, the less risk the

auditor presumably will be willing to take. Thus if the auditor is

certain the expected dollar exposure will be significant, then the

auditor will likely attempt to minimize the amount of his dollar

exposure, and will likely reduce his materiality threshold. The FASB

[1975], in fact, has stated that auditors actually do apply a lower











materiality threshold to materiality decisions involving less un-

certainty. Newton [1977] included the uncertainty factor in a

materiality study concerning auditors' risk behavior and their

materiality threshold. The results of her study, however, were

inconclusive.16


Criteria application. The uncertainty factor satisfies the three

selection criteria. Since the uncertainty factor relates to the

probability of errors occurring due to an IACW, it does satisfy the

first criterion of factor selection. Operationalization of the un-

certainty factor, however, poses a significant problem for the auditor.

The assessment of the uncertainty associated with an IACW must be

subjective, as implied by the suggestion that the auditor personalize

the uncertainty evaluation [FASB, 1975]. The auditor's estimate of the

uncertainty of an IACW, therefore, depends upon his/her experience and

familiarity with that type of IACW and the errors associated with such

an IACW.

A measure the auditor may use to determine the frequency of

errors due to an IACW is the potential error rate. The use of the

potential error rate in the IACW materiality judgment has been

advocated by several authors [Martin and Johnson, 1978; Fisher, 1978;

AICPA, 1978b]; therefore this factor satisfies the second criterion.

The potential error rate may be based on historical error rates in-

curred by the firm or on the perceptions of firm's personnel

[Martin and Johnson, 1978]. The use of the potential error rate as a

measurement of the uncertainty factor would also satisfy the third

criterion of factor selection. Error rates may be estimated for each











IACW identified by the auditor. The error rate is also related to

IAC objectives since higher error rates increase the probability that

the objectives of IAC will not be achieved [Fisher, 1978].


Surrounding Circumstances Associated with the Existing State of Nature


Description. In making a materiality decision, the auditor should

consider the surrounding circumstances associated with the existing

state of nature. There are five factors that may be pertinent to this

evaluation.

The first factor is whether or not the circumstances associated

with the existing state of nature are unusual and/or infrequent for

that particular company. Pattillo [1975] reported that if the

materiality decision involved circumstances that were unusual or

infrequent for that business or the industry, the auditor would

lower his materiality threshold.

The second factor is whether or not the action by management

that led to the existing state of nature was voluntary or involuntary.

Voluntary actions likely will be associated with more careful review

by auditors and with a lowering of the auditors' materiality threshold

[FASB, 1975].

The third factor is whether or not the circumstances associated

with the existing state of nature are permanent or temporary.

Permanent conditions should be considered more significant by the

auditor since they will recur in the future.

The fourth factor is the sensitivity of the circumstances

associated with the existing state of nature. Several authors (e.g.,

Hicks [1964]; Reininga [1968]; FASB [1975]) have indicated that











auditors should lower their materiality thresholds under sensitive

circumstances. Examples of sensitive circumstances are where

materiality decisions relate to non-arms-length transactions and

where decisions may cause a change in the earnings trend (e.g.,

positive to negative trend). A few studies have examined whether

auditors do lower their thresholds in these situations (e.g.,

Woolsey [1954a]and Pattillo [1976]). In Frishkoff's study [1970]

and Boatsman and Robertson [1974], earnings trend was essentially

insignificant in the auditor's materiality decision. Also Moriarity

and Barron [1976] and Messier [1979] found that the relative

importance of earnings trend, as compared to the percent effect of

net income, was weighted substantially less by auditors in their

materiality decisions. However, for a small number of individual

auditors in these studies, the earnings trend was considered to be

the most important factor in their materiality judgments.

The final factor is the type of circumstances associated with

the existing state of nature. In a sense this is a catch-all factor

covering circumstances not included in the above factors. Examples

include 1) the relationship of the circumstances to the liquidity

position of the firm (i.e., does it involve cash, working capital,

fixed assets?), and 2) the type of accounting transaction involved

(e.g., a reclassification entry, contingency, gains and losses on

fixed assets). From the results of empirical studies (e.g., Frishkoff

[1970] and Pattillo [1975]), it appears that these factors affect

materiality decisions, but are not the primary factors used in the

decision. Frishkoff [1970] found that the type of accounting

transaction involved was a significant factor in explaining











materiality decisions concerning auditor's qualified opinions.

Boatsman and Robertson [1974) found that in materiality judgments

relating to disclosure of gains or losses on sales of non-current

assets, changes in accounting principles or contingencies, the type

of accounting transaction was a significant factor in explaining

auditors' judgments. Woolsey [1954b] found that in materiality

decisions concerning contingencies, the auditor would increase his

materiality threshold and would evaluate the effect of the con-

tingency on the liquidity position of the firm (e.g., working capital).

In the experiment by Ward [1976], auditors agreed that liquidity

effects were an important materiality factor in financial accounting

materiality decisions. Finally, Pattillo [1975) examined several

types of judgment items in materiality decisions and concluded that

the auditor would probably decrease his materiality threshold if the

effect of the judgment item were unfavorable to the client. This is

probably due to a conservative attitude on the part of the auditor.


Criteria application. The first four factors described in this

category (frequency of materiality judgment item, management control,

lasting nature of materiality judgment item and sensitivity of the

materiality judgment item) fail to satisfy the criteria for factor

selection or are repetitive of previous IACW materiality factors.

The following indicates the reasons for this failure:

1) The auditor may consider an IACW to be unusual or
infrequent for a particular type of firm, but
knowing this does not give any indication of the
probability of errors due to the IACW or of the
dollar exposure of the errors permitted by the IACW.
Therefore, this factor does not satisfy the first
criterion.











2) The existence of an IACW is a voluntary action by
management. That is, management always has control
of whether or not they have an IACW within their IAC
system. Therefore, management control would not
help discriminate between material and immaterial
IACWs.

3) The lasting condition of the IACW (i.e., the degree
of permanence of the effects of the IACW) should be
considered by the auditor in his evaluation of the
uncertainty factor. Therefore, the lasting condition
of an IACW should have been already accounted for in
the uncertainty evaluation in an auditor's IACW
materiality decision (see page 61).

4) The auditor may consider an IACW to be sensitive
(e.g., allows for a non-arms-length transaction to
occur), but this knowledge gives no indication of
the probability of errors due to the IACW or of the
dollar exposure of the errors permitted by the IACW.
Therefore, this factor does not satisfy the first
criterion.

The final factor in this category, type of judgment item, does

satisfy the criteria for factor selection and is assumed to be
17
potentially important to the IACW materiality judgment. This factor

is the type of IAC that is affected by an IACW. The two types of IACs

are basic and disciplinary controls [Martin and Johnson, 1978]. Basic

controls (procedural or clerical controls) are the elementary

techniques necessary for an IAC system and are intended to provide

assurances that the transaction flows are valid, complete and

clerically accurate. The basic controls are mechanical and clerical

procedures used in an IAC system. Examples of these controls are

authorization and approval of purchase orders, double checking, or

reconciliations. Disciplinary controls represent the operationalization

of the properties of a strong IAC system and provide assurance that the

basic controls are operating continuously. These controls are the

foundation of a firm's IAC system. Examples of disciplinary controls











include adequate segregation of duties, proper supervision, limited

access to assets and an internal audit staff.

Type of IAC affected by the IACW satisfies the first criterion

for factor selection because it is relevant to estimating the

probability of an error due to an IACW. If the IACW affects a

disciplinary control rather than a basic control, a higher probability

should exist that the IACW will lead to material errors. The primary

reason is that a lack of a disciplinary control provides a direct

indication that the properties of a strong IAC system have not been

maintained; on the other hand, a lack of a basic control does not

always indicate an IACW. A firm may have various combinations cf

basic controls that provide for a satisfactory IAC system, and thus,

the absence of a particular basic control does not necessarily imply

an IACW [Defliese, Johnson and McLeod, 1977]. This factor also

meets the second criterion and, in fact, its applicability to the

IACW materiality decision has been suggested by Martin and Johnson

[1978]. Ashto. [1974] found a lack of segregation of duties, an

effect on a disciplinary control, to be the most significant factor

in explaining the auditor's evaluation of an IAC system. Finally, the

third criterion is satisfied because this factor is directly concerned

with IAC properties and the effects of a specific IACW on the presence

of those properties.


Dollar Effects

Description. In order for an auditor to make any materiality

decision, some dollar approximation of the existing state of nature

generally is required before he evaluates materiality. A surrogate











factor for this approximation is the dollar effect. The dollar effect

is some observable dollar amount associated with the existing state of

nature (e.g., a $5,000 writedown of inventory). Dollar effects have

been the dominating factors suggested in the literature. The dollar

effect can be evaluated by the auditor in one of two ways: 1) in

terms of an absolute dollar magnitude, or 2) in terms of a relative

dollar magnitude (e.g., the percentage relationship between the

dollar effect and current net income before taxes).

Woolsey [1954a, 1954b] and Frishkoff [1970] included absolute

dollar magnitude of the materiality decisions in their studies, and

both reported that auditors do not consider the absolute magnitude

to be significant. Boatsman and Robertson [1974] and Hofstedt and

Hughes [1977] also included absolute magnitude factors in their

experiments, and found them to be statistically significant (although

not dominant factors) in the judgment models of the auditors. The

FASB [1975] and Pattillo [1975] suggested that absolute magnitude

factors should be important in materiality decisions when 1) the

business has a net loss or is near breakeven, 2) the materiality

judgment has a potential future effect, or 3) the materiality

judgment involves a sensitive situation.

The relative dollar magnitude factor has also received con-

siderable attention in the literature. Hicks [1962, p. 64] has

asserted that the auditor's judgment of "materiality normally turns

upon the relation between the amount of the item in question and the

amount of some appropriate basis for comparison. ." Research

indicates that the relation of dollar effect to current net income

is an important factor in materiality judgments [Woolsey, 1954a and











1954b; Frishkoff, 1970; Boatsman and Robertson, 1974; Pattillo, 1975;

Moriarity and Barron, 1976; Ward, 1976, and Messier, 1979]. The

study by Neumann [1968] found a lack of consensus among auditors on

how to apply the relationship of dollar effect to current net income.

Pattillo [1976], Bernstein [1967], and Woolsey [1954a] reported

similar findings in their studies. Other researchers have considered

the possibility that auditors may try to judge the materiality of the

dollar effect in relation to average income [Bernstein, 1967],

operating profit (a significant factor in Hofstedt and Hughes [1977])

or gross profit [Canadian Institute of Chartered Accountants, 1972].

Pattillo [1976] and Boatsman and Robertson [1974] examined the

relationships of other income statement items (e.g., sales, expenses)

to the dollar effect, but found that these factors had little practical

significance to the auditor's materiality judgment. Another relation-

ship whose applicability to materiality judgments has been considered

is that between the dollar effect and earnings per share [Rose, Beaver,

Becker and Sorter, 1970]. Frishkoff [1970], however, included this

factor in his study and did not find it to have a significant effect

on materiality decisions. The dollar effect relationship to liquidity

appears to be an important factor when the existing state of nature

primarily concerns the balance sheet [Ward, 1976; Reininga, 1968; and

Woolsey, 1954b]. The dollar effect can be assessed with respect to an

individual account affected, in relation to an aggregation (e.g.,

effect on total assets), or in terms of the effect on various ratios

(e.g., the quick ratio). Woolsey [1954b] found that if the materiality

decision concerned a contingent liability, auditors considered the

effect on working capital as an important factor. Messier [1979]











reported that when the materiality decision involved a writedown of

inventory, the percent effect on total inventory was important to

the judgment of some individual auditors, but that the effect on net

income remained the dominating factor. Similar conclusions, with

different circumstances associated with the existing state of nature,

have been made by Boatsman and Robertson [1974] concerning the effect

on working capital; by Hofstedt and Hughes [1977] concerning the

percent effect on subsidiary investments; and by Moriarity and Barron

[1976] concerning the effect on total assets and debt to equity ratio.

Based on the above research it may be concluded that the auditor

considers the relationship of the dollar effect to both the balance

sheet and income statement to be important, with greater significance

being attached to the relationship of the dollar effect to net

income.


Criteria application. The dollar effect satisfies all three

selection criteria. In an IACW materiality judgment the dollar effect

is the estimated dollar effect of the errors due to an IACW. The

auditor should estimate the dollar effect due to an IACW using a two

step process. The first step is to estimate the total dollar flow

through an IAC area where an IACW is located (e.g., total cash

disbursements). The total dollar flow represents the maximum dollar

effect a firm would be exposed to if the IACW caused a 100% error

rate in that IAC area. The second step is to estimate the potential
18
error rate of the errors that may occur due to the IACW. The

equation for determining the most likely dollar effect due to an IACW

would be the potential error rate multiplied by the estimate of the










19
dollar flow through the specific internal control point.19 Since this

factor is a direct estimation of the dollar exposure of errors caused

by an IACW, it satisfies the first criterion. This factor also meets

the second criterion because this type of estimation of the dollar

exposure was advocated by Martin and Johnson [1978]. Other authors

have also suggested that the auditor needs to estimate the dollar

effect of IACWs, but do not detail procedures for use in deriving the
20
dollar exposure [Fisher, 1978; AICPA, 1978b]. The dollar effect

also satisfies the third criterion of factor selection. Although the

dollar effect is not relevant to determining whether IAC properties

are present, it is an indication of the seriousness of not achieving

the IAC objectives and maintaining the IAC properties.


Summary of Factors Satisfying the Factor Selection Criteria

Table 2.2 lists the factors that satisfied the criteria for

factor selection. Of course an auditor is not likely to use each of

these factors in every IACW materiality judgment because these

factors may be intercorrelated and could contain the same information

or be irrelevant to the particular judgment. Nevertheless, based on

the evidence in the previous section, it may be assumed that the

selected factors are most likely to be the primary factors that the

auditor would perceive to be important in an IACW materiality

judgment.21 In order to derive more information on the validity of

this assumption, formal interviews were conducted with a small sample

of CPAs. A summary of the results, relevant to factor selection,

is given in the next section.











TABLE 2.2
FACTORS WHICH SATISFIED THE THREE SELECTION CRITERIA


General Factor Category


Environmental Factors

Enterprise Related Factors


Accounting Policy Related Factors

Uncertainty of the Existing
State of Nature

Surrounding Circumstances
associated with the Existing
State of Nature


Dollar Effects


Specific Factors which Satisfied
Selection Criteria

NONE

Quality of Management and
Personnel

Business Risk--nature of items
affected by IACW

Size of auditor's client

Cost/Benefit considerations


NONE


Potential error rate


Type of IAC affected by the
IACW


Expected dollar effect











Summary of Interview Results Concerning Factors in the IACW
Materiality Judgment

As indicated above, a primary purpose of the pre-experimental

interviews was to obtain additional insights into the importance

of the factors selected as potentially relevant in an auditor's

IACW materiality judgment.23 The interviews focused upon the

auditor's preliminary evaluation of IAC and the IACW materiality

judgment at that point of the audit.

The primary means by which information on the importance of the

IACW materiality factors was obtained were a series of objective

rating questions and a self-weighting allocation task. The eight
24
factors24 which satisfied the factor selection criteria were each

rated by the interview participants on a 9-point monotonic scale,

ranging from "1 = Not Important at All" to "9 = Extremely Important."

Each interview participant also allocated 100 points to the eight

factors plus any other factors the participant considered important.

The participants also had an opportunity (in an open-ended question)

to mention additional important factors relevant to the auditor's

IACW materiality judgment.

Each IACW materiality factor which satisfied the factor selection

criteria, except for the size of client factor, was considered to be

important in the IACW materiality judgment by at least some of the

interview participants. A summary of the responses given by the

participants is shown in Table 2.3. The size factor was considered

to be unimportant by all the participants, who rejected the proposition
25
that it met the first criterion.25 The participants considered that

if an IACW was material (immaterial) for one size of client, the same

IACW (given a proportional relationship for all other factors) would























w -








I -4 I -
f N C


-- I








W>0











V 7z
~ N -
-

I- N C




0'0'

wj f
cr -'4


Ir I.. -,

a, r r i" C T1 /
Z : :! jt -: i :-/
H/
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/ _____________________________











be material (immaterial) for a client of a different size. Their

reasoning was that there are sufficient compensating controls

(e.g., owner review to offset lack of segregation of duties)

available to the small client to offset the greater resources

available to the large firm. They further considered that given

these compensating controls the probability of an error occurring

for any particular IACW would be the same for large or small clients.

If their comments were representative of the auditor population, then

the resources available to a particular client for the development of

an IAC system would not seem to be an important consideration. In the

face of the participants' response and since the original argument

about the size factor and the first criterion was not strongly based,

this factor was rejected for the purpose of this study.

One interview participant attached importance to two factors

that were rejected previously by the selection criteria.26 These

factors are the regulatory environment within which the clients'

business operates and general knowledge of the clients' relationship

with its external environment. These factors were rejected because

they did not satisfy the third criterion: that is, they were con-

sidered to be too general for the auditor to apply to any materiality

judgment of a specific IACW. This conclusion was arrived at for three

reasons. First, the participant said that these factors are more

likely to be considered in a review of a particular materiality de-

cision (e.g., the audit partner concurs with the manager's materiality

decision) and not as factors in determining whether or not a particular

IACW was material or not. Second, the participant considered the factors

as only somewhat important to an IACW materiality decision and were not











identified as primary factors used in an IACW materiality decision

(i.e., these factors were not among the three most important factors

as rated by the participant ). Finally, no other participant

mentioned any environmental factors as being relevant to an IACW

materiality judgment. Therefore, it is concluded that these factors

are probably not very important to most auditors' IACW materiality

judgments.


Summary and Conclusions

This chapter attempted to answer the first research question

concerning the factors that have potential importance to IACW

materiality judgments of auditors. Essentially two types of evidence

were presented: 1) a priori evidence based on logic and a review of

the literature, and 2) results from interviews conducted with a small

sample of auditors.

It is assumed, based on the evidence presented in this chapter,

that the factors most likely to be perceived as important factors in

an IACW materiality judgment by an auditor are:

1) Expected dollar effect of an IACW

2) Potential error rate due to an IACW

3) Type of IAC affected by the IACW

4) Risk--the type of asset affected by the IACW

5) Quality of management and personnel

6) Cost/benefit considerations.

The next chapter will present the methodology used in this study for

an experiment concerning the impact of certain of these factors

upon auditors' IACW materiality judgments.











Notes


The two definitional elements of a material IACW are 1) the
probability that the IACW will cause a material error and 2) the
dollar exposure of errors due to the IACW [AICPA, 1973].
These properties are the properties associated with a strong
IAC system. The properties are: competent personnel, adequate
segregation of duties, authorization procedures, adequate accounting
documentation, procedures for record keeping, safeguarding of assets
and records, and independent checks on performance [Arens and
Loebbecke, 1976].
The second edition of Arens and Loebbecke [1980] combine
"adequate documents and records" and "proper procedures for record
keeping" into one property. Nevertheless, the discussion presented
in this section is consistent with their new edition.
4
See Robertson [1979] and Martin and Johnson [1978] for further
discussions on how auditors may evaluate personnel.
Other properties included in Ashton's study were: proper pro-
cedures for authorization, adequate documents and records, proper
procedures for record keeping, and independent checks on performance.
A factor also considered by Ashton was previous years audit results.
Similar results have been found by Hamilton and Wright [1977j,
Ashton and Kramer [1980] and Ashton and Brown [1980] in replications
and extensions of Ashton's original work. The primary difference
between these studies and Ashton's study is that the effects of audit
experience was isolated. Nevertheless, segregation of duties was
still found to be the primary influence in the subjects' evaluative
judgments.
This assumption appears reasonable because it is difficult to
imagine a material IACW that, in the long run, would benefit one of
the above parties at the expense of another party. Nevertheless,
it is acknowledged that this assumption may not always hold.
8
It is assumed that the expected dollar exposure due to the IACW
has a positive linear relationship to the expected dollar exposure of
the errors and irregularities due to the IACW. That is, the greater
the expected dollar exposure of errors and irregularities due to the
IACW implies a larger expected dollar exposure to all relevant parties.
9
See FASB [1975] for more such "definitions."
10
A condition set forth in FASB Statement No. 5 to accrue for a loss
contingency is that the amount of the loss can be reasonably estimated.
The FASB states that when the estimate involves a dollar range and a
single dollar amount is a better estimate than any other amount in the
range, the amount shall be accrued. Using the most likely dollar ef-
fect as an estimate of the expected dollar effect appears to be con-
sistent and similar to the circumstance described in FASB No. 5.
1That is the existing dollar exposure related to management or
to the auditor or to a creditor or to a stockholder or to any relevant
decision-maker will increase as the expected dollar effect becomes
greater.











12
2This level of utility is assumed to be the auditor's (manager's)
level of utility, and not the auditor's estimate of external users'
level of utility (see Chapter I in which this type of assumption re-
lated to the auditor's behavior is discussed.).

1This assumes that the dollar exposure is minimized, for all
relevant parties, when financial statements are fairly presented.
14
This is consistent with the three standards of field work as
given in the AICPA's Professional Standards of Auditing [AICPA,
1973].
15
See Frishkoff [1970] and Moriarity and Barron [1976].
16
Her definition of the uncertainty factor was consistent with the
definition given in this study. That is, she defined uncertainty in
terms of the probability of future consequences.
1The auditor may also consider the types of IACW from the
perspective of the IAC area within which the IACW occurs (e.g., cash,
sales and receivables, inventory). However, this has already been
raised in connection with the risk factor and will not be repeated
here. (Supra, page 54).
18
See discussion of the uncertainty factor, page 60-62 for
elaboration on the relevance of the potential error rate to the IACW
materiality judgment.
19
1This assumes that the individual transactions within the IAC
area have the same error rate (regardless of dollar size or type of
errors). If this is not true, the auditor should stratify the
population to derive the most likely dollar effect.
20
The auditor may use his estimate of dollar exposure of an IACW
within an absolute analysis or in a comparative analysis for his
materiality judgment. That is, the auditor may use the absolute
magnitude of the dollar effect or may compare the dollar effect to
net income (or some other relevant base) in making his materiality
judgment. The auditor could also use his estimate of the dollar
exposure of an IACW in the cost/benefit factor. The dollar effect
would represent the expected benefits of correcting the IACW.
2This must be considered within the context of this study which
assumes that an IACW has no compensating control. That is, compensating
controls used as a factor in the auditor's IACW materiality judgment
are considered to be beyond the scope of this study (see Chapter I).
22
2The participants in the interviews were four audit managers from
four national CPA firms. All the participants were from Jacksonville,
Florida.
23
See Appendix A for the interview methodology and instrument.
24
2The quality of management and personnel was divided into two
separate factors: the quality of management and the quality of
personnel associated with an accounting function.
25Infra: page 55.
Infra: page 55.






78



2Another interview participant (Number 2) mentioned an additional
factor which he perceived to be important in an IACW materiality
judgment. The factor suggested was the existence of compensating
controls.. Interview participants were told to assume no compen-
sating controls existed when responding to the interview's questions
and were told to only consider factors exclusive of compensating
controls (i.e., what factors do auditor's perceive to be important
in the IACW materiality judgment besides the existence of com-
pensating controls?). This was done because the inclusion of the
compensating control factor was considered to be beyond the scope
of this study (see Chapter I). This participant must have mis-
understood the interview instructions in this respect.

















CHAPTER III
METHODOLOGY


Introduction

The purpose of this chapter is to describe the methodology used

to address the following research questions:

--Can the auditor's judgment of the materiality of IACWs be
described by a mathematical model?

--Is there consensus across auditors regarding the IACW
materiality judgment?

--How much "self-insight" does the auditor have into his
judgment process?

The chapter presents two major sections. First, the fixed

effects analysis of variance model (ANOVA) (employed in describing

and investigating judgment processes) and the pairwise comparison

procedures are described. Included in this section is an example

of the incomplete pairwise comparison procedure and calculation of

scale values.

Second, the experimental design is presented. In this section

the experimental variables (independent, moderating and dependent)

are presented, the experimental task and setting are reviewed and

the data analysis procedures and limitations of the experiment are

described. This section includes a discussion of the control

techniques used in the pairwise comparison task. The above research

questions are reviewed and the detailed procedures used to answer

the questions are presented. This section also includes descrip-

tions of the administration of the experiment and the subjects.











The Model


ANOVA

Several researchers have used ANOVA to model and describe the

judgment process. Examples of these studies include Hoffman, Slovic

and Rorer [1968]; Slovic [1969]; Ashton [1974]; and Joyce [1976].

The primary advantage of ANOVA is that it allows for the examination

of both linear and configural factor usage by the expert judge

(auditor). The formulation of a fixed effects ANOVA model for

judgments involving two factors would be:


J.. = M + A. + Bk + ABjk + E. (1)
ijk j k jk ijk
th
where J.. is the i judgment for a case that was observed to have
ijk
level j with respect to factor A, and to have level k with respect

to factor B; M is the grand mean for all judgments J; A. and Bk are
3 k

the main effects due to factors Aand B respectively; ABik represents

the effect of the interaction between factor A and factor B; and

Eijk is the random error component (assumed to be independent and

normally distributed) in each individual's judgment model.

A significant main effect (say for factor A.) would imply that

the judge's response varies systematically with changes in the level

of the particular factor (A.) when the levels of the other factors

(Bk) are held constant. If in a particular judge's model only the

main effects are significant, this would indicate that the judge's

responses can be described as an additive combination of the individual

factors.

A significant two factor interaction (ABj ) indicates that the

judge is responding to specific patterns of the two factors; that is,










the interpretation of one factor (say A.) is dependent upon the level of

another factor (Bk). This dependency of a factor upon other factors

is called configural factor usage and represents a more complex type

of information usage by the judge.

ANOVA modeling research has consistently shown that (1) the

main effects account for nearly all the explained variance in

individuals' judgments and (2) the models explain a high proportion

of the variance in the individuals' judgments [Ashton, 1974; Joyce,

1976]. In addition to the ANOVA model, an estimate of the individual

factor's proportion of explained variance is normally derived for all

significant effects by means of the omega-square statistic [Hays,

1973].1 This statistic provides an estimate of the total variance in

the individual's judgment that can be attributed to a specific

factor (through its main effects and interaction effects). Finally,

fixed effects ANOVA models are typically restricted to using independent

factors which 1) are represented by categorical levels rather than

continuous variables (e.g., high vs. low) and 2) are orthogonal

(statistically independent). The orthogonality of the factors is

2
ensured by use of a factorial design.


Pairwise Comparison Measure

This study applied a pairwise comparison procedure to obtain the

dependent variable(J. ) in the subjects' ANOVA models. The pairwise
lik
comparison procedure is adapted from Bechtel [1976] and Torgerson

[1958]. The advantages of the procedure are 1) the dependent

variable may be interpreted as a measure of relative strength and

direction assigned by the subject to a particular stimulus (IACW)

as compared to another stimulus and 2) the scale values assigned to










a set of stimuli (IACWs) may be more discriminating than those

obtained using a single rating scale since they are derived from

several observations for each stimulus.


Complete pairwise comparison procedure. A complete pairwise

comparison procedure would require the subjects to compare and rate

each stimulus with all other stimuli in the experiment. To illustrate

this, consider that a subject is asked to compare and rate the

materiality of four different IACWs (A, B, C and D). Since there are

four IACWs, this would require the subject to make six pairwise

comparisons (A to B, A to C, A to D, B to C, B to D and C to D).

The primary advantage of the complete pairwise comparison procedure

is that it allows for a check on the internal consistency of the

subject. That is, the data generated from the pairwise comparison

procedure may be checked for the number of transitivity errors

contained in the data. However, this advantage of a complete pairwise

comparison task may be offset by the fact that the procedure is

difficult and time consuming. Subjects may become bored and fatigued

if they must respond to a large number of comparisons. Modest

increases in the number of stimuli quickly raise the number of

comparisons to onerous levels. For example, if the number of stimuli

is raised from four to twelve, the number of complete pairwise

comparisons jumps from six to 66. Where a subject provides responses

to a large set of comparisons and these are found to be internally

inconsistent, this could be attributed to either the task or the

subject's judgment process. Hence, in order to overcome the disad-

vantage of fatigue and potentially unreliable data, incomplete pairwise

comparison procedures are necessa
comparison procedures are necessary.











Incomplete pairwise comparison procedure. Torgerson [1958)

has suggested the use of a simple incomplete pairwise comparison

procedure to derive a scale for a large number of stimuli without

having to perform the complete pairwise comparison procedure. The

procedure involves dividing the total set of stimuli into two sub-

sets. One subset would be considered the standard stimuli and the

other subset would be the comparison stimuli. The reduction in the

pairwise comparison judgments comes about because this procedure only

requires the subject to compare all the comparison stimuli to each

standard stimuli. To illustrate this reduction, consider the example

of 12 stimuli. Assume the set of stimuli is divided into four

standard and eight comparison stimuli. The reduced procedure would

require the subject to make 32 comparisons (4 X 8), whereas a complete

pairwise procedure would require 66 comparisons [(12 X 11)/2].

The standard stimuli selected should contain the information

most relevant to the dimension of interest (e.g., materiality).

That is, the standard stimuli selected should be spaced out over

the length of the dimension scale (e.g., very material to immaterial).

Finally, the scale value for each stimulus is used as the

dependent variable in the ANOVA models. To illustrate how the scale

value for each stimulus is calculated, consider the following

simplified example. Assume that a subject is asked to rate the

comparative materiality of four IACWs (A, B, C and D). Assume the

rating was made on a scale which has an interpretive range from

-3 to +3. The rating would take the form of: IACW A: 3 : 2 : 1 :

0 : 1 : 2 : 3 : IACW C. If there are four IACWs, this would

require six pairwise comparisons in a complete procedure. However,











assume that IACWs A and B are chosen as standard stimuli and C and D

are chosen as comparison stimuli. This incomplete procedure would

require only four comparisons (A to C, A to D, B to C and B to D).

The subject's materiality rating for one IACW over another IACW is

expressed by circling the appropriate number on either side of zero;

indifference on the part of the subject is represented by circling

zero. Assume the individual responded as follows:

IACW A over C = 3
IACW A over D = 2
IACW C over B = 1
IACW D over B = 3

The following materiality data matrix would then be constructed, where

it is interpreted as row materiality over column materiality:


Comparison Row Row
Standard IACWs C D Total Average
IACWs (Scale Values)

A 3 2 5 2.5*


B -1 -3 -4 -2.0*


Grand Average .25
([3+2-1-3]'4)


Column Total


-1


Column Average 1 -.5


Grand Av. Col. Av. -.75* .75*
(scale values)


The "*" numbers are the calculated scale values for the respective

IACWs. The row averages are materiality scale values for the standard

IACWs; the grand average minus each column average represents the

scale values for the comparison IACWs. Torgerson [1958] has shown that











the above calculations are the least-squares estimates of the scale

values of the stimuli. The interpretation of the materiality scale

values are: the subject definitely rates IACW A (2.5), as compared

to the other IACWs, to be most material, followed by IACW D (.75),

then IACW C (-.75) and finally the least material of the four IACWs

is IACW B (-2.0).


Experimental Design


Experimental Setting and Subjects

The subjects (Ss) for the experiment were 38 practicing auditors

from five large national public accounting firms located in Miami,

Florida, and Houston, Texas. All Ss were required to have at least

two years of experience and were senior level auditors who would

typically be in charge of the fieldwork during an audit.6

Ss were told to assume (see Appendix B, Booklet 1) that they are

the seniors-in-charge of a current audit for a fictitious dental

supply company. The Ss received information concerning the IACWs

that were identified prior to any compliance testing or substantive

testing. The task required the Ss to make judgments concerning their

preliminary evaluation of the materiality of the identified IACWs.


Independent Factor Selection

The bases of selection of the independent factors (to be

manipulated in the experimental design) were 1) the conclusions of

Chapter II with regard to the important factors in an IACW materiality

decision, 2) the feedback received from pre-experimental interviews

regarding the importance and the measurement of factors used in the











preliminary IACW materiality judgment, and 3) the need for factors

that could be manipulated throughout a set of individual IACWs.

These considerations led to the choice of three factors as inde-

pendent variables.

The first factor is the type of missing IAC attribute created

by the IACW (TYIAC). This factor was manipulated at two levels.

Each IACW represented either a lack of formal authorization for

execution of a transaction or a lack of segregation of duties as to

asset custody and record-keeping.

The second factor is the type of asset affected by the IACW (AS).

This factor was manipulated at three levels. Each IACW affected

either cash (cash disbursements), dental supplies (floss, silver,

brushes, drills, etc.), or dental equipment (x-ray machines, chairs,

stools, etc.).

The third factor is the maximum dollar effect due to the IACW

(DOL). This factor is used rather than the most likely dollar ef-

fect due to the IACW (expected dollar effect due to the IACW) be-

cause the latter factor could not be operationalized in the experi-

mental design.0 In an IACW materiality judgment, the most likely dol-

lar effect is assumed to be closely related to the maximum dollar ef-

fect, since the most likely dollar effect is approximately equal to the

maximum dollar effect times the potential error rate due to the IACW.

To control for the most likely dollar effect in the experimental

design, Ss were told to assume that the potential error rate is the

same for each IACW. The maximum dollar effect was then manipulated at

two levels. Each IACW either involved a high dollar effect or a low

dollar effect. Since the experimental design involved one hypothetical











company, this factor was operationalized by creating two divisions in

the company at separate locations (Michigan and California). Each

division had identical IACWs except that one division was large and

had a high dollar effect and the other division was small with a low

dollar effect for each IACW.

The three independent factors selected were then manipulated in a

2 X 3 X 2 factorial design. This design then required the creation

of twelve IACWs (see Appendix B for case and tasks). This experimental

design is shown in Figure 3.1.


Background Data

While only three factors were manipulated in the experimental

design, Chapter II and pre-experimental interviews (Appendix A)

indicated there were other important factors in the preliminary IACW

materiality decision (e.g., quality of management and personnel,

potential error rate). As many of these factors as possible were

incorporated in the experimental materials (Appendix B, Booklet 1)

as unchanging background data for the company. The data concerning

the hypothetical dental supply wholesaler were compiled from 1979

Security and Exchange Commission 10-K reports for two Dental Supply

Wholesale Companies.


Dependent Variables and Tasks

Two sets of dependent variables were elicited from each S during

the experiment. This required the use of two different tasks (see

Appendix B where Task 1 is the pairwise comparison and Task 2 is the

single rating procedure). The reasons for the elicitation of two sets

of dependent variables were
















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1) to use a multi-method approach in order to test the validity

of each S's data. That is, the dependent variables

obtained from the two tasks should be positively correlated

since the variables purportedly are measures of the same

attribute (i.e., the materiality of the IACWs).

2) to obtain a relative evaluation of materiality from each S

(materiality of IACW A as compared to IACW B) and an

absolute evaluation of materiality from each S (IACW A is

or is not material).

The first task involved the Ss pairwise comparison response to the

relative significance of each IACW. The second task required the Ss

to classify each IACW as material or not material and to then rate the

level of materiality for the material IACWs.


Pairwise comparison task. The incomplete pairwise comparison

procedure was used to obtain the relative materiality ratings of each

S. The 12 IACWs were divided into four standard IACWs and eight

comparison IACWs. Two sets of standard and comparison IACWs were
11
used. An attempt was made to select standard IACWs which were

spaced over the relative materiality range of the 12 IACWs. The

selection procedure was the following:

1) In order to rank the 12 IACWs from most material to least

material, on an a priori basis, it was assumed that:

a) an IACW representing a lack of segregation of duties

is more material than an IACW representing a lack of formal

authorization; b) an IACW affecting cash is more material

than an IACW affecting dental supplies or dental equipment,