The Effect of a Justification Memo and Hypothesis Set Quality on the Review Process

Abstract

This study provides evidence on the effects of a preparer's supporting justification memo and hypothesis set quality on a reviewer's ability to identify a preparer's incorrect conclusion. We hypothesize that the presence of a supporting justification memo will lead to a significant performance decline for reviewers who evaluate working papers containing a correct hypothesis set (one that includes the correct cause), but not those with an incorrect hypothesis set. This expectation follows because reviewers of the correct hypothesis set can link each hypothesis in the working papers to an underlying piece of evidence while those with the incorrect hypothesis set cannot. Thus, the former are more likely to presume that evidence pointing to the actual cause has been integrated, and hence are more willing to rely on the preparer's supporting justification memo. To test our hypothesis, 97 audit seniors reviewed working papers documenting work done by a preparer while investigating five potential explanations (i.e., hypotheses) of an unexpected fluctuation in a client's gross margin. We manipulated justification (Supporting Justification Memo versus No Justification Memo) and hypothesis set quality (Correct Set versus Incorrect Set). All reviewers received work paper documentation showing the results of six tests and an incorrect preparer conclusion. The dependent variable was whether reviewers agreed or disagreed with the preparer's conclusion. The experimental rsesults are consistent with our hypothesis suggesting that in a correct hypothesis set scenario a supporting justification memo may undermine the effectiveness of the review process. The findings underscore the need for reviewers to first evaluate the underlying audit evidence before looking at the preparer's overall conclusion and justification memo.