Critical Perspectives on Accounting (1992) 3, 273-290

CRITICAL COMMENTARIES
THE IMPACT OF SELECTED ENVIRONMENTAL
CUES ON AUDIT DISCLOSURE JUDGMENTS
ARNOLD WRIGHT
College of Business, Northeastern University

This paper presents the results of an experiment on the impact of

environmental cues on audit decisions. Environmental cues are characteris-
tics of the client (the setting of the audit) that may affect the objectivity and
judgments of auditors. Practicing auditors were asked to determine the
appropriate disclosure for a proposed audit adjustment in two actual,
disguised cases. The environmental cues manipulated were: client size,
prior association and client growth pattern.
The results indicated that environmental cues did not significantly alter
audit disclosure judgments but may affect reliance on other potentially vital
cues. Enhanced auditor training or decision aids may be needed to increase
auditor sensitivity to potentially important cues.

Introduction
In arriving at audit decisions, practitioners evaluate diverse types of evidence.
A distinction may be drawn between two general catagories of audit
evidence: (1) audit test data; and (2) environmental cues’. Audit test data
represents evidence gathered through audit procedures specifically to ex-
amine the internal control structure or verify financial statement assertions
(e.g. examination of invoices, confirmation of receivables). Auditing standards
and procedures have predominately dealt with this type of evidence.
Environmental cues or factors are defined as characteristics of the client
such as client size and industry. Thus, environmental factors deal with the
setting in which the audit takes place’. The importance and implications of
such data is often difficult to assess. For example, how should the growth
trend of a firm properly affect audit programs, sample sizes or the risk of
material errors?
The purpose of this study is to examine the impact of environmental factors
on audit disclosure judgments. Environmental factors can be extremely
beneficial in alerting auditors to potential problems and inherent risks3.
However, environmental factors may also distort the processing of audit
evidence and lead to suboptimal results. For example, critics (Treadway
Commission, 1987) argue that auditors may be strongly influenced by their
relationship with the client and the nature of the audit such that they are not
truly objective (e.g. a large, influential client). The loss of confidence by many
in the ability of auditors to examine evidence independently has been

Address for correspondence: Professor Arnold Wright , Department of Accounting, School of

Management, Boston College, Chestnut Hill. Massachusetts, 02167, USA.
Received 4 June 1990; revised 15 January 1991; accepted 8 February 1992.
273
1045-2354/92/030273+18$08.00/0 @> 1992 Academic Press Limited
274 A. Wright

prompted by past abuses in accounting practices and a number of

bankruptcies and frauds.
Although there are several assertions as to the significant impact of
environmental cues on audit decisions, we have virtually no empirical results
to address the following important issues:
1. Do auditors actually rely heavily on environmental factors in practice?
And if so, which ones are most heavily utilized?
2. How are these factors incorporated with other audit evidence in making
decisions?
3. How do such cues impact judgments?
4. Is the reliance on various environmental factors beneficial or harmful?
This study is viewed as an exploratory effort in this important area to provide
empirical findings and spur further research.
The remainder of the paper is divided into four sections. The next section
briefly reviews the prior literature. A theoretical framework of the audit
decision process is presented to integrate the prior research findings and
serve as a guide for the study. The second section outlines the research
methodology employed and provides justification for the variables studied.
The results of the study are then outlined and briefly analysed. The final
section provides a discussion of the major findings and avenues for future
research.

Prior Literature and Presentation of a Theoretical Framework

Auditing standards mention the need to consider the setting of the engage-
ment in planning the appropriate audit strategy. For instance, SAS No. 47
indicates inherent risks are related to external factors such as a declining
industry and technological change. SAS No. 22 (1978) also stresses the need
to understand the “nature of the entity’s business, its organization and its
operating characteristics” (para. 7).
SAS No. 55 (1988) is particularly noteworthy in that it directs auditors to
take a broader view of the controls from the traditional micro (account) level
perspective focusing on control procedures to one that also encompasses the
“control environment” (management’s policies and procedures to promote a
strong control setting). The control environment includes macro factors such
as management’s philosophy and operating style, organizational structure
and external influences. SAS No. 55 was quite controversial (Elliott &
Jacobson, 1987b; Neebes & Roost, 19871, with some arguing such factors
reflect “soft evidence” that is very difficult to measure and may lead to
over-reliance on management and consequently insufficient audit testing.
Proponents (Temkin &Winters, 1987) argue that the auditor must consider the
broader control setting to identify appropriate controls that are present and to
evaluate how errors may occur.
In the spirit of SAS No. 55, Lewin (1989) also challenges auditors to examine
the organizational setting and objectives of the client. He notes that work in
fields such as organizational behavior and sociology may provide rich
theories to guide auditors and argues that such an inter-disciplining approach
can greatly enhance audit effectiveness.
 Input of selected environmental cues 275

Finally, as noted earlier, the Treadway Report (1987) directs auditors to

place a greater emphasis on environmental factors of the client. Elliott and
Jacobsen (1987a) argue the Treadway Report has broad implications for
enhanced education and analytical skills for auditors and also an increased
focus on ethics. Mednick (1990) argues that auditing standards regarding
independence increasingly are rule-based and focus on what is prohibited.
The shortcoming of such an approach is that it is not possible to delineate all
possible scenarios of independence dilemmas that might be encountered in
practice. Instead, he contends that the profession needs to emphasize in
education, training and incentives an awareness of values. Thus, the auditing
profession is at a critical juncture where consideration of environmental
factors is likely to play an increasing role in risk assessment and evidential
strategy.
Environmental cues, however, can have dysfunctional affects on audit
quality. A significant finding or prior human information processing (HIP)
studies is that decision makers reach judgments that substantially deviate
from normative models in complex information processing circumstances.4 In
an attempt to explain this finding, Tversky and Kahneman (1974) posit that
individuals often resort to certain heuristic rules (“rules of thumb”) in order to
reduce the cognitive strain of making judgments in such complex situations.
In most cases the use of heuristic rules is anticipated to result in reasonably
appropriate decisions, and, in fact, decision-making in a very complex setting
may not be possible without such rules. However, as Tversky and Kahneman
point out, heuristic rules can also result in significant judgment errors and
biases, if not discovered and compensated for.
Auditors, for instance, may view “growth” firms in a different light than
stable or declining companies. They may perceive such enterprises to be
“progressive, liberal, or open” and, as a result, maintain a less skeptical and
questioning manner, thus failing properly to investigate for material errors
and fraud.
Human information processing research in auditing has found that CPAs
display similar capabilities and limitations in decision making as discovered in
earlier HIP studies. Auditors also appear to employ heuristic rules (Ashton,
1982). This finding would lead one to anticipate that auditors may rely upon
and be influenced by environmental biases or cues. However, none of the
prior auditing studies directly examines the effect of environmental factors on
audit decisions.

Empirical Findings on the Effect of Environmental Factors

As noted earlier, there has been scant empirical research on this issue.
Frishkoff (1970) examined 190 audit opinions where a change in accounting
methods had occurred. Using multiple discriminant analysis, the size of the
client (total stockholder’s equity) was found to have significant predictive
ability in properly classifying the type of opinion actually issued (clean or
qualified). Large firms were more likely to receive an unqualified opinion than
smaller firms.
The findings of the Frishkoff study suggest an environmental bias in favour
of larger firms. However, as the author of the study concedes, only 16 of the
276 A. Wright

155 firms selected were “large”, which is a very small sample to generalize
from.
The impact of environmental cues has also been investigated as a
secondary topic in a number of prior survey studies on materiality (Pattillo,
1976; Woolsey, 1973). However, there have not been any controlled ex-
perimental studies in this area. Survey studies possess serious internal
validity problems, especially in this situation where a primary issue, auditor
independence, is controversial and sensitive and where a great number of
extraneous variables must be controlled.
Haskins (1987) examined auditor perceptions of the importance of 48
control environment attributes. He also investigated the affect of certain
environmental cues (“contextual factors”) such as client size and industry on
these perceptions. Haskins found auditors considered several attributes to be
of great or very high importance, suggesting a macro-engagement view is
taken in control assessments. Of particular relevance to this study, client size
and complexity (level of decentralization) were found to impact control
perceptions. Haskins and Henarie (1985) also note auditors viewed incentives
that might prompt managers to act in unacceptable ways and client economic
troubles as important control environment considerations.
In a field study, McAllister and Dirsmith (1982) found that auditors
considered the client’s business focus, industry and predictability of financial
performance in audit planning. Some clients were “externally” oriented in
continually monitoring and responding to industry and economic changes.
These clients were in industries of rapid change due to technology or other
market factors. Other clients were “internally” oriented, residing in stable
environments. Management focus appears to affect various potentially impor-
tant inherent and control risks, which was found to impact the nature and
extent of procedures.

Framework of the Audit Decision Process

Figure 1 presents a theoretical framework of the audit decision process. The
framework depicts an “input, process, output” sequence. The financial
statements of the client represent the “input” to the model. The “process”
component of the framework involves the audit procedures taken to gather
evidence, the information thus accumulated (audit test data and environmen-
tal factors) and the final conclusions. The output of the model is the final audit
report and the resulting risks and payoffs to the practitioner. The arrows in the
model indicate apparent relationships between variables based on prior
research findings and the flow of the model. Two directional arrows suggest a
feedback relationship.
The most important variable of the model is “The auditor”. An audit is a
complex undertaking that is largely grounded in the professional judgment of
the auditor, as guided by generally accepted accounting principles and
generally accepted auditing standards. The auditor specifies the direction
(audit programs), extent (sample sizes), timing and eventual conclusion of the
audit. As depicted in the model, the auditor’s judgment appears to be greatly
influenced by several factors. Of particular relevance to this study is the
potential use of heuristic rules.
 Input of selected environmental cues 277

‘The auditor
HIP limttatmns
Behavioural malts
Education and tminmg
Prcrfess~v~~l experience
111,111

Study and evaluate the system of mtemal control

Test the effecttvenas of the system

Figure 1. Framework of the audit decision process.

For this study, the most salient relationship posited by the model is that
audit judgments may be significantly influenced by environmental cues. This
relationship implies that it is very important to determine which environmen-
tal factors are relied upon, since the nature and extend of audit procedures
may be affected by environmental factors; e.g. auditors may do less extensive
testing on a long-time client and rely a great deal on prior working papers5.
The auditor may thus fail to discover an error that would have altered the final
audit report.

Research Questions
Based on prior research findings and the theoretical framework presented, the
primary research question examined in this study is:
1. Are audit judgments significantly affected by environmental factors?
As secondary issues, three additional research questions are addressed:
2. Will the affect of environmental cues vary significantly by experience
level?
3. Will subjects correctly assess the degree of reliance on environmental
cues? (self insight question)
4. Do environmental factors influence the perceived reliance on other vital
cues?
 A. Wright

The second research question deals with the familiarity (experience and
training) of the subject with the decision context and the resulting impact of
environmental factors. Swieringa et al. (1976) found that subjects have a
greater tendency to use heuristic rules when they are familiar with the
situation and have well-defined models of the process in mind.
Self insight is an important concern of HIP research and is frequently
investigated. Prior HIP findings have consistently shown poor self-insight of
decision makers (Ashton, 1982).
Based on a review of the literature, the theoretical framework presented
earlier suggests that there is an interrelationship in the perceived reliance
placed on various evidence sources and environmental cues. Such an
interrelationship would suggest the auditor takes a complex information
processing approach in evaluating the various sources of audit evidence.

Research Methodology

Subjects and Task

This research study employed a laboratory experiment. To attain a high
degree of external validity, subjects were practicing auditors (n = 63) with
generally extensive audit experience. Seventy-six percent of the respondents
had more than 5 years of audit experience; 53 and 19% were partners and
supervisors, respectively. Practitioners at these higher staff levels are those
that make the complex, audit decisions investigated in this study. Further, a
representative cross-section of CPAs from various firms was obtained by
administering the experiment during three professional meetings of the
California Society of Certified Public Accountants.
Subjects are presented two audit cases (McAllister Inc. and Winslow Co.) in
which a “significant error” is discovered by the audit staff during the
engagement, resulting in a proposed audit adjustment. A description of the
firm and the audit issues are provided along with a set of summarized
financial statements and key statistics. An example of the actual test
instrument is contained in the Appendix. Auditors are requested in each case
to indicate on a seven-point Likett-type scale whether an audit adjustment is
necessary or a qualified opinion is appropriate.
CPAs were essentially asked to make a disclosure/materiality judgment.
This type of decision represents a high-level, complex judgment. In each case
the auditor faced a dilemma. Failure to require the adjustment resulted in
higher net income, violating the commonly asserted conservative bias of
CPAs. Yet, the client objected to the adjustment on reasonably strong
grounds. Further, the proposed adjustment was 4.5 and 6% of net income for
the Winslow Company and McAllister Inc. cases, respectively. The size of the
“error” makes the determination of materiality a difficult, “borderline”
decision. In a review of prior studies, Holstrum and Messier (1982) found the
most frequently cited professional “rule of thumb” for materiality judgments
to be 5-10% of net income.
To strengthen external validity further, the cases presented were actual
disguised situations. The utilization of actual cases provided realism and
 Input of selected environmental cues 279

complexity in the decision setting. Several cases were screened for the
appropriate complexity, length and generality of the issues involved. The
McAllister Inc. case involves a contingent loss, while revenue recognition is
the issue in the Winslow Co. case. Thus, these cases deal with matters
frequently encountered by practitioners. The cases were further modified
from the comments of five audit managers or partners requested to review
the cases and the results of the pilot study (n = 14).
Respondents also were requested to indicate the perceived reliance placed
on three decision factors:
1. materiality;
2. objections of the client; and
3. generally accepted accounting principles.
The response mode was a six-point Likert-type scale from “the most
important factor” to “insignificant or irrelevant”. Subjects additionally were
asked to explain in an open-ended question the reasoning for their audit
decision in each case. Finally, subjects were requested to provide various
demographic data (age, audit experience, staff level and education).

The Independent Variables (Environmental Cues)

All subjects received the same facts in each case except for the manipulation
of three environmental cues:
1. length of association with the client, “short” or “long”;
2. client size, “large” or “medium”; and
3. growth pattern of client, “stable” or “strong”.
These factors were selected for study because of their frequent mention in the
literature (discussed in this and earlier sections) as variables that may
significantly affect the objectivity of auditors6.
As discussed earlier, a long-established relationship with a client may
produce a complacency heuristic where problems are not expected and
summarily dismissed. For instance, in archival studies of audit work papers,
Bedard (1989) and Mock and Wright (1990) found a very large proportion of
audit procedures were repeated across years. SAS No. 22 (1978) also states
that past experience with a client should be considered in formulating an
appropriate audit plan. The danger is if there were few prior problems, the
auditor may fail to respond adequately to changes or issues encountered.
Normatively, the length of client association should not impact the audit
disclosure decisions examined, which according to auditing standards should
be based on materiality and generally accepted accounting principles.
Length of association with the client was manipulated as either 2-3
years (“short”) or 11 and 13 years (“long”). The time periods chosen are the
result of discussions with practitioners during the audit case selection and
formulation phases of the study. A new client situation was avoided due to
the unique risks present in such a setting resulting from lack of knowledge of
the client.
In a synthesis and extension of the audit pricing literature, Magee and
Tseng (1990) identify conditions where auditor independence may be com-
280 A. Wright

promised due to the “value of incumbency”, i.e. future quasi-rents. Thus, one
might expect auditors to favour larger clients in resolving accounting or
auditing issues.
In contrast, auditing standards identify client size as a salient factor that
affects risk assessment and audit programs. For instance, SAS No. 55 (1988,
para. 12) notes that larger firms require more complex and enhanced controls
to prevent and detect errors than smaller firms. Haskin’s (1987) results,
discussed earlier, indicate auditor perceptions also recognize the need for
greater controls among larger clients. SAS No. 47 (1983, para. 6) emphasizes
that materiality is driven by the needs of potential users of the financial
statements. Since larger clients involve more potential stakeholders (e.g.
investors, creditors) and are followed more closely by the financial press than
smaller clients, a smaller relative materiality threshold is normatively ex-
pected (e.g. say 3% of income for larger clients as compared to 5% for
average sized clients). In this research, since the relative materiality of the
proposed adjustment is held constant for a given case, an increased likelihood
of a qualified opinion is thus anticipated for the larger client.
Client size was defined as total sales. A “large” firm is one that would be
among Fortune Magazine’s 500 largest industrial corporations. The “medium”
sized firm was 20 times smaller in all respects. Therefore, all relative
measures and relationships were identical for both large and medium firms,
e.g. current ratio. The “large” firm is merely a multiple of the “medium” one.
Rapidly growing clients present a number of potential inherent and control
risks. For example, controls often lag. Further, growth often promotes the
incentive for management to distort earnings to sustain the trend, especially if
compensation is tied to earnings (SAS No. 53, 1988, para. 10). Normatively, in
this research a higher likelihood of a qualified opinion is expected for growth
clients than stable clients due to management misstatement incentives, a
higher probability of other undetected error and increased user needs to be
informed of potential problems for such companies.
The company designated as “stable” demonstrated no discernible pattern
of growth in earnings per share, return on assets and return on equity for the
5-year period of summary data provided. The “growth” company displayed
a strong 12% compounded annual growth rate over this period. Both firms
had the same earnings per share over the 5-year period; the “growth” firm
merely started at a lower level and showed the indicated upward trend in
earnings.

Experimental Design

The overall research design was 23 factorial analysis of variance (ANOVA).

The factors were the experimental factors studied. Subjects were randomly
assigned to experimental groups on each case. Thus, a subject would be
expected to be placed in a different treatment group on the McAllister Inc.
case and on the Winslow Co. case.
The primary statistical approaches employed were analysis of variance
(ANOVA) and analysis of covariance (ANCOVA). The use of covariates were
demographic data solicited.
 Table 1. Analysis of covariance: effect of environmental factors on audit decisions

McAllister case Winston case

Adjustment decision Qualified opinion Adjustment decision

Source of Degrees of ___ _ ---- -___---.- - - -___
variation freedom MS F P* MS F TV* MS F D*

Covariates
Experience 1 1.4 0.3 NS 0.6 0.4 NS 1.3 0.3 NS
Education 1 23.7 5.8 0.02 2.1 0.5 NS 1.6 0.4 NS
Main effects:
Client size (A) 1 3.2 0.8 NS 2.0 0.5 NS 0.3 0.1 NS
Association (B) 1 0.2 0.0 NS 0.0 0.0 NS 1.5 0.4 NS
Growth pattern (C) 1 2.8 0.7 NS 0.2 0.0 NS 1.7 0.4 NS
Interactions
AxB 1 0.2 0.0 NS 5.1 1.3 NS 2.0 0.5 NS
AxC 1 0.0 0.0 NS 4.4 1.1 NS 13.0 3.3 0.08
BxC 1 0.2 0.1 NS 1.6 0.4 NS 0.0 0.0 NS
AxBxC 1 2.5 0.6 NS 0.7 0.2 NS 0.0 0.0 NS
Within groups 43
Total 52

* p 5 0.10.
282 A. Wright

Experimental Results

The major thrust of the study entails empirically testing the impact of the
selected environmental cues on auditor disclosure decisions. A separate
three-way ANCOVA with two covariates was conducted for each decision. The
covariates (demographic factors) were audit experience and education level
(academic degrees17.
The findings regarding the primary research question are presented in
Table 1. There were virtually no significant (pz 0.10) main effects or
interactions present. CPAs in the experiment do not appear to have relied
substantially on the environmental cues studied in arriving at audit judg-
ments. This key finding will be explored further in the final part of this paper.

Effects of Experience Level

Employing the same approach as used to test the main hypothesis, two
three-way ANOVAs were performed for each audit decision. The first ANOVA
coupled audit experience with client size and association as the independent
variables. The second analysis combined audit experience with client size and
growth. The interactions between experience and environmental factors are of
major interest.
The results (Table 2) appear to provide partial support for the belief that
reliance on environmental cues varies by experience level since significant
interactions were found in both of the audit decisions in the McAllister Inc.
case. However, no such interactions occurred in the Winslow case. This
finding suggests that the impact of experience on environmental biases is
dependent on the decision context.
A closer examination of the treatment means revealed that the results do
not demonstrate a clear pattern of responses as the level of experience rises.
For example, in the audit adjustment decision, CPAs with less than 5 years
and IO-13 years were more insistent on an adjustment for long-time clients
than relatively new ones. The other experience groups (6-9 years and over 13
years) displayed the opposite judgments.

Table 2. The effect of environmental factors on audit

judgments as a function of level of audit experience

Three-way ANOVA

Judgment Factors F Significance

ANOVA (E, S, L*)

McAllister inc.
Audit decisions
Audit adjustment LxE 3.662 0.02
Qualified opinion SxLxE 2.235 0.10

* Refer to factors: E, audit experience; S, client size; L, length

of association; G, client growth pattern.
Note: Only significant results are shown (~~0.10). df = 1 for
factors S, L and G; 3 for E; df=38 and 39 for within-group
variance for McAllister Inc. and Winslow Co. cases, respectively.
 Input of selected environmental cues 283

Self Insight

The main findings suggest that environmental cues do not have a substantial
influence on audit decisions. Therefore, auditors would display proper insight
if they “infrequently” mention reliance on such factors in the open-ended
question of the test instrument. Examining the perceived cues utilized is also
worthwhile to provide information on factors seen as important by respon-
dents for the complex audit decisions investigated.
Table 3 indicates the frequency of the various reasons cited for the audit
decision arrived at in each of the two situations. This table is tabulated from a
content analysis of the responses given to the open-ended question at the end
of each case: “Briefly describe your reasoning for the audit indicated in the
case”.
To test the reliability of the content analysis, all replies were recorded
without reference to the initial classification. Only 12 “errors” (discrepancies)
were discovered; an error rate of about 10%. Some of these errors resulted
from vagueness of the subject’s reply. In lieu of this low error rate, the coding
scheme employed appears to have a high level of reliability.

Table 3. Cues mentioned (reasons noted) in arriving at audit

decision

Percent of subjects
noting cue
Cue cited reference

McAllister Inc:(land writedown):

Uncertainty of rezoning efforts 55
Materiality 47
Generally accepted accounting principles 20
Other 20
Conservatism 16
Difficulties in measuring the loss 11
Environmental factors (growth trend, etc.) 9
Prior failures to obtain rezoning 7
Proper role of financial statements 7

Winslow Co.: (revenue recognition:

interpretation of sales return provision):
Materiality 40
Feasibility of establishing an allowance for
estimated returns 23
Completion of the earnings process 21
Substance of the transaction 18
Client arguments 16
Existence of a contractual return clause 16
Client manipulation of income for new
stock issue 14
Environmental factors 14
Slow present sales rate of tapes 12
Unusual nature of the transaction 11
Other 11
Cash receipt on sale 9
Legal risk on CPA 7
Generally accepted accounting principles 7
Strong probability of returns 4
Difficulty in reselling tapes 4
284 A. Wright

Table 3 reveals that there were a large number of cues perceived by

subjects to be relevant. Consistent with the main results, CPAs perceived
environmental cues to be only incidental considerations. The most frequently
cited environmental factor was growth trend of the firm.

Impact of Environmental Cues on Decision Factors

To test for the interrelationship between various evidence sources and

environmental cues, subjects were asked to evaluate the perceived weight
placed on the three key “decision factors” noted earlier:

1. materiality;
2. objections of the client; and
3. generally accepted accounting principles.

The weighting of each factor is treated as an additional respondent judgment.

A three-way analysis of covariance (ANCOVA) was conducted for each
dependent variable.
Table 4 provides the summarized results of these analyses. The subjective
weighting placed on virtually all of the three decision factors is significantly
(~~0.10) affected by the environmental cues. Unfortunately, there is not an
apparent pattern across the cases of this effect. The relationship between the
decision factors and environmental cues appears to be complex and situation-
specific.
An analysis of the mean cue weightings of the experimental groups
indicated that in both cases the objections of a medium-sized client are
perceived to be weighted less than those of a large client. The apparent
greater perceived reliance and consideration of management viewpoints by
auditors of larger concerns would be a great advantage to such clients in
influencing audit judgments that benefit the firm. In the McAllister Inc. case,
the lowest weighting is placed on the objections of a medium-sized, stable
client. The Winslow Co. case results demonstrate greater reliance by CPAs on

Table 4. Results* of analyses of covariance: effect of environ-

mental factors on weighting of decision factors

Hard evidence Environmental

cue factor(s) F Significance*

McAllister Inc.
Materiality Client size 3.7 0.06
Length of association 4.1 0.04
Client objections Client size 2.8 0.10
Size x growth 3.2 0.07
Accounting principles Client size 3.2 0.07
Winslow Co.
Client objections Growth pattern 4.1 0.04
Size x association 3.3 0.07
Accounting principles Growth pattern 3.4 0.07

* Only significant (p 5 0.10) results are presented. df = 1 for all factors

and interactions; df = 36 and 37 for within-group variance for McAllister
Inc. and Winslow Co. cases, respectively.
 Input of selected environmental cues 285

the assertions of long-time clients; low reliance is especially indicated for a

newer, medium-sized client.
The perceived weighting of various key decision factors was found to be
significantly impacted by environmental factors. An interpretation of the
experimental group mean cue weightings suggests the existence of various
environmental heuristics, the influence of environmental cues on the weight-
ing of test data evidence.

Discussion of the Major Findings

The most significant finding was that the environmental cues do not appear to
be relied upon heavily enough to alter CPA judgments. This result has both
favourable and unfavourable implications. Length of client association did not
seem to impair auditor objectivity, which is a positive indication. However, the
need for lower relative materiality and greater disclosure for large and growth
clients was not recognized, suggesting a potential lack of sensitivity for these
environmental cues. A possible explanation for the lack of decision sig-
nificance of environmental cues may be due to the training and educational
background of auditors. Audit standards, courses and training programs deal
almost exclusively with the consideration and gathering of audit test data.
Environmental cues are treated as only peripheral information. Thus, greater
attention may be needed in auditing education, training and the development
of decision aids to draw attention to these potentially important cues. As
suggested by SAS No. 55 (1988) and Lewin (1989), auditors need to take a
global view of the client in its environmental setting to consider fully the risks
of material errors present.
Environmental factors apparently are “intermediary” or “secondary” cues
influencing perceived weightings placed on other decision information. This
impact may be substantial enough in some cases to affect the reliance and
interpretation of such information so as to alter final judgments. The asserted
indirect link between reliance on environmental cues and ultimate disclosure
decisions appears tenable when taking into account that the primary decision
factors studied (materiality and accounting principles) are widely acknow-
ledged to be vitally important to actual audit judgments.
Reliance on environmental factors was found to be significantly affected by
professional experience. However, there was not an established pattern
across the audit cases. Any such relationships appear situation specific.

Limitations of the Study

A potential limitation of the study is the extent of external validity in the
decision setting. The issue is whether the audit cases employed are a
reasonably close simulation of an actual audit accompanied by the usual
client pressures, risks and rewards encountered by the auditor. Several
measures were taken to strengthen external validity:
1. a cross-section of practicing auditors served as subjects;
2. the cases were taken from actual practice and were thoroughly reviewed
for realism by CPAs;
286 A. Wright

3. client pressures, risks (i.e. new security issue) and difficult issues were
interjected into the cases that are typical of those experienced in
practice; and
4. two cases were investigated with different accounting issues in an
attempt to find pervasive usage of environmental cues across decision
settings.
Another limitation present is that subjects were requested to arrive at audit
judgments without consultation with peers. In practice, CPAs often seek the
opinion of other practitioners on difficult decisions. However, participants in
the study were generally at high staff levels and would be anticipated to make
the final decision on audit issues.

Avenues for Future Research and Conclusions

Given the exploratory nature of this research, corroborating studies are
needed examining different samples of auditors and other audit decisions.
Additionally, the use of other research methods would be useful, such as
archival and process tracing approaches. It would be especially valuable to
explore further the reasons for the lack of significance here of client size and
growth.
An extension of the present study is to investigate the impact of other
environmental factors. For example, reputation of the client, anchoring on
prior working papers and sophistication of the accounting system (manual,
computerized) may be examined. All of these factors have been alleged to
influence audit decisions substantially.
Another extension would be to determine the effect of environmental
factors on other audit judgments. Such cues may differentially influence
various decisions, e.g. may substantially impact internal control assessments
but have little influence on footnote disclosures. An additional refinement to
the present study would be to examine the effect of environmental cues on
group decision making. Analytical and empirical studies are also needed to
normatively evaluate how various environmental factors should be weighted
and interpreted by auditors.
This research study has found a lack of significance of environmental
factors for audit disclosure judgments. Although it is widely suggested that
such cues are considered in the planning and other stages of an audit, little is
known as to how and which environmental factors are actually utilized. This
study is viewed as an initial inroad into this area of research that hopefully
will stimulate future efforts.

Acknowledgements
I wish to thank Cristi Lindblom and the two anonymous reviewers on this paper for
their valuable and insightful comments.

Notes
1. Figure 1, presented in the following section of the paper, provides several examples of each
type of evidence.
 Input of selected environmental cues 287

2. It is recognized that any taxonomy, such as the one presented here, involves some overlapping
and classification difficulties. However, this taxonomy in audit evidence (audit tests results vs.
environmental data) appears to be reasonably clear and, as will be discussed, is an important
distinction for research and audit planning considerations.
3. “Inherent risk” is the likelihood of material errors existing irrespective of the control structure
(SAS No. 47, 1983).
4. For extensive reviews see: psychological research-Slavic and Lichenstein (1977); Slavic et al.
(1977); accounting research-Ashton (1982).
5. See Mock and Turner (1978) on the presence of anchoring in audit decisions and Wright (1988)
on the inpact of prior working papers in program planning.
6. Due to the lack of prior empirical research in this area and the exploratory nature of this study,
it is difficult to select the optimal set of environmental cues to study. Only a priori assertions
are available in the literature regarding reliance on such cues. Other cues should be examined
in future research (see “Avenues for Future Research”).
7. Data was also compiled on age and staff position. However, these additional variables were
found to be highly correlated with audit experience (p < 0.05). Thus, only audit experience was
employed as a covariate in the analysis. This choice also provides for greater degrees of
freedom.

References

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the Internal Control Structure in a Financial Statement Audit”, Statement on Auditing Standards
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Responsibility to Detect and Report Errors and Irregularities”, Statement on Auditing Standards
No. 53 (New York: AICPA, 1983).
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Materiality in Conducting an Audit”, Statement on Auditing Standards No. 47 (New York:
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Elliott, R. & Jacobson, P., “The Treadway Report-Its Potential Impact”, CPA Journal, November
1987a, pp. 20-32.
Elliott, R. & Jacobson, P., “Assessing the ASB’s Ten Exposure Drafts”, CPA Journal, December,
1987b, pp. 16-25.
Frishkoff, P., “An Empirical Investigation of the Concept of Materiality in Accounting”,
supplement to Journal ofAccounting Research, 1970, pp. 116-129.
Haskins, M., “Client Control Environments: An Examination of Auditor’s Perceptions”, The
Accounting Review, July 1987, pp. 542-563.
Haskins, M. & Henarie, R., “Attributes and Audit Impact of Client’s Control Environment”, CPA
Journal, July, 1988, pp. 18-26.
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Auditing: A Journal of Practice and theory, Fall, 1982, pp. 45-63.
Lewin, A., “Organizational Design and Auditing: An Agenda for Research”, USC Audit Judgment
Symposium, February, 1989, pp. 1-18.
Magee, R. & Tseng, M., “Audit Pricing and Independence”, The Accounting Review, April, 1990,
pp. 315-336.
McAllister, J. & Dirsmith, M., “How the Client’s Business Environment Affects the Audit”, Journal
of Accountancy, February, 1982, pp. 68-74.
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pp. 86-93.
Mock, T. & Wright, A., “The Relationship Between Inherent and Control Risk Factors and Auditor
Evidential Planning Judgments”, USC Working Paper, Los Angeles, September, 1990, pp. l-34.
Mock, T. & Turner, J., “The Effect of Changes in Internal Controls on Audit Programs”, Behavioral
Experiments in Accounting II, Ohio State University, 1978.
Neebes, D. & Roost, W. “The ASB’s Ten Expectations Gap Proposals-Will They Do the Job?“,
CPA Journal, October, 1987, pp. 22-28.
288 A. Wright

Pattillo, J., The Concept of Materiality in Financial Reporting, (New York: Financial Executives
Research Foundation, 1976).
Slavic, P., Fischkoff, B. & Lictenstein, S., “Behavioral Decision Theo&‘, , Annual Review of
Psychology, 1977.
Slavic, P. & Lichtenstein, S., “Comparison of Bayesian and Regression Approaches to the Study
of Information Processing in Judament”, Oroanizational Behavior and Human Performance,
November, 1977, pp. 649-744. -
Swieringa, M., Gibbins, L., Larsson, L. & Lawson, L. “Experiments in the Heuristics of Human
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Temkin, R. 81 Winters, A., “SAS No. 55: The Auditor’s New Responsibilities for Internal Control”,
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Treadway Commission, Chairman J. C. Treadway, National Commission on Fraudulent Financial
Reporting, 1987.
Tversky, A. 81 Kahneman, D., “Judgment Under Uncertainty: Heuristics and Biases”, Science,
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Accounting, Organizations & Society, 1988, pp. 595-606.

APPENDIX. TEST INSTRUMENT

INSTRUCTIONS

You will be presented two hypothetical case situations and then asked to make an audit decision
on each. This is a research project in auditing. It cannot be overemphasized that you are asked to
make each decision as if it were an actual audit engagement and you were assigned to do the job.
The results of this research study will not be valid or useful if it does not represent actual audit
decisions as they normally would be made by practitioners on the job. Your response will be
anonymous and strictly confidential. Your assistance is greatly appreciated.

MCALLISTER INC.

You are reviewing the workpapers on an audit of McAllister Inc. The company is a real estate
developer, specializing in luxury vacation areas. Profits have been reasonably stable over the last
5 years. Most of the development property is pledged as collateral on bank loans, but there is a
reasonable stockholders’ equity. McAllister Inc. has been an SEC client of the firm for only 2
years.
McAllister has a substantial investment in a large parcel of land in Key Biscayne, Florida. The
company originally paid $1 250000 for the property 2 years ago and has since capitalized an
additional $250 000 in interest and other capital expenditures.
The property is zoned for single family homes, but McAllister has been working diligently to
have it rezoned for condominiums. As a site for condominiums, the property would be more
valuable and the company has an appraisal to that effect. However, if the property were to be sold
as single family home sites, it would be worth no more than $1 170 000.
McAllister’s management concedes that their efforts at rezoning have met stiff local resistance,
but they refuse to admit defeat. They are planning a subtle social pressure campaign on local
political groups. Your audit inquiries confirm that the company has carried its rezoning campaign
through all the legal steps and has been turned down each time. It will clearly be difficult to obtain
rezoning for multi-family use-difficult, but certainly possible.
Your staff people on the engagement report real frustation on this matter. They have concluded
that the client cannot be successful in its rezoning efforts, and therefore, they have suggested
that the carrying value of the land be written down by $330 000. The client has objected, arguing
that any such adjustment prejudges their ability to do their job. They acknowledge an uncertainty
and have suggested that perhaps a footnote describing their plans and problems may be more
appropriate than a write-down.
The Treasurer further argues that “Financial Statements are relied upon by several groups;
borrowers and lenders, stockholders, etc. There should be no purposeful bias favoring any group.
The application of conservatism may actually introduce bias and thus, must be carefully
considered. Confining financial statements to the result of transactions and other events for which
substantial evidence exists and recognizing the varying degree of uncertainty would aid in avoid
bias”.
 Input of selected environmental cues 289

“It seems to me that any write-down on that land would reflect a bias, benefiting only out. Your
benefit would be the reader’s loss. I believe that, if necessary, a frank disclosure of the uncertainty
results in a fairer presentation. Additionally, the write-down does not appear to be that material in
my opinion”.
Attached are the financial statements and selected statistics for McAllister Inc. before the
proposed audit adjustment.

Experimental group No. 8: small client, short association, stable growth.

MCALLISTER INC.
BALANCE SHEET
31 DECEMBER 1977
(Thousands of dollars)
Assets Liabilities and stockholder’s equity
Cash and temporary investments ... . $963 Current liabilities . . . . .. . .. . .. . . . . . . . . . . . . . . . . . . . $5 146
Investments in Land . . . . . . . . . . . .. . .. . . . . . . . . . . . $34 883 Long-term debt . . .. . . . .. . .. . . . . . . . . . . . . . . . . . . . . . . $34 981
Plant assets-net . . . . . . . . . . . . . . . . .._.............. $16 361 Stockholders’ equity . . . . . . . . . . . . . . . . . .._...... $13 658
Other assets . . . ..._..__.............................. $1 578 --_-
Total liabilities and
Total assets . . .. .. ..I................................. $53 785 stockholders’ equity ....I......_...,.__,...... $53 785
-- -.

INCOME STATEMENT
FOR THE YEAR ENDED 31 DECEMBER 1977
(Thousands of dollars)

Revenue from land sales.. .................... $30 369

Cost of land ........................................... $19 040
Gross profit.. .......................................... $1 I 329
Operating expenses ............................... $2 224
Income before taxes ............................. $9 105
Income tax expense.. ............................ .$3 642
Net income ............................................ --- $5 463

KEY STATISTICS
1977f 1976 1975 1974 1973
-----
Return on assets 10% 9% I 1% 12% 10%
Return on equity 40% 39% 40% 42% 38%
Earnings per share $1.95 $1.92 $1.99 $2.07 $1.87
* Before considering the proposed adjustment

WINSLOW COMPANY

Winslow Company, an SEC client of your firrn for the last I3 years, has engaged underwriters and
decided on a public offering of common stock. The underwriters, having reviewed the audited
financial statements for the last 5 years, are interested in selling the new issue but have stated
that they would not do so unless earnings for the current year were equal to or exceeded $1.00
per share. Your long-standing relationship with Winslow has been quite smooth and mutually
advantageous.
Winslow Company basically has two lines of business. It manufactures a large peripheral
computer equipment device, which either may be leased or purchased, and it provides computer
maintenance services, either on an individual transaction or contract basis. In addition, the
equipment division sells computer tapes and drives. Winslow is the largest company in the
peripheral equipment industry. The company has had a relatively stable growth pattern.
During the course of the audit, your staff discover a large sale of tapes to Western Inc., a
business supply house. This transaction is unusual because Winslow generally sells its tapes to
the ultimate user. The full order was shipped to Western under normal payment terms of
1/20/n60; Western had paid all amounts due by year end. Western was reluctant to ourchase
290 A. Wright
such a large order but did so after a provision was added to the sales agreement stipulating that
Winslow would take any unsold tapes back if so requested within 3 years. Winslow management
anticipates no problem on resale. Your staff has proposed an adjustment to account for this
transaction as a consignment sale; the effect of this adjustment would be to reduce earnings per
share by 5c. There are two reasons advanced by your audit staff in support of the adjustment:

1. there is no reliable and demonstrable experience to use as a basis to establish an allowance

for sales returns (new type customer); and
2. a confirmation from Western indicates that sales of the tapes have been slow.

Therefore, consignment accounting is appropriate in this case.

The client sternly objects to this adjustment, contending that earnings per share ($1.10) is
already close to the lower limit specified by the underwriters and any adjustment might impair
the success of the new stock issue. The Treasurer goes on to say, “We are against this proposed
adjustment for two reasons:

1. we can recognize the revenue currently and establish an allowance for return sales based on
industry averages. Also, Western is selling the tapes. If the tapes are returned, we could
readily sell them to other customers; and
2. the adjustment does not have a material effect on the overall financial statements anyway.”

Attached are the summarized Financial Statements and selected statistics for Winslow
Company before the proposed audit adjustment.
Experimental group No. 2: large client, long association, stable growth.

WINSLOW COMPANY
BALANCE SHEET
31 DECEMBER 1977
(Thousands of dollars)

Assets Liabilities and shareholder’s equity

Cash and temp. investments . . . . . .. . .. .. $24 151 Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $283 155
Accounts receivable . . . . . . . . . . . . . . . . .. . .. . .. . . $271 787 Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. $191 402
Inventories . . . . . .. . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. $248 950 Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . $359 641
Plant assets-net .. . . . . . . . . . . . . . . . . . . . . . . . . . .. .. $292 307
Other assets .. . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . .. . .. .. $5 003 Total liabilities and
Total assets . . . . . . . . . .. . . . .. . .. . . . . . . . . . . . . . . . . . . . . . $842 198 shareholders’ equity .. . . . . . . . . . . . . . . . . . . . . . . $842 198

INCOME STATEMENT
FOR THE YEAR ENDED 31 DECEMBER 1977
(Thousands of dollars)

Equipment sales .. . .. . .. .. . . . . . . . . . . . . . . . . . . . $727 971

Lease revenue . . . . . . . . . . . .. . . . . . . . . . . . . . . . . $292 377
Maintenance revenue . .. .. . . . . . . . . . . . $93 022
Total revenue . . . . . . . .. . . . .. . ...__............. $1 113 370
Cost of goods sold . . . . . . . . . . .. .. . . . . . . . $641016
Gross profit . . . . . . . . . . . . . . . . .. . . . . . . .. . . . . .. . . . . . $472 354
Operating expense.. ....................... $330 584
Income before taxes ...................... $141 770
Income tax expense.. .....................
Net income .....................................

KEY STATISTICS

1977* 1976 1975 1974 1973

~----
Return on assets 12% 10% 10% 9% 10%
Return on equity 27% 25% 25% 23% 24%
Earnings per share $1.10 $0.90 $0.89 $0.82 $0.87

* Before considering proposed adjustment