An empirical investigation of the auditor's decision to project errors

SUMMARY Statement on Auditing Standards No. 39 requires that auditors project to the population being sampled the dollar errors in tests of details of balances. This study uses an archival approach to examine auditors' sample error projection decisions for inventory and accounts receivable errors from audits conducted by three large accounting firms. This archival approach provides a rich environment for describing the auditor's sample projection decision. We suggest that sample evaluation consists of both error quantification and error resolution. Consistent with previous experimental research, auditors often fail to quantify errors by projecting them to the population. The decision to project an error is related to several factors, including the materiality of the error, direction of the error, type of test, and audit firm characteristics. Error immateriality was the most common documented reason for not projecting an error. Although most errors were small in relation to planning materiality, failure to project seemingly immaterial amounts may increase audit risk by an unacceptable amount, especially if sampling risk is not considered. The auditors in our study did not explicitly consider sampling risk in making error projections. Consistent with previous research, error containment was also associated with the decision to not project errors. We suggest that this strategy is used for large errors as part of the auditor's resolution of the error. Professional standards indicate that auditors should consider qualitative aspects of errors (AU [section] 350.27), but do not address whether error containment is appropriate. The results of this study suggest the need for further guidance and additional research in the use of error containment, and of the consideration of sampling risk in the evaluation of errors. Key Words: Error projection, Audit sampling, Error containment, SAS No. 39. Data Availability: Data used in this study are available on request. The data were provided on condition of anonymity; the audit firms and clients will not be identified. Audit sampling in tests of details of balances is widely used in gathering evidence for the auditor's decision on the fairness of client financial statements. When sampling is used, SAS No. 39 (AICPA 1981) indicates that the auditor should estimate the total error in the population by projecting sample errors to the population. Failure to project errors lowers the estimate of the total error, which could cause the auditor to improperly issue an unqualified opinion on the financial statements. Previous experimental research demonstrates that auditors have a propensity to not project errors considered to be "unique" (Burgstahler and Jiambalvo 1986). Dusenbury et al. (1994) found that the error projection decision is related to the containment of errors to well-defined sub-populations and to the perceived frequency of the error. (1) We examine auditors' projection decisions using an archival approach based on data drawn from audit workpapers for 64 audits from the offices of three large accounting firms (two Big 6 firms and one regional firm) located in different geographic regions. In addition to validating the results of previous empirical research using a range of sampling applications, we develop an expanded description of the auditor's error evaluation decision as a two-stage process that depends on several error and firm characteristics. Error projection is used in the first stage to quantify errors, and error containment is a strategy used in the second stage to resolve large errors. Error projection is related to error materiality, error direction, type of test, and audit firm characteristics. As expected, auditors are less likely to project immaterial errors, and errors which reduce net income. Auditors are more likely to project errors arising from tests with high error rates, especially for tests with a specific objective for a well-defined population. …