## ABSTRACT

Using experiments with 58 corporate managers and 215 auditors, we examine whether managers attempt to reduce the perceived intentionality of their fraudulent misstatements by perpetrating fraud via omission, as opposed to a more active form of commission, and how auditors evaluate the resulting misstatements. We find that managers choose to omit a transaction from the financial statements rather than record a transaction inappropriately. They also choose to omit critical information from supporting documents rather than provide misleading information. However, auditors generally believe misstatements involving omissions are unintentional. Specifically, we find auditors are less skeptical of an omitted transaction compared to a misrecorded transaction. They are also less skeptical of a misstatement that results from management omitting information from a supporting document compared to misrepresenting information. Overall, our studies identify a method of fraud—omission—that managers are likely to use, but that auditors are unlikely to judge as being intentional.

## I. INTRODUCTION

Auditors have an explicit responsibility to detect material misstatements, “whether caused by error or fraud” (Public Company Accounting Oversight Board [PCAOB] 2002a, ¶ 02). However, it is important that auditors are able to differentiate between these two causes of an identified misstatement, as this distinction has far-reaching consequences for the performance of the audit.1 Accordingly, auditing standards require auditors to consider whether identified misstatements may have resulted from an intentional act and, thus, are indicative of fraud (PCAOB 2010, ¶ 20–22). Unfortunately, if client managers choose methods of perpetrating fraud that appear less intentional on the surface, the ability of auditors to effectively evaluate the intentionality of identified misstatements may be compromised.

There are two primary methods by which an intentional misstatement can be achieved: “misrepresentation in or intentional omission from the financial statements” (PCAOB 2002b, ¶ 06). That is, when committing fraud, a client manager can either choose to actively misrepresent, alter, and/or falsify information contained within the financial statements and supporting documents (e.g., record a fictitious sale or capitalize a valid expense) or omit, through inaction, a necessary transaction or piece of information (e.g., fail to record an incurred expense or a valid sales return). Archival evidence suggests most frauds are perpetrated via active forms of misrepresentation, such as recording fictitious sales and recognizing revenues prematurely, while far fewer frauds are perpetrated by omitting necessary transactions (e.g., omitting expenses and liabilities) (e.g., Dechow, Ge, Larson, and Sloan 2011; Beasley, Carcello, Hermanson, and Neal 2010). However, this characterization of fraud seems inconsistent with psychology theory, which indicates that individuals prefer to bring about morally objectionable outcomes via omission (i.e., inaction) as opposed to commission (i.e., action) (e.g., Ritov and Baron 1999; Baron and Ritov 2004; DeScioli, Christner, and Kurzban 2011b).2 In this paper, we examine whether financial reporting managers perpetrate fraud using an “omission strategy” (DeScioli et al. 2011b). We also examine auditors' perceptions of misstatements resulting from omission compared to a more active form of commission. Theory from psychology suggests auditors may be inclined to believe a misstatement resulting from omission is unintentional (i.e., due to error rather than fraud) (e.g., Spranca, Minsk, and Baron 1991). Obtaining results consistent with these expectations would suggest the frequency with which fraud is perpetrated via omission may be greater than previously thought, but it may go undiagnosed due to auditors' tendency to view omissions as unintentional errors.

To test our predictions, we initially use a pair of experiments—one with experienced financial reporting managers, the other with professional auditors. We provide both sets of participants with similar case materials, presented from two different perspectives. Specifically, we present manager participants with potential methods available for perpetrating fraud and ask them to select the preferred method. Auditor participants receive one of these same fraud methods, but presented as an identified misstatement (with no explicit indication that it is fraudulent), and are asked to evaluate the likelihood that the misstatement was caused intentionally by client management. This dual-study design allows us to examine managers' chosen fraud strategies and auditors' perceptions of these strategies, which provides unique insights regarding the ability of client managers to conceal fraud from the auditor.

In our initial pair of experiments, we manipulate the nature of the client action (or inaction) that causes the misstatement by varying two facts about the misstatement. First, we manipulate whether the misstatement relates to the improper omission of an expense transaction from the financial statements or the improper recording of a revenue transaction—both of which cause earnings to be overstated for the period.3 Second, we manipulate whether a supporting document omits relevant information about the transaction or contains information that misrepresents the true nature of the transaction, causing the accounting department to record the transaction incorrectly. Consistent with our expectations, we find that managers choose to perpetrate fraud by omitting the expense transaction as opposed to misrecording the revenue transaction. Furthermore, when fraud can be achieved by manipulating information within a supporting document, managers choose to omit relevant information from the document rather than misrepresent information. Importantly, we find that auditors judge a misstatement as less likely to be intentional and are less likely to take further action (e.g., collect additional evidence) when the misstatement involves omission (i.e., an omitted transaction or information omitted from a supporting document) compared to a more active form of manipulation.

In this initial pair of studies, the omitted transaction is always an expense, while the misrecorded transaction is always a revenue. Therefore, we conduct a third experiment, using auditor participants, that disentangles the effects of the (in)action that caused the misstatement (omitting versus misrecording a transaction) from the account involved (expense versus revenue).4 We find that when evaluating a misstatement within the revenue cycle, auditors believe the misstatement is significantly less likely to be intentional and are less likely to report the misstatement as suspicious to a supervisor when it involves an omitted transaction compared to a misrecorded transaction. Within the expense cycle, we find the nature of the misstated transaction (omitted or misrecorded) has no influence on auditors' intentionality judgments; however, auditors are significantly less likely to pursue additional evidence about the misstatement when it results from an omitted transaction compared to a misrecorded transaction. These results suggest that while auditors may respond differently based on the account involved (revenue or expense), their responses exhibit less skepticism when a misstatement involves an omitted versus misrecorded transaction.

Our study makes several important contributions to the audit literature, as well as to audit practice and policy. Prior studies that examine both sides of strategic auditor-client interactions have generally used abstract experimental laboratory settings and student participants (e.g., Bloomfield 1997; Zimbelman and Waller 1999; Bowlin 2011; Church, Peytcheva, Yu, and Singtokul 2015). In contrast, our study uses experienced financial reporting managers and auditors, allowing us to provide important insights regarding the strategic knowledge each party possesses about the other, based on their professional experiences interacting in practice.

Furthermore, we extend the audit literature related to fraudulent financial reporting by providing evidence that client managers not only choose fraud strategies that minimize the likelihood of the fraudulent misstatement being detected, but also strategies that minimize the perceived intentionality of the misstatement, if it is detected. While empirical evidence exists regarding the former consideration (i.e., minimizing detection) (e.g., Zimbelman and Waller 1999; Bowlin 2011), our study provides the first evidence that managers attempt to conceal fraud by choosing methods that appear less intentional on the surface. This finding has important implications regarding auditors' ability to detect fraud. While a substantial amount of research has examined how the audit can be planned to maximize the likelihood of detecting fraudulent misstatements (e.g., Asare and Wright 2004; Wilks and Zimbelman 2004; Carpenter 2007; Hoffman and Zimbelman 2009; Hammersley, Johnstone, and Kadous 2011; Simon 2012), one cannot simply assume that a detected misstatement will be correctly judged as fraudulent. Very little evidence exists regarding the factors that influence auditors' evaluations of misstatements, once they have been identified—specifically, factors that may cause a misstatement to be perceived as intentional.5 Our study suggests some frauds may go undiagnosed, not because client managers have effectively concealed their fraudulent misstatements, but because they have effectively concealed their fraudulent intentions.

Our results should also be of interest to practitioners and regulators. Our finding that managers choose to perpetrate fraud through omission suggests that auditors should give greater consideration to misstatements characterized by omission and avoid dismissing them prematurely as unintentional errors. Finally, the results of our study suggest the commonly held belief that fraud is perpetrated more frequently through active forms of manipulation (e.g., recording fictitious or premature revenues, capitalizing expenses, altering documentation) may be overstated. Contrary to this belief, managers in our study were significantly more likely to perpetrate fraud via omission as opposed to a more active form of commission. These results suggest it is at least possible that some managers are perpetrating fraud via omission, but auditors and others may be more inclined to misclassify the resulting misstatements as unintentional errors due to the innocuous appearance of omissions. The implications of this possibility on audit and financial reporting quality warrant the attention of academics, practitioners, and regulators.

The remainder of the paper is divided into four sections. We provide background information in Section II, and then describe our theory, experimental design, and results for the manager experiment and auditor experiments in Sections III and IV, respectively. We conclude the paper in Section V by summarizing the findings and their implications for audit practice and future research.

## II. BACKGROUND

### The Nature of Fraudulent Financial Reporting

The publicity surrounding high-profile frauds, such as Enron and WorldCom, may make it seem as if frauds involving egregious acts and company-wide conspiracies are typical or quintessential. However, many identified instances of fraud (e.g., those described in Accounting and Auditing Enforcement Releases (AAERs)) do not involve high-profile companies or become front-page news. Some of these frauds may even appear relatively harmless on the surface, such as “an aggressive rather than indefensible interpretation of complex accounting rules” or “a temporary misstatement of financial statements … expected to be corrected later...” (PCAOB 2002b, ¶ 06). In fact, auditing standards identify only one key difference between an unintentional error and a fraudulent act: the intent of management when taking the action that leads to the misstatement (PCAOB 2002b, ¶ 05). Accordingly, if the auditor concludes management intended for the financial statements to be misstated, then the misstatement should be considered fraudulent. Unfortunately, assessing whether an identified misstatement was caused intentionally can be challenging (Hamilton 2016), especially when fraud has been perpetrated in a way that appears unintentional on the surface. Nonetheless, any intentional misstatement is concerning, as it may signal a more pervasive issue regarding the integrity of management, even if the magnitude of the misstatement is small (PCAOB 2010, ¶ 22).

### What We (Think We) Know About Fraudulent Financial Reporting

Although it can be difficult to detect fraud, when fraud is detected, it often involves active forms of manipulation (e.g., recording revenues inappropriately), while rarely involving inaction/omission (e.g., omitting incurred expenses). In fact, of the top five categories of common fraud techniques identified in the most recent COSO fraud report, four involve action: (1) recording fictitious revenues, (2) recording revenues prematurely, (3) overvaluing existing assets or capitalizing expenses, and (4) recording fictitious assets or assets not owned. In contrast, only one category is likely to include inaction/omission: understatement of expenses/liabilities (Beasley et al. 2010).6 One explanation for this asymmetry could be that managers perpetrate fraud more frequently by actively manipulating the financial statements. However, we consider a possible alternative explanation: that intentional misstatements are more likely to be recognized as fraudulent when they involve action as opposed to inaction. That is, when fraud is perpetrated via an active form of commission, the resulting misstatements may appear more intentional on the surface, increasing the likelihood that the fraud is ultimately discovered. In contrast, frauds perpetrated via omission may appear less intentional, decreasing auditor skepticism and the likelihood of fraud detection.

## III. STUDY 1: DO MANAGERS EMPLOY AN OMISSION STRATEGY?

### Theory and Hypothesis Development—Study 1

Research in psychology suggests individuals prefer to bring about morally objectionable outcomes through omission (i.e., inaction) compared to commission (i.e., action) (e.g., Ritov and Baron 1999; Baron and Ritov 2004; DeScioli et al. 2011b). For example, poisoning someone (an act of commission) is generally viewed more negatively than intentionally withholding an antidote from someone who has been poisoned (an act of omission), even though the intended consequences are the same (Cushman, Young, and Hauser 2006). Many potential explanations exist for why individuals prefer to bring about harm through omission rather than commission. For example, inaction often results in less regret when a negative outcome occurs (Kahneman and Tversky 1982), and it may be easier to justify the choice of inaction given that the resulting outcome maintains the status quo (Anderson 2003). Furthermore, causing harm through inaction often feels less unethical than doing so via an explicit action (Ritov and Baron 1999).

More recently, researchers have posited that the preference for causing harm by omission rather than commission is a strategic attempt by wrongdoers to avoid third-party condemnation, referred to as the “omission strategy” (DeScioli et al. 2011b). Third-party observers typically condemn others less harshly when harm results from omission compared to commission (Spranca et al. 1991; Kordes-de Vaal 1996; DeScioli, Bruening, and Kurzban 2011a). One reason omissions may be viewed less harshly than commissions is because they make it more difficult for outside observers to know an individual's true intentions (Kordes-de Vaal 1996; DeScioli et al. 2011b). Omissions generally produce less evidence of wrongdoing compared to a physical action and may be easier to “explain away” by claiming the failure to act resulted from being unaware of the circumstances (e.g., “I forgot”). For these reasons, individuals who want to conceal their true intentions are likely to prefer omissions as opposed to acts of commission.

There is substantial evidence within the audit literature that managers act strategically in the perpetration and concealment of fraud in an effort to avoid detection by the auditors (e.g., Bloomfield 1995, 1997; Zimbelman and Waller 1999; Bowlin 2011). For example, in an experimental laboratory setting, Bowlin (2011) finds that managers who anticipate that greater audit resources will be allocated to high-risk accounts choose to perpetrate fraud within lower-risk accounts to avoid detection. While this research suggests managers attempt to conceal their fraudulent misstatements from the auditors, we argue managers also attempt to conceal their fraudulent intentions by perpetrating fraud in ways that will appear less intentional if the underlying misstatement is ultimately detected. Specifically, we expect when managers can achieve an earnings goal by either omitting a transaction from the financial statements or by recording a transaction inappropriately, they will behave consistent with psychology theory and choose the omission strategy.7 Stated formally, our first hypothesis is:

H1:

When manipulating company earnings, managers will be more likely to omit a transaction than to misrecord a transaction.

When perpetrating a fraudulent act, managers not only must decide the type of transaction(s) to manipulate, but also how to carry out and conceal their manipulation. One way to ensure a transaction is accounted for incorrectly is to manipulate a supporting document upon which the transaction is based. For example, a manager could manipulate information on a sales order form to ensure the accounting department records the sale prematurely. Such a manipulation could be accomplished by either omitting relevant information about the nature of the transaction or by providing false information that misrepresents the true nature of the transaction.8 Consistent with theory related to the omission strategy, we predict managers will prefer to omit critical information from a supporting document rather than misrepresent information on the document. Stated formally, our second hypothesis is:

H2:

When manipulating a supporting document, managers will be more likely to omit relevant information from the document than to misrepresent information.

### Study 1 Methodology

#### Participants—Study 1

Fifty-eight corporate managers with financial reporting experience participated in Study 1.9 Demographic data for these managers is provided in Panels A and B of Table 1. Participants were obtained through a combination of personal contacts (32 participants) and a Qualtrics Panel (26 participants).10 On average, participants had 9.06 years of experience working in a financial reporting role. Two-thirds of participants (67.2 percent) reported working for companies with more than 1,000 employees, and more than one-third (36.2 percent) reported working for companies with more than 10,000 employees.11 Participants also had substantial experience interacting with external and/or internal auditors, as indicated by a self-reported measure (see Table 1). Additionally, 72.4 percent of participants had prior experience working as an external and/or internal auditor. The experience level of our participants, both in terms of financial reporting experience and knowledge of the audit process, makes them well-suited for a study that examines how managers strategically perpetrate fraud to conceal it from the auditors.

TABLE 1

Participant Demographics

#### Experimental Materials and Procedures—Study 1

Study 1 consisted of two stages. In the first stage, manager participants read background information about a hypothetical company, Blaze Jewelers Corporation (Blaze), which is approaching its year-end. The case informed participants that Blaze's earnings are likely to fall short of analysts' expectations by just over $1 million, and management is being pressured to “do its part to make sure the company meets its earnings goal.” Participants were then told that Blaze's Corporate Controller has identified two transactions (just over$1 million each) that occurred just before year-end and has decided that one of these transactions should be “slightly manipulated” to allow the company to meet its earnings target. Participants were presented with the two options being considered by the Controller—one that involved omitting a transaction from the financial statements and one that involved recording a transaction inappropriately (i.e., “misrecording a transaction”). Participants finished stage one of the study by answering a series of questions regarding which of the two options the Controller is likely to choose if he does not want the auditors to know he intentionally manipulated earnings.

In stage two, participants were told to assume the Controller had selected one of the two options for manipulating earnings (either omitting or misrecording a transaction, determined by random assignment) and had instructed a Vice President (VP) to make sure the relevant transaction is successfully manipulated, while avoiding detection. Participants then read about two methods the VP could use to manipulate information communicated to the accounting department within a supporting document to ensure the transaction is processed incorrectly. The methods of manipulation available to the VP included (1) omitting relevant information from the form, and (2) misrepresenting information on the form. Participants answered a series of questions regarding which method the VP is likely to choose and ended the study by providing demographic information. Panel A of Figure 1 presents the sequential flow of the experimental procedures.

##### Experimental Flow
FIGURE 1
FIGURE 1

Panel A: Experimental Flow—Study 1: Managers

Panel A: Experimental Flow—Study 1: Managers

Panel B: Experimental Flow—Study 2: Auditors

Panel B: Experimental Flow—Study 2: Auditors

#### Independent Variables—Study 1

Study 1 manipulates two independent variables at two levels: Fraud Method (Omit Transaction or Misrecord Transaction) and Evidence Manipulation (Omit Information or Misrepresent Information). Fraud Method is first presented to participants as a within-subjects variable, in which both options for manipulating earnings are viewed simultaneously.12 The Omit Transaction option relates to advertising expenses that could be deferred (i.e., omitted from the current period), even though the expenses were incurred before year-end. The Misrecord Transaction option relates to a sale that could be recognized prematurely (i.e., recorded in the current period), even though all sales criteria have not been satisfied by year-end.13 See Appendix A for the full wording of the variable manipulations.14

After participants view Fraud Method as a within-subjects variable, we randomly assign them to one of the two Fraud Method conditions. That is, we manipulate between-subjects the type of fraud scheme chosen by the Corporate Controller (Omit Transaction or Misrecord Transaction). In the Omit Transaction condition, we inform participants that the Controller has instructed the VP of Marketing to make sure a portion of advertising expense is improperly deferred. In the Misrecord Transaction condition, we tell participants that the Controller has instructed the VP of Sales to make sure a year-end sale is recorded prematurely.15

Finally, we manipulate Evidence Manipulation within-subjects by presenting participants with two options available to the VP for manipulating information in a supporting document to ensure the accounting department records the transaction incorrectly. The VP can either omit relevant information or misrepresent the nature of the transaction by providing inaccurate information. For the Omit Information option, the VP would omit a critical piece of information from a supporting document, causing the accounting department to be unaware that additional advertising expenses were incurred before year-end (in the Omit Transaction condition) or unaware that a sale made prior to year-end has an outstanding contingency (in the Misrecord Transaction condition). For the Misrepresent Information option, the VP would provide inaccurate information in the supporting document, causing the accounting department to mistakenly believe the company did not incur additional advertising expense before year-end (in the Omit Transaction condition) or believe the sales contingency was satisfied before year-end (in the Misrecord Transaction condition). Appendices B and C provide the full description of each Evidence Manipulation method: Omit and Misrepresent Information for participants assigned to the Omit Transaction and Misrecord Transaction conditions, respectively, as well as a picture of what the resulting Service (or Sales) Order Form would look like under each method.

#### Dependent Variables—Study 1

The dependent variables in Study 1 are (1) preferred method of fraud and (2) preferred method of evidence manipulation. We measured managers' preferred method of fraud by asking participants which option they believe the Corporate Controller would be likely to choose if he does not want the auditors to know he intentionally manipulated company earnings.16 We collected responses on an 11-point scale where 0 was associated with omitting an expense transaction and 10 was associated with misrecording a sales transaction.17 The midpoint of 5 indicated no preference. We measured managers' preferred method of evidence manipulation by asking participants which method they believe the VP would be most likely to choose if he does not want the auditors to think that he intentionally manipulated information on the Sales (Service) Order Form. We collected responses on an 11-point scale with endpoints labeled “0–Definitely Method 1 (omit information)” and “10–Definitely Method 2 (misrepresent information)” and a midpoint of “5–No preference for one or the other.”18

### Study 1 Results

#### Hypotheses Tests—Study 1

H1 predicts managers will choose to perpetrate fraud by omitting a transaction as opposed to misrecording a transaction. Panel A of Table 2 presents results associated with the test of H1 and related supplemental questions, which we discuss in the next section. Recall that we elicited managers' preferred method of fraud using a scale in which lower (higher) values indicate a belief that the Corporate Controller would choose to omit a transaction involving advertising expense (misrecord a transaction involving sales revenue). The mean response on the 0 to 10 scale is 3.12, which is significantly below the scale midpoint of 5 (t57 = −4.76, p < 0.001, one-tailed), indicating a preference for omitting the expense transaction as opposed to misrecording the revenue transaction.19 As an additional test of H1, we dichotomize our dependent variable, based on whether participants responded below or above the scale midpoint. We find that a significantly greater proportion of participants indicate a preference for omitting a transaction (74.1 percent) compared to misrecording a transaction (22.4 percent) (χ2 = 22.23, p < 0.001, one-tailed, untabulated), with the remainder indicating no preference. These results provide support for H1 and suggest that managers view omitting a transaction to be a preferable method of perpetrating fraud, compared to misrecording a transaction.

TABLE 2

Study 1: Managers' Preferred Fraud Strategies and Related Strategic Considerations

H2 predicts managers will choose to manipulate a supporting document by omitting relevant information as opposed to misrepresenting information. Panel B of Table 2 presents results associated with the test of H2 and related supplemental questions, which we discuss in the next section. Recall that we elicited managers' preferred method of evidence manipulation using a scale in which lower (higher) values indicate a belief that the VP would choose to omit (misrepresent) information in a supporting document. The mean response on the 0 to 10 scale is 1.36, which is significantly below the scale midpoint of 5 (t57 = −12.43, p < 0.001, one-tailed), indicating a preference for omitting information as opposed to misrepresenting information.20 As an additional test of H2, we dichotomize our dependent variable based on whether participants responded below or above the scale midpoint. We find a significantly greater proportion of participants prefer to omit information (93.1 percent) than to misrepresent information (5.2 percent) (χ2 = 213.98, p < 0.001, one-tailed, untabulated), with the remainder indicating no preference. These results provide support for H2 and suggest managers view omission to be a preferable method for manipulating audit evidence compared to misrepresentation.

#### Supplemental Analyses—Study 1

H1 and H2 are based on our expectation that managers choose methods of perpetrating fraud that are (1) less likely to be detected and (2) less likely to be judged as intentional if they are detected. To provide evidence that the managers in our study considered one or both of these factors, we asked participants a series of questions based on theory related to the preference for omission. Results appear in Table 2. Panel A of Table 2 focuses on managers' strategic considerations when selecting a fraud method (omitting a transaction or misrecording a transaction), while Panel B focuses on strategic considerations related to the manipulation of audit evidence (omitting information or misrepresenting information).

In Panel A of Table 2, we present a series of one-sample t-tests comparing participants' mean response (measured on a 0 to 10 scale where 0 is associated with omitting an expense transaction and 10 is associated with misrecording a revenue transaction) to the neutral scale midpoint of 5. We find that managers believe auditors are more likely to detect the misstatement if it involves a misrecorded transaction compared to an omitted transaction (p < 0.001, one-tailed). With regard to how managers think auditors will perceive each type of misstatement, if detected, managers indicate that the misrecorded transaction is more likely to be perceived as intentional and to raise auditors' suspicions compared to the omitted transaction (both p-values < 0.001, one-tailed). Managers also believe the omitted transaction will be easier to explain away compared to the misrecorded transaction (p = 0.035, one-tailed). In addition to these strategic considerations, we also find that managers believe it is more unethical to misrecord a transaction than to omit a transaction (mean of 6.31 > 5, t57 = 3.84, p < 0.001, one-tailed, untabulated).

In Panel B of Table 2, we present a series of one-sample t-tests comparing participants' mean response (on a 0 to 10 scale where 0 is associated with omitting information from a supporting document and 10 is associated with misrepresenting information) to the neutral scale midpoint of 5. We find that managers believe auditors are more likely to detect the manipulation of audit evidence when it involves misrepresented information as opposed to omitted information (p < 0.001, one-tailed). With regards to how managers think auditors will perceive the manipulation, if it is detected, managers believe misrepresenting information is more likely to be perceived as intentional and raise auditors' suspicions compared to omitting information (both p-values < 0.001, one-tailed). Managers also believe that misrepresenting information will leave behind more physical evidence and will be harder to explain away compared to omitting information (both p-values < 0.001, one-tailed). We also find managers believe the manipulation of audit evidence is more unethical when it involves misrepresenting information compared to omitting information (mean of 7.47 > 5, t57 = 6.43, p < 0.001, one-tailed, untabulated).

These supplemental results are consistent with our theory, which suggests managers choose omissions strategically because they believe omissions will appear less intentional to third party observers (e.g., auditors). We also find that managers believe omissions are less likely to be detected in the first place and are less unethical compared to more active forms of fraud.

## IV. STUDIES 2 AND 3: ARE AUDITORS SUSCEPTIBLE TO THE OMISSION BIAS?

### Theory and Hypothesis Development—Studies 2 and 3

Given the findings of Study 1—that managers choose to perpetrate fraud through omission rather than commission—an important related question is whether auditors are less skeptical of misstatements resulting from omission compared to commission. While most of the audit literature related to fraud detection has examined auditors' fraud-related audit planning judgments (e.g., Wilks and Zimbelman 2004; Carpenter 2007; Hoffman and Zimbelman 2009; see also Hammersley [2011] for a review of the fraud planning literature), it cannot be assumed that once a fraudulent misstatement is identified, it will be accurately evaluated as fraudulent.

Psychology research provides evidence that third-party observers often are susceptible to an “omission bias” wherein they perceive omissions as less intentional and less blameworthy than acts of commission (Anderson 2003; Cushman et al. 2006; DeScioli et al. 2011b). Importantly, omissions are judged less harshly, even when omission and commission result in identical outcomes (e.g., Spranca et al. 1991; Kordes-de Vaal 1996).21 Omissions are perceived as less intentional because they provide no indication that a choice was made, making the actor's intentions unclear (Kordes-de Vaal 1996; DeScioli et al. 2011a). That is, it is unclear whether inaction was chosen or resulted from being unaware that action was needed. If a manager fails to record a sales return, for example, it is unclear whether the manager intended to overstate revenues or simply forgot to record the transaction. In contrast, a manager who records revenue prematurely took an observable and inappropriate action, making it appear more intentional.

Accordingly, we predict auditors will judge identified misstatements as less likely to be intentional when they result from omission compared to a more active form of commission. Specifically, we predict auditors will judge a misstatement as less likely to be intentional when it relates to a transaction that was improperly omitted from the financial statements compared to a transaction that was recorded inappropriately. Stated formally, our third hypothesis is:

H3:

Auditors will judge an identified misstatement as less likely to be intentional when it involves an omitted transaction compared to a misrecorded transaction.

When a misstatement is identified, auditors typically review supporting documents associated with the transaction in question (e.g., sales order forms, invoices, contracts). Such supporting audit evidence can provide auditors with information about how the misstatement occurred and the client actions (or inaction) that led to the misstatement. According to auditing standards, “Fraud may be concealed by withholding evidence or misrepresenting information … ” (PCAOB 2002b, ¶ 09). As such, the omission bias may also be relevant to how auditors perceive inaccuracies in the audit evidence underlying an identified misstatement. Specifically, we expect auditors will judge a misstatement as less likely to be intentional when a supporting document omits relevant information compared to when the document contains information that misrepresents the nature of the transaction. Stated formally, our fourth hypothesis is:

H4:

Auditors will judge an identified misstatement as less likely to be intentional when it results from an omission of relevant information from a supporting document compared to a misrepresentation of relevant information.

### Study 2 Methodology

#### Participants—Study 2

Participants in Study 2 consisted of 108 auditors with an average of 6.80 years of audit experience.22 We provide demographic data for the auditor participants in Panels C and D of Table 1. The majority of participants were from global public accounting firms (62 percent), while remaining participants came from a mixture of national, regional, and local firms. We obtained participants primarily through our network of professional contacts, and they completed the study online using Qualtrics.23,24 Participants with this level of audit experience are appropriate for a study involving the initial evaluation of an identified misstatement. When asked how frequently they evaluate misstatements in practice (on a scale ranging from “0–Never” to “10–Always”), participants indicated a mean response of 6.68, which is significantly above the scale midpoint (t107 = 6.49, p < 0.001, untabulated) and suggests a sufficiently high level of task experience.

#### Experimental Materials and Procedures—Study 2

Auditors received case materials that were similar to those provided to manager participants. The auditors read about the same hypothetical company, Blaze Jewelers, and assumed the role of an auditor engaged in the year-end audit of Blaze. We informed participants that the audit team had identified a misstatement, and it was their responsibility to obtain an understanding of how it occurred and to determine whether additional actions are needed. The misstatement fell below all quantitative materiality thresholds; however, its correction “would cause the company to miss analysts' fourth quarter consensus EPS forecast.” We varied the nature of the misstatement between subjects, so participants learned about either an omitted transaction or a misrecorded transaction, each described in more detail in the next section.

After learning about the identified misstatement, we told participants they had decided to speak with the accounting clerk who processed the transaction in question. At the end of the conversation, the clerk provides an important piece of audit evidence—a supporting document related to the misstated transaction. Participants received a document that either omitted relevant information about the transaction or included information that misrepresented certain details about the transaction, each described in more detail in the next section.

After reading about the misstatement, discussing it with the accounting clerk, and viewing the related audit evidence, we asked participants a series of questions regarding their initial impressions of and responses to the identified misstatement. Participants ended the experiment by answering manipulation check questions and providing demographic information. Panel B of Figure 1 presents the sequential flow of the experimental procedures.

#### Independent Variables—Study 2

Study 2 uses a 2 × 2 between-subjects design, in which we vary Misstatement Method (Omitted Transaction or Misrecorded Transaction) and Audit Evidence Inaccuracy (Omitted Information or Misrepresented Information). We manipulated Misstatement Method by varying the description of the identified misstatement. In the Omitted Transaction condition, the misstatement results from the company's failure to record a portion of advertising expense incurred during the year. In the Misrecorded Transaction condition, the misstatement results from the company recognizing revenue on a sale, even though the sale involved a contingency that was not satisfied until the following year. (See Appendix D for the full description of the misstatements.) Importantly, these misstatements were the same two methods available to manager participants for perpetrating fraud in Study 1. By presenting them to auditors as identified misstatements (with no explicit indication that they are fraudulent), we are able to evaluate how managers' fraud strategies are evaluated by auditors once they are detected.

We manipulated Audit Evidence Inaccuracy by varying the nature of information (or the lack thereof) communicated to the accounting department within a company form. In all conditions, the informational inaccuracy causes the accounting department to process the transaction incorrectly—either causing them to improperly defer an expense (in the Omitted Transaction condition) or to record a sale prematurely (in the Misrecorded Transaction condition). Specifically, in the Omitted Information condition, relevant information is missing from the form, which leaves the accounting department unaware of certain facts about the transaction (e.g., unaware that a sales contingency exists). In the Misrepresented Information condition, the form contains inaccurate information, which causes the accounting department to form incorrect beliefs about the status of the transaction (e.g., to believe the sales contingency was satisfied before year-end). The forms provided to auditor participants are the same ones given to managers in Study 1, allowing us to examine how auditors judge managers' chosen methods of manipulating audit evidence. (See Appendices B and C to view pictures of the manipulated forms in the Omitted and Misrecorded Transaction conditions, respectively.)

#### Dependent Variable—Study 2

For our primary dependent variable, auditors provided a preliminary evaluation of the intentionality of the identified misstatement. Specifically, auditors assessed the likelihood that the VP intentionally manipulated information in the Sales (or Service) Order Form to ensure the transaction was recorded incorrectly. We collected responses on an 11-point scale with endpoints “0–Very Unlikely” and “10–Very Likely.”25 We also asked auditors how they would respond to the misstatement. Specifically, we asked their likelihood of pursuing additional evidence about the misstatement and their likelihood of reporting the misstatement as suspicious to their supervisor (collected on 11-point scales where 0 = “Not at all likely” and 10 = “Very likely”).

### Study 2 Results

#### Manipulation Checks—Study 2

We asked auditor participants two manipulation check questions to ensure they attended to our experimental manipulations. First, we asked whether the misstatement described in the case had caused revenues to be overstated or expenses to be understated. One-hundred-six participants (98.1 percent) correctly answered this question. Next, we asked whether the VP had failed to provide certain information within the Sales/Service Order Form or had provided inaccurate information. One-hundred-five participants (97.2 percent) correctly answered this question. Excluding participants who failed a manipulation check question does not change our results; therefore, we include all participants in the analyses that follow.

#### Hypotheses Tests—Study 2

H3 predicts auditors will judge a misstatement as less likely to be intentional when it involves an omitted transaction compared to a misrecorded transaction. Panel A of Table 3 provides adjusted least squares (LS) means for the dependent variable across conditions, and Panel B provides an ANCOVA that includes Misstatement Method and Audit Evidence Inaccuracy as independent variables and years of audit experience (Audit Experience) as a covariate.26 Consistent with H3, we find a significant main effect for Misstatement Method (F1, 103 = 6.95, p = 0.010). The direction of the LS means in Panel A of Table 3 suggests auditors judge a misstatement as less likely to be intentional when it involves an omitted transaction (LS mean = 6.03) compared to a misrecorded transaction (6.94) These results provide support for H3.

TABLE 3

Study 2: Effect of Misstatement Method and Audit Evidence Inaccuracy on Auditors' Judged Likelihood of Intentional Misstatement

We also asked auditors how they would respond to the misstatement (i.e., their likelihood of pursuing additional evidence and reporting the misstatement to their supervisor). In untabulated analyses, we find auditors are significantly less likely to pursue additional evidence about the misstatement when it results from an Omitted Transaction (mean = 7.98) compared to a Misrecorded Transaction (8.94) (t106 = 2.33, p = 0.011, one-tailed). They are also less likely to report the misstatement as suspicious to a supervisor when it involves an Omitted Transaction (mean = 8.34) compared to a Misrecorded Transaction (9.18) (t106 = 2.16, p = 0.016, one-tailed). These results suggest auditors not only evaluate an omitted transaction with less skepticism than a misrecorded transaction (as predicted in H3), but they also respond with less skeptical actions.

H4 predicts auditors will judge a misstatement as less likely to be intentional when it results from a client manager omitting relevant information from supporting audit evidence compared to misrepresenting information. As predicted, we find a significant main effect for Evidence Inaccuracy (F1, 103 = 4.36, p = 0.039). The direction of the LS means reported in Panel A of Table 3 suggests auditors evaluate a misstatement with less skepticism when it results from a client manager omitting information from a supporting document (LS mean = 6.12) compared to misrepresenting information (6.85). These results provide support for H4.

With regards to how auditors respond to inaccuracies within audit evidence, we find auditors are less likely to pursue additional evidence about a misstatement when information has been Omitted from a supporting document (mean = 8.11) versus Misrepresented (8.75), (t106 = 1.55, p = 0.062, one-tailed, untabulated). However, auditors are no more likely to report the misstatement to a supervisor when supporting audit evidence contains Omitted Information (mean = 8.56) versus Misrepresented Information (8.91) (t106 = 0.87, p = 0.193, one-tailed, untabulated). These results suggest that when relevant information is omitted from audit evidence, auditors not only evaluate the resulting misstatement with less skepticism (as predicted in H4), but they also respond with less skeptical action (i.e., they are less inclined to pursue additional evidence) compared to when a document contains misrepresented information.

### Study 3 Methodology

In Study 2, the omitted transaction is always an expense, while the misrecorded transaction is always a revenue. Because of this design, we are unable to conclude whether the main effect for Misstatement Method is driven by the belief that misstatements involving an omitted transaction are unintentional, by the belief that misstatements involving expenses are unintentional, or both. To provide evidence regarding the underlying construct driving results associated with H3, we design an experiment that fully crosses the account in which the misstatement occurred (expense or revenue) with the (in)action that caused the misstatement (omitting or misrecording a transaction).

Participants consisted of 107 auditors obtained through the Center for Audit Quality (CAQ) Access to Audit Personnel Program.27 Seven large public accounting firms participated in the study, and participants averaged 3.71 years of audit experience. When asked how frequently they evaluate identified misstatements in practice (on a scale ranging from “0–Never” to “10–Always”), participants indicated a mean response of 5.76, which is significantly above the scale midpoint (t106 = 3.04, p = 0.003, untabulated) and suggests a sufficiently high level of task experience.

Similar to Study 2, we provided auditor participants with a description of a misstatement and asked them to evaluate the likelihood that company management intentionally manipulated the transaction to overstate earnings (on a scale ranging from “0–Very Unlikely” to “10–Very Likely”). We manipulated the description of the misstatement on a between-subjects basis by varying the Account involved (Expense or Revenue) and the Method by which the misstatement occurred (Omitted Transaction or Misrecorded Transaction). This design creates four conditions: Omitted Expense, Misrecorded Expense, Omitted Revenue, and Misrecorded Revenue. In the Omitted Expense condition, repair and maintenance expense was improperly omitted from the financial statements, while in the Misrecorded Expense condition, repair and maintenance expense was misclassified as a capital improvement. In the Omitted Revenue condition, a sales return was improperly omitted from the financial statements, while in the Misrecorded Revenue condition, revenue was recorded before all sales criteria were satisfied. In all instances, the correction of the misstatement, which falls below quantitative materiality thresholds, would cause the company to miss analysts' fourth quarter EPS forecast.

### Study 3 Results

Table 4 presents the results of Study 3.28 Panel A provides adjusted LS means, and Panel B provides an ANCOVA that includes Account and Method as independent variables. We also find that years of audit experience (Audit Experience) significantly interacts with Method, and as such, we include Audit Experience and the Audit ExperienceMethod interaction term in our model. The nature of this Audit ExperienceMethod interaction suggests less-experienced auditors are more susceptible to the omission bias—that is, they are more inclined to believe an omitted transaction is unintentional compared to more-experienced auditors.29

TABLE 4

Study 3: Effect of Account and Method on Auditors' Judged Likelihood of Intentional Misstatement

As shown in Panel B of Table 4, we find a significant main effect for both Account (F1, 101 = 7.24, p = 0.008) and Method (F1, 101 = 5.42, p = 0.022), suggesting auditors judge the intentionality of a misstatement differently depending on whether the misstatement occurs within an Expense or Revenue account and whether it involves an Omitted or Misrecorded Transaction. The direction of the LS means in Panel A of Table 4 suggests auditors judge a misstatement as less likely to be intentional when it involves Expense (LS mean = 5.55) compared to Revenue (6.46) and when it results from an Omitted Transaction (LS mean = 5.86) compared to a Misrecorded Transaction (6.15). This significant main effect for Method provides further support for H3.

After performing a series of untabulated simple effects tests, we find the main effects for Account and Method are driven primarily by one type of misstatement that auditors judge as more likely to be intentional than all other misstatements included in our study: a Misrecorded Revenue.30 Most importantly, we find that, consistent with H3, auditors judge an Omitted Revenue (LS mean = 6.13) as significantly less likely to be intentional compared to a Misrecorded Revenue (6.79) (t101 = 2.51, p = 0.007, one-tailed).31 That is, when auditors identify a misstatement within the revenue cycle, they are less skeptical of the misstatement when it involves an omitted transaction compared to a misrecorded transaction. In contrast, we do not find support for H3 within the Expense condition (i.e., the means in Panel A of Table 4 are in the direction opposite of our prediction). Rather, when auditors identify a misstatement in the expense cycle, their intentionality judgments remain relatively low regardless of whether the misstatement resulted from an omitted or misrecorded transaction.

Next, we examine (in untabulated analyses) whether auditors take different actions depending on the nature of the misstatement. Similar to Study 2, we asked auditors their likelihood of pursuing additional evidence about the misstatement and their likelihood of reporting it as suspicious to a supervisor (both measured on 11-point scales where 0 = “Not at all likely” and 10 = “Very likely”). Recall that within the Expense condition, we did not find support for H3—that is, auditors' intentionality judgments do not differ based on the nature of the misstated transaction (omitted or misrecorded). Consistent with this finding, we also find auditors' likelihood of reporting an expense-related misstatement to a supervisor does not differ between the Omitted Transaction (mean = 8.12) and Misrecorded Transaction (8.04) conditions (t50 = 0.13, p = 0.553, one-tailed). Nonetheless, we find that in the Expense condition, auditors are significantly less likely to pursue additional evidence about a misstatement when it involves an Omitted (mean = 7.72) compared to a Misrecorded Transaction (8.81) (t50 = 1.86, p = 0.035, one-tailed).

Recall that within the Revenue condition, we found support for H3—auditors judge an Omitted Transaction as less likely to be intentional than a Misrecorded Transaction. Consistent with this result, we further find that auditors are significantly less likely to report a revenue-related misstatement to a supervisor when it involves an Omitted Transaction (mean = 8.69) compared to a Misrecorded Transaction (9.42) (t46 = 1.71, p = 0.047, one-tailed, adjusted for unequal variance using the Satterthwaite procedure). In contrast, auditors' likelihood of pursuing additional evidence about a revenue-related misstatement does not differ significantly for an Omitted (mean = 8.66) versus Misrecorded Transaction (9.08) (t49 = 1.08, p = 0.144, one-tailed, adjusted for unequal variance using the Satterthwaite procedure).

In summary, we find evidence in Study 3 that auditors display reduced skepticism in response to misstatements involving an omitted versus misrecorded transaction. Furthermore, our results suggest this reduced skepticism occurs within both the expense and revenue cycles, but takes different forms depending on the account involved. Specifically, within the revenue cycle, auditors judge an omitted transaction as less likely to be intentional than a misrecorded transaction, and as such, they are less likely to report the omitted revenue transaction as suspicious to their supervisor. While these same results are not obtained in the Expense condition, we find that auditors are significantly less likely to pursue additional evidence about a misstatement when it involves an expense transaction that was omitted versus misrecorded. This latter result may suggest that auditors are relatively reluctant to judge a misstatement of expense as intentional and report it to a supervisor without first obtaining more convincing evidence; however, the likelihood of auditors obtaining such evidence is significantly reduced when the misstatement involves omission.

#### Supplemental Analyses—Study 3

To further validate the findings from both auditor studies, Study 3 also provided participants with a list of ten misstatements, four that involved an omitted transaction (e.g., “Not recording a sales discount provided to a customer”) and four that involved a misrecorded transaction (e.g., “Recording a sale before it has shipped to a customer”). The two remaining misstatements related to footnote disclosures required by GAAP in which (1) relevant information had been omitted and (2) information about the company's financial position and operations had been misrepresented. Participants provided their initial impression of whether each misstatement was likely to be intentional on a scale ranging from “0–Definitely Unintentional” to “10–Definitely Intentional.” We averaged participants' responses to the four misstatements involving an omitted transaction and to the four involving a misrecorded transaction. Consistent with previous results related to H3, we find auditors believe omitted transactions (mean = 4.68) are less likely to be intentional than misrecorded transactions (5.60) (t106 = 7.77, p < 0.001, one-tailed, untabulated). We also find that auditors believe the omission of information from a footnote (mean = 3.84) is less likely to be intentional than the inclusion of information that misrepresents company performance (6.20) (t106 = 9.53, p < 0.001, one-tailed, untabulated). This latter result is consistent with earlier findings related to H4, which suggest auditors are less skeptical of omitted information compared to misrepresented information.

## V. DISCUSSION AND CONCLUSIONS

To detect fraudulent financial reporting, auditors not only must identify a misstatement, but also correctly conclude—initially or following additional investigation—that the misstatement resulted from an intentional act. Therefore, it is imperative that auditors are able to effectively judge the likelihood that an identified misstatement was caused intentionally. Unfortunately, this ability may be compromised if managers strategically choose methods of perpetrating fraud that appear less intentional on the surface.

In this study, we examine whether managers choose to perpetrate fraud using an “omission strategy” and whether auditors are less skeptical of misstatements that result from omission compared to a more active form of commission. Through a series of experiments—one with financial reporting managers and two with auditors—we examine two methods by which omissions could be used to perpetrate and conceal fraud: (1) by omitting a transaction from the financial statements, and (2) by omitting information from a supporting document. In Study 1, we find that managers choose to perpetrate fraud by omitting an expense transaction rather than misrecording a revenue transaction. Managers also choose to commit the fraud by omitting relevant information from a supporting document rather than misrepresenting the nature of the transaction. In Study 2, we find that auditors judge a misstatement as less likely to be intentional when it involves omission (i.e., an omitted expense transaction or information omitted from a supporting document) compared to a more active form of manipulation. Taken together, these results suggest the methods of fraud likely to be chosen by managers are also the methods auditors are unlikely to judge as fraudulent.

Because the omitted transaction in Studies 1 and 2 is always an expense and the misrecorded transaction is always a revenue, we conduct a third study, with auditor participants, that disentangles the relative effects of the (in)action that caused the misstatement (omitted versus misrecorded transaction) and the account involved (expense versus revenue). Consistent with previous results, we find in Study 3 that auditors exhibit reduced skepticism in response to omitted transactions compared to misrecorded transactions. While the nature of this reduced skepticism differs based on the account involved (revenue or expense), in all instances, auditors respond in a less skeptical manner to misstatements resulting from omission.

Our study contributes to the literature on fraudulent financial reporting and its detection by auditors. While prior research demonstrates that managers attempt to conceal their fraudulent misstatements (e.g., Zimbelman and Waller 1999; Bowlin 2011), our study suggests managers also attempt to conceal their fraudulent intentions by perpetrating fraud in ways that will appear less intentional if the resulting misstatement is identified. Similarly, the audit literature related to fraud detection has primarily focused on auditors' ability to identify fraudulent misstatements (e.g., via fraud risk assessments and planning procedures) (e.g., Wilks and Zimbelman 2004; Carpenter 2007). However, it cannot be assumed that once a misstatement is identified, it will be accurately evaluated as fraudulent. Therefore, we extend the audit literature by examining factors that influence auditors' evaluations of identified misstatements—specifically, factors that cause a misstatement to be perceived as more or less intentional.

Our research findings should also be of interest to audit practitioners and regulators. While auditing standards require auditors to consider whether identified misstatements may have been caused intentionally (PCAOB 2010, ¶ 20–22), little evidence exists regarding the effectiveness of these evaluations. Our study suggests that when managers use an omission strategy, auditors are inclined to dismiss the resulting misstatements as unintentional. As such, auditors would benefit from additional education and training that increases their awareness of this fraud strategy and encourages them to be more skeptical of misstatements characterized by omission.

Our finding that managers choose to perpetrate fraud by omitting expense transactions may seem inconsistent with archival fraud data (e.g., AAERs) that suggest most frauds involve the improper recording of revenues. However, results from our auditor studies can help to explain this apparent inconsistency. Specifically, our studies suggest that in addition to misrecording revenues, managers may also be perpetrating fraud by omitting expenses (as suggested by Study 1), but fewer of these omissions are identified as fraudulent because auditors are more likely to dismiss omissions as unintentional errors (as suggested by Studies 2 and 3). It is also worth noting that we find evidence in Study 3 that auditors are less skeptical of expense misstatements than revenue misstatements. This may further help to explain why most identified frauds involve revenues that were recorded inappropriately, while far fewer involve omitted expenses—namely, auditors may believe certain types of misstatements (e.g., those involving omissions and/or expenses) are unlikely to be fraudulent. More research is needed to understand the extent to which managers are perpetrating fraud—and successfully concealing it (e.g., from auditors, jurors, and regulators)—via methods that appear unintentional on the surface.

Our study is subject to inherent limitations that should be considered when evaluating these findings. While we find in Study 1 that managers choose to perpetrate fraud by omitting expenses as opposed to misrecording revenues, we are unable to determine whether this choice is driven more by the account involved (expense versus revenue) or the (in)action required (omitting versus misrecording a transaction). Future research is needed to separate these effects and to better understand the ways in which managers perpetrate fraud in an effort to make the resulting misstatements appear less intentional. Additionally, Studies 2 and 3 assume the misstatement was already detected by the auditors. As such, our studies cannot determine whether a misstatement characterized by omission or commission is more likely to be detected in the first place. We find evidence in Study 1 that managers believe omissions are less likely to be detected, but additional research is needed to test whether this is, in fact, the case. If omissions are both (1) less likely to be detected and (2) less likely to be judged intentional if detected, the implications of the omission strategy may be more pronounced than our study suggests.

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### APPENDIX A

#### Study 1: Within-Subjects Manipulation of Fraud Method(Omit Transaction versus Misrecord Transaction)

As fiscal 2015 draws to a close for Blaze, the Corporate Controller—James Nelson—realizes that the company's annual earnings are likely to fall short of analysts' expectations by just over $1 million … James is aware of two large transactions (just over$1 million each) that recently occurred and realizes that Blaze could meet its earnings target if one of these two transactions were to be slightly manipulated. James must now decide which transaction to manipulate, while avoiding detection. The two options he is considering are as follows:

##### Option 2—Record Revenue Prematurely

A large sale of loose diamonds occurred during the month of December. Although the goods have already been delivered to the customer, the sale is contingent on the customer obtaining an independent appraisal and source verification (e.g., to ensure the diamonds are not illegal “blood diamonds”). Unfortunately, because of the holidays, the appraisal and source verification cannot be obtained until 2016. Because the sales contingency has not been satisfied, Blaze should not recognize revenue on the sale during 2015. However, if James were to instruct the VP of Sales to go ahead and record the revenue in 2015, the company could meet its earnings target.

### APPENDIX B

#### Study 1: Within-Subjects Manipulation of Evidence Manipulation(Omit versus Misrepresent Information)for Participants in the Omit Transaction Condition

Assume [the Corporate Controller] chose Option 1 (Understating Expense) and instructs the VP of Marketing, Martin Cobalt, to make sure the additional advertising expenses incurred in 2015 are improperly deferred, while avoiding detection by the external auditors or anyone else. You will now read about two methods Martin could use to manipulate information communicated to the accounting department to ensure they improperly defer the recognition of additional advertising expenses until 2016. Both methods relate to information that should appear in the final section of a Service Order Form. This section is normally left blank (for routine transactions) and is only filled out when non-standard service terms or contingencies exist.

• Method 1: Omit from the Service Order Form any information indicating that the advertising agreement authorizes the purchase of additional advertising services, if needed.

• If the VP of Marketing does not mention that additional advertising services will be purchased if holiday sales projections fail to reach a target amount, the accounting department will be unaware that additional expenses may be incurred and will mistakenly believe that only the standard amount of advertising expense should be recorded when the ad agency provides services in December 2015. As a result, the additional advertising expenses—which were incurred in December to help address meager holiday sales projections—will be improperly deferred until 2016. If this method is chosen, the VP of Marketing would leave the final section of the Service Order Form (which is only filled out when special service terms or contingencies exist) blank. The bottom of the Form would appear as follows when it is submitted to the accounting department:

• Method 2: Misrepresent information on the Service Order Form to indicate that additional advertising services did not need to be purchased in December 2015.

• If the VP of Marketing indicates that holiday sales projections have exceeded the target amount, the accounting department will mistakenly believe that additional advertising services were not purchased and that only the standard amount of advertising expense should be recorded when the ad agency provides services in December 2015. As a result, the additional advertising expenses—which were incurred in December to help address meager holiday sales projections—will be improperly deferred until 2016. If this method is chosen, the VP of Marketing would fill out the final section of the Service Order Form (related to the existence of special service terms and contingencies), but would misrepresent the status of the holiday sales projections by indicating that they were sufficiently high and did not require the purchase of additional advertising services. The bottom of the Form would appear as follows when it is submitted to the accounting department:32

### APPENDIX C

#### Study 1: Within-Subjects Manipulation of Evidence Manipulation(Omit versus Misrepresent Information)for Participants in the Misrecord Transaction Condition

Assume [the Corporate Controller] chose Option 2 (Overstating Revenue) and instructs the VP of Sales, Martin Cobalt, to make sure the sale of loose diamonds gets recorded prematurely, while avoiding detection by the external auditors or anyone else. You will now read about two methods Martin could use to manipulate information communicated to the accounting department to ensure they prematurely record the sale of loose diamonds in 2015. Both methods relate to information that should appear in the final section of a Sales Order Form. This section is normally left blank (for routine transactions) and is only filled out when non-standard sales terms or contingencies exist.

• Method 1: Omit from the Sales Order Form any information indicating that the sales agreement requires an appraisal and source verification to be completed.

• If the VP of Sales does not mention that the sale is contingent on obtaining a satisfactory appraisal and source verification, the accounting department will be unaware of these sales criteria and will mistakenly believe the sales revenue should be recorded when the diamonds ship to the customer in December 2015. As a result, the sale of loose diamonds—which were not appraised and verified until 2016—will be improperly recorded as a 2015 sale. If this method is chosen, the VP of Sales would leave the final section of the Sales Order Form (which is only filled out when special sales terms or contingencies exist) blank. The bottom of the Form would appear as follows when it is submitted to the accounting department:

• Method 2: Misrepresent information on the Sales Order Form to indicate that the appraisal and source verification were completed in December 2015.

• If the VP of Sales indicates that a satisfactory appraisal and source verification were completed in 2015, the accounting department will mistakenly believe that all sales criteria have been met and that the sales revenue should be recorded when the diamonds ship to the customer in December 2015. As a result, the sale of loose diamonds—which were not appraised and verified until 2016—will be improperly recorded as a 2015 sale. If this method is chosen, the VP of Sales would fill out the final section of the Sales Order Form (related to the existence of special sales terms and contingencies), but would misrepresent the status of the sales contingency requirements by indicating that the appraisal and source verification were completed and all sales criteria have been met. The bottom of the Form would appear as follows when it is submitted to the accounting department:33

### APPENDIX D

#### Study 2: Manipulation of Misstatement Method

##### Omitted Transaction Condition

During the testing of accounts payable (A/P), the audit team discovered a misstatement in the amount of $1,237,000 that relates to a purchase of advertising services made during the month of December 2015. The issue was identified relatively late in the audit process when an advertising agency disputed the amount indicated within an A/P confirmation. The ad agency claimed that Blaze owed more than the amount stated on the confirmation because of an addendum to the standard service contract (described in more detail below), which had been agreed to by the ad agency and Blaze's Vice President (VP) of Marketing. The ad agency attached a copy of the contract addendum—signed by Blaze's VP of Marketing—to the A/P confirmation response. • The contract addendum: • The addendum described that the purchase of advertising services was contingent on Blaze's forecast of sales for the holiday season, which spans from late November to mid-February (i.e., Christmas through Valentine's Day). If projected holiday sales failed to reach a target amount by a specified date, the ad agency would run additional promotions to increase holiday sales. • Incorrect accounting for advertising expenses: • By December 2015, holiday sales projections had not reached the target set by Blaze, resulting in the purchase of additional advertising services, which were provided before year-end. Because the services were provided in 2015, the associated costs should have been expensed in 2015; however, Blaze did not record these additional advertising expenses until 2016. As such, a portion of advertising expense was improperly deferred, resulting in an understatement of expenses in the amount of$1,237,000. Although the misstatement falls below all quantitative materiality thresholds, its correction would cause the company to miss analysts' fourth quarter consensus EPS forecast.

[Refer to Appendix B for the Service Order Form provided to auditors, which contains the manipulation of Audit Evidence Inaccuracy (Omitted versus Misrepresented Information)].

##### Misrecorded Transaction Condition

During the testing of accounts receivable (A/R), the audit team discovered a misstatement in the amount of $1,237,000 that relates to a sale of precious stones (loose diamonds) made during the month of December 2015. The issue was identified relatively late in the audit process when a wholesale customer disputed the amount indicated within an A/R confirmation. The customer claimed that it owed Blaze less than the amount stated on the confirmation because of an addendum to the standard sales contract (described in more detail below), which had been agreed to by the customer and Blaze's Vice President (VP) of Sales. The customer attached a copy of the contract addendum—signed by Blaze's VP of Sales—to the A/R confirmation response. • The contract addendum: • The addendum described that the sale of the diamonds was contingent on an independent appraisal and source verification, relatively common practices for wholesale purchases (i.e., to rule out illegal “blood diamond” sourcing). If the diamonds failed to appraise above a specified amount or the reported source of the stones was unconfirmed, the sales contract would be nullified. • Incorrect accounting for the sale of diamonds: • In December 2015, the diamonds were delivered to the customer, but the appraisal and source verification were not completed until 2016. Because the required appraisal and source verification were not completed by year-end, revenue recognition should have been deferred until 2016; however, Blaze recorded the sales revenue in 2015. As such, the sale was recognized prematurely, resulting in an overstatement of revenue in the amount of$1,237,000. Although the misstatement falls below all quantitative materiality thresholds, its correction would cause the company to miss analysts' fourth quarter consensus EPS forecast.

[Refer to Appendix C for the Sales Order Form provided to auditors, which contains the manipulation of Audit Evidence Inaccuracy (Omitted versus Misrepresented Information)].

1

If fraud is suspected, auditing standards prescribe a more thorough response than in the case of an unintentional error, including a re-evaluation of management's integrity, fraud risk, the effectiveness of controls, the need for additional audit procedures, and the materiality level for the engagement (PCAOB 2010, ¶ 20–22; SEC 1999).

2

The psychology literature uses the terms “omission” and “commission” to describe how an individual can mislead another by failing to act or failing to provide relevant information (omission) versus taking explicit action or providing false information (commission), while auditing standards and securities laws use the terms “omission” and “misrepresentation” (e.g., PCAOB 2002b, ¶ 06).

3

Generally speaking, inaction (i.e., omission) more often leads to understatement (because a necessary amount was not recorded), while action (i.e., commission) more often leads to overstatement (because an amount was recorded when it should not have been). Accordingly, in our first two studies, expenses become understated via omission, while revenues become overstated via an act of commission. We do, however, acknowledge that it is possible to understate expenses through action (e.g., misclassifying an expense as an asset) and to overstate revenues through inaction/omission (e.g., failing to record a sales return), and we address these alternatives in our third experiment.

4

The Institutional Review Board at the authors' institution reviewed and approved all three experiments.

5

One exception is a study by Hamilton (2016), which examines the effect of considering the perspective of client management when evaluating the intentionality of identified misstatements.

6

The “understatement of expenses/liabilities” category excludes improperly capitalized expenses and, therefore, likely consists of expenses/liabilities that were improperly omitted from the financial statements.

7

If omissions are being used to perpetrate fraud in practice, one might expect fraud investigations to occasionally uncover instances of omission-related fraud schemes. Upon reviewing a sample of AAERs, we find a number of omission-based fraud schemes, including the omission of operating expenses (AAER Nos. 1692 and 775), depreciation expense (AAER Nos. 2878 and 2623), liabilities (AAER Nos. 3869 and 3855), and impairment losses (AAER Nos. 2878 and 3869). There are also instances in which companies failed to write off uncollectible receivables (AAER Nos. 2878 and 3933), failed to record sales returns and/or discounts (AAER Nos. 847, 775, and 3591), and failed to disclose information required by GAAP (AAER Nos. 3937, 3760, and 3714). These AAERs can be found at the Securities and Exchange Commission's (SEC's) Accounting and Auditing Enforcement Releases website, which can be accessed at https://www.sec.gov/divisions/enforce/friactions.shtml

8

Several fraud schemes described in AAERs were perpetrated by misleading the accounting department through the provision of information—either omitting relevant information (AAER Nos. 1692 and 2815) or providing false information (AAER Nos. 3745 and 1437). These AAERs can be found at the SEC's AAER website, which can be accessed at https://www.sec.gov/divisions/enforce/friactions.shtml

9

Fifteen of the 58 participants indicated a job position below the manager level. Inferences are unchanged when these participants are excluded from the analyses.

10

Using LinkedIn, the authors verified that the 32 participants obtained via personal contacts are currently working as financial reporting managers. The 26 participants from Qualtrics Panel were obtained by contracting with Qualtrics at a price of $20 per participant, which translates to an hourly rate of$62.83, given the mean completion time of 19.1 minutes. Qualtrics Panel participants were required to have at least a bachelor's degree, experience preparing and issuing financial reports, and experience interacting with auditors. They also had to correctly answer three accounting questions and two comprehension check questions. Results hold for each subsample of participants, and we find no differences between subsamples in study completion time or on any demographic variables, including gender, age, highest earned degree, years of work experience, public company experience, extent of interaction with auditors, and prior experience working as an auditor (all p-values > 0.15, two-tailed).

11

For context, the median company size in the Fortune 1000 is 12,574 employees, and the 20th (10th) percentile is 5,000 (2,769) employees (Fortune 2020), suggesting the managers in our study work for relatively large companies.

12

This form of within-subjects manipulation where both levels of the manipulated variable are presented simultaneously and participants choose between the options available is consistent with Clor-Proell, Proell, and Warfield (2014) and Koonce, Lipe, and McAnally (2005).

13

In our first two studies (Study 1 and Study 2), the omitted transaction involves expense (i.e., an expense transaction is omitted from the financial statements, causing expenses to be understated), while the misrecorded transaction involves revenue (i.e., a sale is recorded when it should not have been, causing revenue to be overstated). These manipulations are symmetric in that they have a monetarily equivalent effect on earnings; however, they make it difficult to know whether results are due to the nature of the manager's (in)action (i.e., omitting versus misrecording a transaction) or due to the account involved (i.e., expense versus revenue). We address this concern in Study 3 by running an additional study with auditors that separates these effects.

14

We based the Omit Transaction and Misrecord Transaction fraud schemes on actual frauds from AAERs.

15

The purpose of assigning participants to either the Omit Transaction or Misrecord Transaction condition is to provide a context within which participants can consider how a supporting document should be manipulated to facilitate the fraud (omit information or misrepresent information). We do not expect the effect of the Evidence Manipulation variable to differ between the Fraud Method conditions.

16

Prior research suggests questions that ask participants to predict the behavior of others are less susceptible to social desirability bias and are more strongly correlated with an individual's actual behavior compared to questions that directly ask participants what they themselves would do (Epley and Dunning 2000; Fisher 1993; Fisher and Tellis 1998).

17

Specifically, above our response scales, we reminded participants of their two options for manipulating earnings: “Option 1: Deferring the recognition of advertising expense (i.e., understating expense)” and “Option 2: Recording sales revenue prematurely (i.e., overstating revenue).” We labeled our scale endpoints to refer back to these options: 0 = “Definitely Option 1 (understating expense)” and 10 = “Definitely Option 2 (overstating revenue).”

18

For both within-subjects manipulations, we randomized the order in which the two options were presented, so for some participants “Option 1” was Omit Transaction, while for others, it was Misrecord Transaction. Similarly, for some participants “Method 1” was Omit Information, while for others, it was Misrepresent Information. Because Option 1/Method 1 always appeared on the left side of our scale (associated with a value of 0), we recoded responses, as needed, when analyzing results, so a value of 0 (10) always corresponds to a preference for omitting (misrecording/misrepresenting). Results hold regardless of the order in which the options were presented.

19

All p-values reported in the paper are two-tailed unless otherwise stated. Where theory provides a directional prediction, we use one-tailed tests.

20

The preference to omit versus misrepresent information holds in both the Omit Transaction (mean = 1.60, t29 = 7.62, p < 0.001, one-tailed, untabulated) and Misrecord Transaction conditions (mean = 1.11, t27 = 10.36, p < 0.001, one-tailed, untabulated).

21

In some cases, omission is judged less harshly even when it results in a more harmful outcome than a commission (Baron and Ritov 1994).

22

We removed ten participants with one year or less of audit experience from the sample, because it is unlikely these auditors have sufficient experience evaluating identified misstatements in practice. Inferences are unchanged when these participants are included in the analyses.

23

We obtained 20 of the 108 participants (18.5 percent) by including our study link within a newsletter distributed to auditors. Inferences are unchanged when we exclude these participants from the analyses.

24

We offered all participants the opportunity to register for a blind drawing of three \$100 gift cards. Interested participants provided an email address that we collected and stored separately from their responses to the study.

25

We also asked participants whether they believed the misstatement was most likely due to error or fraud. Because our analyses of the two dependent variables yield nearly identical results (i.e., all inferences are unchanged), we focus our discussions on the principal dependent variable (assessment of intentionality) for the sake of brevity.

26

We find that Audit Experience is a significant covariate in our model and is positively related to auditors' judgments of the misstatement's intentionality (i.e., more experienced auditors are more inclined to believe the misstatement was caused intentionally). Inferences are unchanged if we exclude the covariate from the analyses.

27

To ensure the quality of our data, we included an attention check question in the case materials. Six participants failed the attention check and were removed from the sample. We also analyzed the amount of time participants spent completing the study. Eight participants were removed from the sample after being identified as time outliers, with studentized residuals in excess of +/− 2 and a Cook's Distance exceeding the common cutoff value of 4/n (Leone, Minutti-Meza, and Wasley 2019). Inferences are unchanged when these outliers are included in the analyses.

28

Results include two participants who failed a manipulation check that asked participants to select the misstatement described in the case. Inferences are unchanged when we exclude these participants from the analyses.

29

Specifically, in untabulated analyses, we find Audit Experience is marginally positively correlated with judgments of intentionality in the Omitted Transaction condition (r = 0.25, p = 0.071), but not in the Misrecorded Transaction condition (r = −0.11, p = 0.450), suggesting auditors are less skeptical of omitted transactions (but not misrecorded transactions) when they have less versus more experience. To understand the Audit ExperienceMethod interaction further, we use a median split to transform Audit Experience into a dichotomous variable with two levels: (1) auditors with less than four years of experience (n = 51), and (2) auditors with four or more years of experience (n = 56). When we collapse across the Revenue and Expense conditions, we find less-experienced auditors judge an Omitted Transaction as marginally less likely to be intentional (mean = 5.37) compared to more-experienced auditors (6.30) (t52 = 1.92, p = 0.061). However, when we analyze the effects of experience within each level of our Account variable, we find no significant effects at the p = 0.05 level (two-tailed) to support the idea that less-experienced auditors judge omitted transactions as less likely to be intentional compared to more-experienced auditors or compared to misrecorded transactions. These non-significant findings may be due to a lack of power when we split our data by Account, Method, and Audit Experience (n of 10–14 observations per cell) or due to an unstable relationship between the Audit Experience and Method variables. Because our theory does not specify how experience will influence auditors' judgments of intentionality, we are hesitant to draw conclusions related to the Audit ExperienceMethod interaction found in Study 3. As such, we do not discuss this interaction further. However, we encourage future research that examines whether and how experience influences auditors' intentionality judgments, especially as they relate to omitted transactions.

30

Specifically, we find auditors judge a Misrecorded Revenue (LS mean = 6.79) as significantly more likely to be intentional compared to a Misrecorded Expense (5.50) (t101 = 2.65, p = 0.009, untabulated), an Omitted Revenue (6.13) (t101 = 2.51, p = 0.007, one-tailed, untabulated), and an Omitted Expense (5.59) (t101 = 3.11, p = 0.001, one-tailed, untabulated). This final result replicates Study 2 (the first auditor study) in which we find auditors judge an omitted expense transaction as less likely to be intentional than a misrecorded revenue transaction.

31

When reporting results for Study 3, we use one-tailed p-values for comparisons between the Omitted Transaction and Misrecorded Transaction conditions, due to our directional expectations. In contrast, we use two-tailed p-values for comparisons between the Expense and Revenue conditions, because we did not have a priori expectations regarding the Account variable.

32

In Study 2, auditor participants (in the Omitted Transaction condition) viewed one of the two versions of the Service Order Form (Omitted or Misrepresented Information) that appear in Appendix B. However, auditors only viewed the form itself, while manager participants received both the form and the accompanying explanation.

33

In Study 2, auditor participants (in the Misrecorded Transaction condition) viewed one of the two versions of the Sales Order Form (Omitted or Misrepresented Information) that appear in Appendix C. However, auditors only viewed the form itself, while manager participants received both the form and the accompanying explanation.

## Author notes

We gratefully acknowledge helpful feedback received from Jacqueline S. Hammersley (editor), two anonymous reviewers, Bill Messier, Andrew Reffett, Chad Simon, Ikseon Suh, Aaron Saiewitz, Chris Wolfe, Mark Zimbelman, and workshop participants at The University of Alabama, University of Nebraska–Lincoln, University of Nevada, Las Vegas, University of Wyoming, the 2017 ABO Section Research Conference, and the 2018 Auditing Section Midyear Meeting. We gratefully acknowledge financial support for this research from our EY Faculty Fellowships at University of Nevada, Las Vegas. We also thank the Center for Audit Quality for providing participants for this study through the Access to Audit Personnel Program.

Erin L. Hamilton and Jason L. Smith, University of Nevada, Las Vegas, Lee Business School, Department of Accounting, Las Vegas, NV, USA.

Editor's note: Accepted by Jacqueline S. Hammersley, under the Senior Editorship of Mary E. Barth.