THE ACCOUNTING REVIEW

Vol. LVI, No. 3 July 1981

Perception of the Internal and External Auditor as a Deterrent to Corporate Irregularities

Wilfred C. Uecker, Arthur P. Brief, and William R. Kinney, Jr.
ABSTRACT: Public outcry over widespread disclosures of corporate fraud, bribes, and illegal political contributions has resulted in greater responsibility being thrust upon both internal and external auditors for the prevention and detection of corporate irregularities. Little is known, however, concerning the potential effectiveness of the internal or external auditor in preventing corporate irregularities. In this study, it was hypothesized that an increase in the perceived^"aqqffisslyRrip.ss" of the internal and external auditor in detecting corporate irregularities ,w"c)ujd function ^s^jdeterrent. These two hypotheses were tested in a field experiment employing business managers. Neither of the hypotheses was supported. These results have important implications for the role of the internal and external auditor as "police officers" in corporate society.

ORPORATE fraud, bribes, and illegal political contributions constitute a threat to public confidence in our free enterprise system. Congressional concern for increased corporate account: ability has tirfnust~greaterit;spo'nsibirity' upon both management and the auditing) profession for the prevention and detection of corporate irregularities. The increased responsibility of management is reflected in the report of the Commission on Auditors' Responsibilities [1978]. This report, which has been endorsed by the Financial Executives Institute, recommends that management issue a report on the financial statements and express an opinion on the adequacy of the company's internal accounting control system. Congress, through passage of the Foreign Corrupt Practices Act of 1977, has also placed greater responsibility on management by setting new requirements for the effectiveness of internal accounting controls. The Securi465

ties and Exchange Commission (SEC) has proposed that management be required to issue a report on its internal controls and that auditors be required to attest to the adequacy of those internal controls. (Although the proposed rule has been withdrawn, the SEC continues
This project was funded by a grant from the Peat, Marwick, Mitchell Foundation through its Research Opportunities in Auditing program. The views expressed herein are those of the authors and do not necessarily reflect the views of the Peat, Marwick, Mitchell Foundation. The authors wish to thank the Foundation for its administrative assistance in carrying out the project.

Wilfred C. Uecker is Associate Professor of Accounting, The University ofL^waJ) Arthur P. Brief is AssociateJProfessor of Organizational Behavior(^ew Yprjf University; and William R. ~Kiimey, Jr., is John F. Murray Professor of Accounting, The University of^Iowa?)
Manuscript received April 1980. Revision received July 1980. Accepted September 1980.

466 to encourage the idea.) The concern and responsibility of the independent auditor is reflected in the issuance of State^ments on AiiditingjStaiidards (SAS) 16 f [AICPA, 1977a]and 17 [AICPA, 1977b], / which deal specifically with corporate I irregularities and illegal acts. ^ Although greater responsibility has been imposed upon both management and the auditing profession to prevent and detect corporate irregularities, the technology to meet this responsibility has yet to be tested. Little is known concerning the potential effectiveness of controls that might be employed by management or the independent auditor to prevent corporate irregularities. In this study, we investigate the potential effectiveness of internal and external auditors in preventing corporate irregularities that could materially distort the financial state-ments. Specifically, this study investigates whether managers' perceptions of the internal and external auditor serve as a deterrent to corporate irregularities.
Prevention of Corporate Irregularities

The Accounting Review, July 1981 assessment of potential loss from detection. Numerous procedures and practices have been suggested to prevent and detect corporate irregularities [e.g., Kapnick, 1976; Pomeranz and Cancellieri, 1977; and Baker et al. 1976]. While these recommendations may appear to be reasonable, their effectiveness in preventing corporate irregularities has not been tested. Since initiation of new procedures or practices designed to prevent and detect irregularities will involve additional costs to the external auditor and/or to management, it is important to determine the effiectiveness of these procedures and practices so that their cost-effectiveness can be assessed. One of the most frequently recommended controls for the prevention and detection of irregularities involves the general concept of a strongjiternal auditing department, having free access to records and documentation on all material and potentially sensitive transactions [e.g., Hanson, 1975; Pomeranz and Cancellieri, 1977; and Baker et al. 1976]. A major factor determining the potential effectiveness of the internal auditors is how they are perceived by other members ofthe company. One aspect of this perception is the level in the organization to which the internal auditors report their findings. In the context of material distortion of the financial statements as a rational act, the higher the level in the organization to which the internal auditor reports, the greater the potential loss (to the guilty party) from detection of an irregularity because higher levels of authority have greater power to impose sanctions. Consequently, other things equal, we would expect that having the internal auditor report directly to the Board of Directors would be more effective in preventing

In this study, we assume that deliberate distortions ofthe financial statements are rational acts. This view is consistent with theories of ethical risk taking developed by Rettig and his associates [1963] and with economic theories of crime [Ehrlich, 1974]. In this context, the decision to distort materially thefinancialstatements is based upon a dispassionate assessment of the potential gain, the potential loss if the irregularity is discovered, and the probability that the irregularity will be discovered. The effectiveness of internal and external audit procedures in preventing irregularities is therefore a function of their ability to increase (1) the assessed probability that the irregularity will be detected and, depending upon how or to whom the irregularity is disclosed, (2) the

Uecker, Brief and Kinney corporate irregularities than having the internal auditor report to a vicepresident. A second factor affecting how the intemal auditor is perceived is the auditor's personal style. Personal style may cause others to perceive the auditor as being strong and active or weak and passive within the company. An internal auditor who is perceived as being strong and active will be an important component of the internal control climate of the company. An internal auditor who is perceived as strong and active and who reports directly to the Board of Directors should increase the assessed probability that irregularities will be detected and disclosed. The following hypothesis reflects this argument: Hj: Increasing the perceived "aggressiveness" oif internal auditing activities in the organization decreases the occurrence of corporate irregularities. Similarly, the visibility of external auditors within their client organizations can vary. External auditors may seek evidence concerning policies, practices, and representations of client managements by relatively unobtrusive or highly visible means. For example, external auditors can obtain information directly from chief executive oflicers or indirectly through staff personnel. In addition, extemal auditors can take steps to assure that management is made aware of its responsibility for the faimess of its representations. A highly visible external auditor who informs management of its responsibility for the faimess of its representations should increase the assessed probability that irregularities will be detected and disclosed. The following research hypothesis reflects this position:

467 Hj: Increasing the perceived "aggressiveness" of extemal auditing activities in the client organization decreases the occurrence of corporate irregularities. To test these hypotheses, an experiment involving a "sensitive" business decision which could have a material effect on the financial statements was developed. The subjects in the experiment were practicing business managers. The nature of the experiment and the subject pool are described below.
METHOD

An "in-basket" exercise was developed to test the research hypotheses. In an in-basket exercise, managers are provided with a series of facsimile memoranda requiring immediate attention, much as they could expect to find in their own inbasket. A major advantage of an inbasket exercise is, therefore, its high degree of realism. In-basket exercises have been used extensively in management selection and training [e.g., Lopez, 1966; "How to Spot the Hotshots," 1979]. In the in-basket exercise developed for this study, managers assumed the role of William Scott, the newly appointed president of Federated, Inc., a small U.S.based manufacturer of industrial valves and fittings. Federated had been having serious financial problems and had only recently begun to show signs of "turning around." The company's recovery was due largely to its aggressive and successful marketing program headed by Clay Hamner, vice-president of marketing. Scott's decision to join Federated was based on his assessment of the company's potential for growth and the opportunity f"or increased personal income. If the current year's targeted net income before

468 taxes (NIBT) were to be attained, Scott would receive a $20,000 bonus. Attaining targeted NIBT was also important to convince stockholders that the company was continuing to recover. Dependent Variable The specific decision problem created to test the research hypotheses was the amount to specify for the allowance for doubtful collections on notes receivable from company officers. Failure to establish an adequate allowance would result in a material overstatement of assets and net income. This type of irregularity is therefore one that the independent auditor has a high responsibility to detect under SAS No. 16 [AICPA, 1977a]. The allowance for doubtful collections problem was created in the following manner. William Scott, the role assumed by the participating managers, was informed in a letter from the executive vice-president that Clay Hamner, the marketing vice-president, had experienced a serious financial reversal and would therefore be unable to repay his $84,000 loan from the company. The executive vice-president indicated that it was doubtful that Hamner would ever be able to repay more than ten percent ($8,400) of the loan, but because of the importance of Hamner to the company's marketing effort, he urged Scott to grant Hamner an extension on the loan. Scott was also informed that Hamner had already received one extension from the previous president. Without any write-off, the projected net income before taxes (NIBT) for Federated was $755,000. A write-off of $75,600 ($84,000-$8,400) would therefore reduce NIBT to $679,400. Targeted NIBT, based on a percentage of net sales, was $742,500. Consequently, a write-off of no more than $12,500 could be permitted if targeted NIBT was to be

The Accounting Review, July 1981 achieved. A letter from the Chairman of the Board of Directors asserted that a failure to achieve targeted NIBT would have serious repercussions for the company at the annual stockholders' meeting. If Scott did not extend Hamner's loan, Hamner would be forced to default and would accept a position with one of Federated's competitors. Consequently, failure to grant Hamner an extension would not only prevent the company from attaining targeted NIBT, but would also lose Hamner's services to a competitor. However, if Scott were to grant Hamner an extension and write off more than $12,500, targeted NIBT would fail to be achieved. A write-off of only $12,500 would overstate NIBT by 9.3 percent. In sum, the in-basket materials created the situation that Scott could achieve targeted NIBT and earn a $20,000 bonus only if he overstated NIBT by not writing off more than $12,500 of the loan to Hamner, a highly valued executive. Independent Variables The "aggressiveness' of the internal auditor in the in-basket exercise was a function of the level in the organization to which he reported and the extent to which he was depicted as being strong and active within the organization. The internal auditor's "aggressiveness" was high when the company's organization chart showed him reporting directly to the Board of Directors and when his communications with the Board of Directors depicted him as "strong" and "active" within the organization. Communications that depicted the internal auditor as "strong" and "active" within the company consisted of the following: 1. The internal auditor alerted the Chairman of the Board to the implications of the Foreign Corrupt Practices Act (FCPA) for the inter-

Uecker, Brief and Kinney nal control environment of the company. 2. The internal auditor indicated that he had initiated a comprehensive review of the company's accounting and administrative controls to ensure compliance with the FCPA. 3. The internal auditor questioned the wisdom of the policy of providing unsecured loans to corporate officers and noted that the loan to Clay Hamner had been renewed for the amount of principal plus interest due. He pointed out that renewals in the past had always been for the amount of principal only. 4. Finally, the internal auditor indicated that he would call the Chairman of the Board for an appointment to discuss privately certain rumors concerning Clay Hamner's financial condition. The internal auditor's "aggressiveness" was low when the organization chart showed him reporting to the executive vice-president, and his communications with the executive vice-president depicted him as "weak" and "passive" within the company. Communications that depicted the internal auditor as "weak" and "passive" within the company consisted of the following: 1. The internal auditor indicated that he had been informed of the FCPA by one of his new assistants. 2. He requested the assistance of the executive vice-president in determining the implications and requirements of the FCPA for the company. The "aggressiveness" of the external auditor in the in-basket exercise was a function of the level in the organization at which he communicated and the extent to which he informed management of its

469 responsibility for the accuracy of the financial statements. In the high "aggressiveness" condition, the external auditor included the following paragraph in his engagement letter:
We direct your attention to the fact that the financial statements are the representations of management. As such, management is responsible for their accuracy and can be held legally accountable for deliberate misrepresentation of the financial statements.

In the high "aggressiveness" condition, the external auditor also requested a signed statement from the president, William Scott, concerning the amount to establish as an allowance for doubtful collections from company officers. In the low "aggressiveness" condition, the external auditor did not inform management of its responsibility for the accuracy of the financial statements and did not communicate directly with the president to obtain the amount of the allowance for doubtful collections. Instead, the request for the allowance came from the company's controller who was to communicate it orally to the external auditor. Manipulation Check The actual levels of the independent variables are a function of the perceptions of the managers who participated in the study. Consequently, the levels may not be perceived as being different by the managers exposed to the different conditions. If the levels of the independent variables are not perceived as being significantly different, no effect on the managers' responses to the dependent variable (magnitude of the allowance) can be expected. To validate the levels of the independent variables, a pilot study employing students as subjects was conducted. In the pilot study, the level in the organization to which the internal auditor

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FIGURE 1

The Accounting Review, July 1981

Instructions Do not turn back to the in-basket exercise in answering the following questions. 1. How much bonus will you receive if Federated attains its target net profit before taxes (and before bonus) ? 5 2. Based on the decisions you made, do you still have a chance to receive your bonus? check one: _ yes no I don't know 3. For each of the adjective pairs below, place a (-J) in the scale interval that best describes your perception of Federated's Internal Auditing Department. Place one check on each line. a. Strong b.Passive c. Visible : Weak : Active : Invisible

4. For each of the adjective pairs below, place a {^) in the scale interval that best describes your perception of the public accountingfirm.Garrison, Grady, Hughes and Co., retained by Federated. Place one check on each line. a. Strong b. Passive c. Visible 5. Please check your area(s) of functional expertise. Accounting Finance Sales Personnel Manufacturing Engineering Other (please specify) : Weak : Active : Invisible

reported and the manner in which he was depicted were treated as separate independent variables. The results of the pilot study indicated that the levels of the external auditor were perceived as being significantly different, but the levels of the internal auditor were not. To strengthen the manipulation of the internal auditor, the level in the organization to which the internal auditor reported and the manner in which he was depicted were combined as previously described. As an additional precaution, a post-

experimental questionnaire was included in the present study (Figure 1). The questionnaire was designed to provide evidence on the internal validity of the experiment and the areas of functional expertise, e.g., marketing and finance, represented by the participants. Questions 1 and 2 attempted to assess the extent to which the respondents understood the in-basket exercise. Questions 3 and 4 provided a measure of the effectiveness of the manipulations of the independent variables. The three scales em-

Uecker, Brief and Kinney ployed in questions 3 and 4 were selected because of their high intercorrelation from a set of seven scales employed in the pilot study. Question 5 asked the managers to identify their area(s) of functional expertise. Experimental Design The two independent variables were combined into a 2 x 2 factorial analysis of variance design. Subjects were randomly assigned to each treatment condition. This design permits an assessment of the separate effects of each independent variable (main effects) and the effects of the independent variables in combination (interaction effects). Following is a pictorial representation- of this design:
High Aggressiveness EXTERNAL AUDITOR (EA) Low Aggressiveness High Low Aggressiveness Aggressiveness INTERNAL AUDITOR (IA)

471

in the form of a sealed booklet with instructions that it should not be completed until the in-basket exercise was completed. The managers were also instructed not to change their responses to the in-basket exercise after opening the questionnaire booklet. A stamped, selfaddressed envelope was included for the return of the completed in-basket exercise and questionnaire. A total of 143 in-basket exercises were mailed. One hundred-and-four were returned. Of those returned, 18 were excluded from the analysis because they did not contain usable responses. Five of the 18 were excluded because the manipulation-check questionnaire was not completed. The remaining 13 did not provide

Procedure Subjects were middle- and upper-level managers in business and industry located throughout the United States. Their participation was obtained through the researchers' contacts with industry and the assistance of Peat, Marwick, Mitchell & Co. The in-basket exercises and manipulation-check questionnaires were mailed directly to the managers with a letter of introduction from their employer encouraging their voluntary participation and assuring the anonymity of their responses. To prevent the questionnaire from influencing the managers' responses to the in-basket exercise, the questionnaire was included in the packet

an allowance for doubtful collections. A chi-square analysis showed that the frequency of unusable responses was unrelated to the experimental conditions. The functional areas of expertise represented by the 86 managers who provided usable responses are listed in Table 1. Other Memoranda In addition to the memoranda and letters related to the independent and dependent variables in the study, several additional memoranda were included in the in-basket exercise. They provided additional information about the company and served to mask the independent and dependent variables in the study.

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TABLE 1 AREAS OF FUNCTIONAL EXPERTISE REPRESENTED IN THE SAMPLE

The Accounting Review, July 1981

TABLE 2 MANAGER'S UNDERSTANDING OF TASK

(Manipulation Check) Question 1: Proportion correct in recalling amount of bonus (84/86 = 97.7%) "Question 2; Awareness of the implications of their decision on company's NIBT and their bonus FREQ Response consistent with decision Response not consistent with decision Managers acknowledging lack of awareness TOTAL %

(7^=86) % of Sample Accounting Finance Sales Personnel Marketing Engineering Purchasing Management Other 16% 14% 22% 19% 40% 22% 3% 14% 14%

62 9 15 86

72 10 18 100

* Exceeds 100% because some respondents listed several areas of expertise.

Some required no action or only minor action, such as arranging an appointment. Others were of a more sensitive nature, but did not involve potential material misrepresentation of the financial statements. The managers' responses to the two memoranda of a more sensitive nature were also analyzed. One of these asked Scott, the president, to authorize the seeking of competitive bids for sheet metal supphes even though the Chairman of the Board's brother was on the board of directors of the present supplier. The other requested authorization to pay an "extra" commission to a consulting firm that was helping Federated to establish a market for its valves and fittings in the Middle East.
RESULTS

Manipulation-Check Questionnaire

Because the actual levels of the independent variables are a function of the perceptions of the managers, results of the analysis of the manipulation-check questionnaire are presented first. Once the internal validity of the experiment is established, the results of the hypotheses tests will be presented.

The first two questions in the manipulation-check questionnaire (Figure 1) were designed to provide an indication of the care with which the managers had completed the in-basket exercise. The question tested their recall of the amount of the bonus. Since the $20,000 bonus was a primary factor in their motivation to overstate NIBT, evidence that they were aware of the bonus was important to the internal validity of the study. Eighty-four (97.7 percent) of the managers in the sample answered this question correctly (Table 2). The second question assessed the extent to which the managers were aware of the consequences of their decisions with respect to the bonus. A memorandum from Federated's controller indicated that the margin for error on attaining targeted NIBT was only $12,500. Consequently, the correct response to question 2 for managers who wrote off more than $12,500 was "no". For managers who wrote off $12,500 or less, the correct response was "yes". Of the 71 managers responding either yes or no to this question, 62 correctly

Uecker, Brief and Kinney

TABLE 3 AGGRESSIVENESS OF THE INTERNAL AUDITOR (1A)

473

(Manipulation Check) Test for Significant Differences High Aggressiveness Low Aggressiveness

n
Strong-Weak Active-Passive Visible-Invisible 44 44 44

Mean 4.32 4.55 4.55

Standard Deviation 1.83 1.70 1.72

n 42 42 42

Mean 2.76 3.10 3.60

Standard Deviation 1.68 1.76 1.65 3.71 3.54 2.50

Prob. .0005 .0005 .0100

TABLE 4 AGGRESSIVENESS OF THE EXTERNAL AUDITOR ( E A )

(Manipulation Check) Test for Significant Differences High Aggressiveness Low Aggressiveness

n
Strong-Weak Active-Passive Visible-Invisible 40 40 40

Mean 5.35 5.18 5.33

Standard Deviation 1.53 1.71 1.19

n 46 46 46

Mean 3.83 4.07 4.37

Standard Deviation 1.68 1.64 1.78

t
4.05 2.96 2.77

Prob. .0005 .0025 .0050

identified the consequences of their decisions. Fifteen of the managers indicated that they did not know whether they could still obtain the bonus (Table 2). Questions 3 and 4 of the manipulationcheck questionnaire were designed to verify that the levels of "aggressiveness" of the internal and external auditor were perceived as significantly different by the managers. Each question employed three seven-point Likert scales to assess differences in the perceived "aggressiveness" of the company's internal and external auditor. A measure of the reliability of the three scales is provided by coefficient alpha [Nunnally, 1967, p. 196]. The values of coefficient alpha for the scales assessing managers' perceptions of internal and external auditor "aggressiveness" are, respectively, .846 and .892. These values indicate that the three scales are measuring the same attribute.

The results of the analysis for differences in managers' perceptions of internal auditor "aggressiveness" are presented in Table 3. Managers in the high "aggressiveness" condition rated the internal auditor as significantly stronger, more active, and more visible than managers in the low "aggressiveness" condition. The results of the analysis of managers' perceptions of the external auditors' "aggressiveness" (Table 4) are similar to those for the internal auditor. Managers in the high "aggressiveness" condition rated the external auditor as significantly stronger, more active, and more visible than managers in the low "aggressiveness" condition. The consistency of these results is not surprising and only confirms that the three scales are measuring the same attribute. It is the direction and magnitude of the differences that are important, for they indicate that the

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TABLE 5

The Accounting Review, July 1981

ANOVA OF AMOUNT OF ALLOWANCE FOR DOUBTFUL COLLECTIONS

Source EA Aggressiveness lA Aggressiveness EA*IA ERROR

df
1 1 82

Mean Square 32916809 1122929227 1517710768 1475327922 0.02 0.76 1.03

Prob. 0.88 0.38 0.31

Summary Statistics for Amount of Allowance for Doubtful Collections For Each Experimental Condition INTERNAL AUDITOR (IA) Low Aggressiveness High Aggressiveness jE=$57,004 i=$39,497 Frequency Allowance 7 $ 0 1 31,500 60,000 75,600 76,000 10 84,000 85,000 I 100,000 n=18 Jc=S47,311 i=$39,402 Frequency Allowance $ 0 t) 6,000 40,000 74,000 75,600 76,000 ! 80,000 > 84,000 x = $55,822 5=$39,223 Frequency Allowance 6 $ 0 1 12,500 1 40,000 1 75,600 1 76,000 II 84,000 1 100,000

Low
Aggressiveness

EXTERNAL AUDITOR (EA)

/j=22

x=$63,027 5=$35,452
Frequency Allowance

5
1 1 1 2 10 2

SO
60,000 75,000 75,600 80,000 84,000 88,000

High Aggressiveness

manipulations of the independent variables were eifective. Dependent VariableAmount of the Allowance The average amount of the allowance in each of the four experimental conditions ranged from a high of $63,027 to a low of $47,311 (Table 5). Thus, none averaged greater than the minimum acceptable allowance of $75,600. An analysis of variance of the allowances

produced no statistically significant results. On the average, the largest allowance in Table 2 is for the HIGH EAHIGH IA "aggressiveness" group, but the second largest is for the LOW EALOW IA "aggressiveness" group. The average dollar amount of the allowance would seem to indicate that the managers did not attempt to overstate NIBT materially. The smallest average allowance ($47,311 in Table 5) constituted an overstatement of only

Uecker, Brief and Kinney 4.16 percent, and at least one-quarter of the managers in each cell wrote off the full amount of the loan. To provide a better assessment of the extent to which the managers may have attempted to materially overstate the firm's NIBT, the allowances were dichotomized into "material" overstatements and ''not material" overstatements, using a range of materiality thresholds. Inspection of the data (Table 5) revealed that most of the managers chose either to write off almost all of the uncollectible part ($75,600) of the loan or to write off no more than $12,500, the maximum amount that could be written off and still achieve the targeted NIBT. However, two managers wrote off $40,000 and one manager wrote off $31,500. Write-offs of $40,000 and $31,500 constitute overstatements, respectively, of 5.2 percent and 6.5 percent of NIBT. The next smallest write-off was $12,500, which constitutes an overstatement of 9.3 percent of NIBT. Based on these observations, the allowances were dichotomized into "material" overstatements and "not material" overstatements, using materiality thresholds of 5.2 percent and 9.3 percent. Using a 5.2 percent materiality threshold results in classifying the $40,000 and $31,500 allowances as "material overstatements" of NIBT. Using the 9.3 percent materiality threshold results in classifying these allowances as "not material" overstatements of NIBT. Using a materiality threshold of 5.2 percent of NIBT, 29 managers, (approximately 34 percent) materially overstated NIBT. Using a materiality threshold of 9.3 percent, the percentage of managers classified as materially overstating NIBT was 30.2 percent. For each of the materiality thresholds, the frequency of "material" and "not material" overstatements in each of the "aggressiveness"

475

conditions is tabulated in Table 6. A chi-square test for significant differences in the proportion of material overstatements among the "aggressiveness" conditions does not support the research hypotheses that an increase in the perceived "aggressiveness" of the internal and/or external auditors decreases the occurrence of corporate irregularities. As a precautionary measure, the research hypotheses were tested by using only the responses of those subjects who correctly recalled the dollar amount of the bonus and who correctly identified the consequences of their decisions. The results were even less significant than those obtained in the analysis of the responses of all of the subjects. At the 5.2 ' percent materiality threshold, the value of chi-square was 1.3; at the 9.3 percent materiality threshold, the value of chisquare was .497. Based on their responses to the final question in the questionnaire, the managers were divided into three groups finance and accounting, engineering, and all others. The purpose of this categorization was to investigate the possibility that some of the managers may not have understood enough about accounting to be aware that their decisions could materially distort thefinancialstatements and that such deliberate distortion was an act of management fraud. Of the three categories, the finance and accounting specialists are the most likely to have understood that failure to establish an adequate allowance was an act of management fraud. Of the remaining specialists, the engineers were probably the least likely to have understood the f^ull implications of their decisions. Consequently, if ignorance was a factor in their decisions we would expect the smallest proportion of material overstatements to occur among thefinanceand accounting group and the largest proportion among the

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TABLE 6

The Accounting Review, July 1981

FREQUENCY OF MATERIAL OVERSTATEMENT IN EACH AGGRESSIVENESS CONDITION

A. Material overstatement defined to be an allowance <$40,000: An overstatement 25.2% of NIBT aggressiveness EAIA Low-Low Low-High High-Low High-High overstatement material overstatement not material

8 8 8 5

16 14 10 17

Prob>.20 B. Material overstatement defined to be an allowance <$I2,5OO: An overstatement ^ 9 . 3 % of NIBT aggressiveness EAIA Low-Low Low-High High-Low High-High z ' = l-27 Prob>.70 overstatement material overstatement not material

7 7 7 5

17 15 II 17

engineering group. A comparison of the proportion of material overstatements among the three groups produced no significant differences.
Responses to Other Memoranda

Two memoranda dealing with relatively sensitive issues, but not of a nature that could result in material distortion of thefinancialstatements, were included in the in-basket exercise to mask the variable of primary interest. In response to the question on seeking competitive bids in spite of the Board Chairman's connection with the present supplier, 77 of the 84 managers who responded to this memorandum chose to seek competitive bids. In response to the memorandum concerning payment of the questionable

excess commission, only eight of the 86 managers chose to pay the "extra" commission. Internal and external auditor "aggressiveness" had no significant effect on either of these decisions. Furthermore, the proportion of material overstatements of NIBT by the 15 managers who chose not to seek competitive bids or chose to pay the "extra" commission did not differ significantly from the proportion of material overstatements by the remaining managers.
DISCUSSION

The data did not support either of the research hypotheses concerning internal and external auditor "aggressiveness." One possible interpretation of these results is that internal and external audi-

Uecker, Brief and Kinney tors are not perceived as a deterrent to corporate irregularities. Before this interpretation can be accepted, however, a number of competing interpretations must be ruled out. These competing interpretations relate to the internal validity of the experiment. Specifically, did the managers understand the task, did they become involved in the task, and were the manipulations of the independent variables perceived by the managers? The evidence to assess the validity of the competing interpretations was derived from the manipulation-check questionnaire and the actual in-basket exercises completed by the managers. Evidence that the managers under^ stood the task is provided by the results of the analysis of questions 1,2, and 5 ofthe manipulation-check questionnaire (Figure 1). Almost all of the managers (97.7 percent) recalled the amount of the bonus they would receive if the company's target NIBT were achieved. Seventy-two percent of the managers correctly identified the consequences of their decisions for company profits and their bonus (Table 2). Analysis of the responses of only those managers who correctly recalled the amount of the bonus and who correctly identified the consequences of their decisions produced the same results as those obtained in the analysis of all ofthe managers' responses. Finally, the distribution of the proportion of material overstatements by functional area of expertise indicates that ignorance of the full accounting/legal implications of their actions was not a factor in their decisions. Additional evidence that the managers participated conscientiously was provided by an examination of the in-basket exercises completed. They contained numerous marginal comments and a great deal of underlining or highlighting of important points. The managers also

477

frequently supplemented their responses to the memoranda with discussions of additional actions they would take. Evidence that the managers perceived differences in the levels of "aggressiveness" ofthe internal and external auditors is provided by the results of the analyses of questions 3 and 4 ofthe manipulationcheck questionnaire (Tables 3 and 4). For both the internal and external auditor, the high "aggressiveness" condition was perceived as being significantly greater than the low "aggressiveness" condition. Based upon the results of the analyses ofthe manipulation-check questionnaire, it is unlikely that the failure to support the research hypotheses can be attributed to a lack of internal validity. In addition, the absence of a clearly discernible trend in the managers' responses indicates that it is also unlikely that the sample size, although smaller than we had desired, is responsible for the results. On the average, the largest allowance was obtained in the HIGH EA-HIGH IA "aggressiveness" condition, but the second largest was obtained in the LOW EA-LOW IA "aggressiveness" condition (Table 5). When the allowances were dichotomized as "material" and "not material" overstatements, three ofthe cells had the same frequency of "material" overstatements (Table 6). Consequently, the failure to support the research hypotheses indicates that an increase in the perceived "aggressiveness" of the internal and external auditor did not significantly nor systematically decrease the occurrence of corporate irregularities. The findings of this study have important implications for the role of the auditor as a "police officer" in corporate society. In recent years, the courts and the SEC have placed increasing pressure on auditors to deter and detect fraud and questionable payments [e.g., Williams, 1979; Sloan, 1979]. The external auditor

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The Accounting Review, July 1981

is expected to make additional efforts to detect corporate irregularities, and the internal auditor is expected to monitor more closely the company's internal control system. The analogy with increasing the number of police officers on the "beat" in high-crime areas is all too

similar. This study suggests, however, that the analogy does not hold, because managers contemplating acts of management fraud are not deterred by the presence of internal and external auditors.

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