Audit Partner Evaluation of Compensating Controls: A Focus on Design Effectiveness and Extent of Auditor Testing
Prior research has shown that when auditors are aware of overall risk information from procedures performed earlier in the audit, halo effects in subsequent judgments result (e.g., O'Donnell and Schultz 2005). The purpose of this study is to examine whether such effects occur in the context of evaluating the effectiveness of a client's internal control over financial reporting. We experimentally examine whether information about overall risks (i.e., existence of a material weakness unrelated to a compensating control being evaluated and level of overall inherent risk) influences audit partners' judgments related to a compensating control that has been implemented within a specific client process. The judgments we examine include the (1) level of precision needed in a compensating control for it to be assessed as effectively designed, and (2) extent of evidence needed for auditor testing of the operating effectiveness of the control.
Our results are based on responses from 90 audit partners. We find that the existence of a material weakness unrelated to a compensating control being evaluated results in partners preferring a more precise compensating control and requiring more auditor testing. Further, while prior research has demonstrated that knowledge of overall inherent risk factors results in halo effects, our results indicate that this knowledge does not influence partners' judgments about a compensating control.