Misbehaving and behaving: improving audit quality

CASSL's (Chartered Accountant Student Society London) Alec Burt suggests a new way to approach audit. 

The recent criticism directed at the audit industry should prompt auditors to think creatively about how they can improve the quality of their work. In this blog post I suggest that behavioural economics - a discipline that developed in the 1980s when some scholars, sceptical about the understanding of human nature that underpinned “classical” economic models, looked to psychology for new approaches - might offer useful insights for auditors. 

Confirmation bias and better judgments 

One idea that behavioural economists lifted from psychology was “confirmation bias”, the observation that people tend to seek out evidence that confirms their existing thinking. Being aware of this could help auditors make better judgments.

For example, if an auditor proceeds from an assumption that “x” is likely to be the most appropriate accounting treatment in a certain scenario, they will tend to look for evidence that confirms this assumption, instead of objectively assessing the facts against the relevant standards.

Prospect theory and assessing fraud risk

What circumstances might lead an otherwise ethical and cautious FD to take a risk and commit fraud? One key insight, originating in Daniel Kahneman and Amos Tversky’s “prospect theory”, is that, in the words of Richard Thaler “people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse.” 

Overconfidence effect and going concern

Studies have shown that people tend to be overly optimistic in assessing their own abilities. Don Moore & Paul Healy used the “overconfidence effect” to understand why entrepreneurs set up businesses in markets with a high risk of failure.

Being aware of this tendency could help auditors more rigorously assess directors’ assessments of going concern risk.

Nudging toward better audits

Thaler and Cass Sunstein popularised “nudge theory” as a means of encouraging desired behaviours in people. Their ideas have proved influential.

For example, HMRC studied how small changes in the wording of letters sent to people who were late in paying their taxes could improve recovery rates. Might it be possible to “nudge” auditors into making better decisions? Could firms run experiments to see if making small changes in, for example, the wording of audit programmes impacts the chances of staff picking up on potential misstatements?

For anyone looking to read more on behavioural economics, Nobel prize winning economist Thaler’s Misbehaving: The Making of Behavioral Economics offers a good introduction.  

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