EXPLANATION AND COUNTEREXPLANATION DURING AUDIT ANALYTICAL REVIEW

Analytical review, the diagnostic process of identifying and determining the cause of unexpected fluctuations in account balances and financial ratios, has become an increasingly important part of auditing. Recent research suggests that analytical review is beneficial for detecting such unexpected fluctuations (Kreutzfeldt and Wallace 1986; Wright and Ashton 1989). It is, however, difficult for an auditor utilizing analytical review to know when the "correct" cause for an observed fluctuation has been determined, especially since no offical guidance exists to assist the auditor. Thus, accepting a plausible but incorrect cause is a dangerous and largely unresearched possibility (Kinney 1987). This article describes two experiments that investigate conditions under which auditors may be prone to accepting a plausible, but potentially incorrect, cause when performing attention-directing analytical review. Identifying such conditions is important because either audit effectiveness or efficiency would be compromised with such incorrect acceptance. Although there are no normatively correct causes for the analytical review problem situations employed in this study, relative evidence on such compromises will be obtained by investigating conditions that lead auditors to make different judgments about the cause of an unexpected fluctuation. Differences in auditors' judgments are important since they can lead to differences in decisions as to the cause of an unexpected fluctuation and subsequent auditor actions (cf. Asare 1991). Dichotomizing causes into error and non-error classes reveals several ways in which an auditor performing analytical review may accept a plausible but incorrect cause. One that has particularly significant implications for the effectiveness of the audit would be concluding that a non-error cause adequately accounts for an unexpected fluctuation when the "correct" cause involves a financial-statement error. Since it is unlikely that the auditor would increase planned tests of details if indications of a material error were not present (and it is possible that the auditor may decrease such testing), the likelihood of subsequent detection of the error would be reduced in this situation. Conditions that may lead to this type of decision error will be investigated in this study. The effects of explanation, counterexplanation (i.e., consideration of why an hypothesized cause may not be correct), and their order of performance were studied to determine how such factors affect the propensity for acceptance of a plausible but incorrect non-error cause. Investigating explanation is important since auditors typically document explanations for analytical review findings. Even though current auditing standards do not require auditors to counterexplain, investigating how counterexplanation and the order of counterexplanation and explanation affect auditors' judgments is nevertheless important since it enhances our understanding of the potential for acceptance of an incorrect cause. Auditors from five public accounting firms participated in two experiments conducted to determine the effects of the aforementioned factors on auditors' judgments. Consistent with expectations, auditors revised their beliefs about an hypothesized non-error cause of an unexpected fluctuation in the auditee's gross margin in an upward (downward) fashion when asked to document an explanation (counterexplanation) for that cause. Inconsistent with expectations, however, auditors who were asked to document an explanation initially and then a counterexplanation judged the non-error cause to be less likely to have occurred than did auditors asked to document a counterexplanation initially and then an explanation. Overall, these results identify conditions in which auditors may be prone to compromising audit effectiveness by accepting a potentially incorrect non-error cause.