The Dangers of Heuristics and Biases in Audit

The Dangers of Heuristics and Biases in Audit James Bone President Global Compliance Associates, LLC

The Dangers of Heuristics and Biases in Audit What a strange topic for Internal Audit! There can’t be any research or relevance! YOU MAY BE IN FOR A SURPRISE! WE WILL EXPOSE A FEW MYTHS AS WELL………

What is this philosophical hogwash? Ø Who is the founding father of “Free Enterprise” in America? Ø Adam Smith Ø What was his occupation and title? Ø Professor of Moral Philosophy at the University of Glasgow Ø What year was “An inquiry into the nature and causes of The Wealth of Nations” written? Ø 1776 Ø What year was “The Theory of Moral Sentiments” written? Ø 1759 (17 years earlier)

SOX speaks to Human Behavior but does not address how to audit for it? Sarbanes-Oxley (PCAOB) Title I, Section 103 q Defines auditor independence q Processes & Procedures for compliance audits q Inspecting and Policing Conduct and Quality Control q Corporate Responsibility q Enumerates specific limits on certain Behaviors of Corporate Officers

How does it apply to audit? Auditing involves judgment and expertise Judgment is very good most of time We can be lead astray Heuristic; Greek: "Εὑρίσκω", "find" or "discover") refers to experience-based techniques for problem solving, learning, and discovery that give a solution which is not guaranteed to be optimal. (EXPERIENCE, INTUITION, INSTINCTS)

How does it apply to audit? "inherent bias" refers to the effect of underlying factors or assumptions that skew viewpoints of a subject under discussion. In statistics, sampling bias is a bias in which a sample is collected in such a way that some members of the intended population are less likely to be included than others. It results in a biased sample, a non-random sample[1] of a population (or nonhuman factors) in which all individuals, or instances, were not equally likely to have been selected. [2] If this is not accounted for, results can be erroneously attributed to the phenomenon under study rather than to the method of sampling.

Practical examples of Heuristics and Biases Heuristics q Cars q Beautiful woman/man q 10, 000 hours (expert) – golf, study, auditing q Do you know everything there is to know? Biases q What You See Is All There Is q Beliefs q Exposure q Novel experience/events – we must make sense of strange new things/events/change

How Heuristics and Biases lead us astray System 1 System 2 Bernoulli’s errors The Law of Small Numbers Availability, Emotion and Risk Law of Least Effort Illusions: Anchors Substitution Priming Causality (WYSIATI) A bias of confidence over doubt

Detect financial statement fraud Insufficient audit evidence 80% A lack of sufficient business skepticism? New tools are Needed to overcome these errors Failure to assess risk & adjust audit plan 44% Failure to Apply GAAP 50%

Cognitive Bias 3 common audit weaknesses q Evidence and evaluating data q Evaluating risks and professional skepticism q Procedural & Process orientation (time crunch) Cognitive solutions q Law of small numbers q (WYSIATI) What You See Is All There Is q Substitution/Bernoulli’s error

Why “Tone” at the Top Misleads q Very few business leaders start out intent on committing fraud Enron’s Code of Ethics q "As officers and employees of the Enron Corp. , its subsidiaries, and its affiliated companies, we are responsible for conducting the business affairs of the companies in accordance with all applicable laws and in a moral and honest manner. "

Sam Antar & Crazy Eddie Master’s of Heuristics & Biases Judgement Errors Lack of internal controls Poor audit training Inadequate Poor testing: AP, questions/follow up Poor or incomplete Inventory, etc. on trust of Over reliance analytics management

Sam Antar, CFO Crazy Eddie Why does Heuristics and Biases matter? http: //youtu. be/o 0 t. UZ 6 lmnls

What does science suggest? Building organizational awareness Audit expectations gap: q Use technology to facilitate/enhance data gathering and analysis q Audit as learning – Not punishment q Audit as deterrence - Strategically q Audit as motivation q Audit as process improvement q Organizational support for audit q Audit as risk awareness

“Switch” How to change things when change is hard Chip Heath & Dan Heath q. Direct the Rider q. Motivate the Elephant q. Shape the path

Workshop/Questions

James Bone q Global Compliance Associates, LLC q The. GRCBlue. Book. com q jbone@globalcomplianceassociates. com q info@thegrcbluebook. com q Copies of the presentation or references and publications used