How Do Reward Versus Penalty Framed Incentives Affect Diagnostic Performance in Auditing?

Prior research examines how rewards versus economically equivalent penalties affect effort. However, accountants perform various diagnostic analyses that involve more than exerting effort. For example, auditors often need to identify whether a material misstatement is the underlying cause of a phenomenon among the possible causes. Testing helps identify the cause, but testing is costly. When participants are incentivized to test accurately (rather than test more) and objectively (unbiased between testing and not testing), we find that framing the incentives as rewards versus equivalent penalties increases testing by lowering the subjective testing criterion and by increasing the assessed risk of material misstatement. However, testing increases primarily when a misstatement is absent, causing more false alarms under a reward frame with no improvement in misstatement detection. Penalties are pervasive in auditing. Our study suggests that rewards are more effective for increasing testing, and that increasing testing blindly can impair audit efficiency.