Can Increased Auditor Scrutiny Deter R&D Underinvestment? The Importance of Communication with the Board and Consistency with Peer Behavior

• In Event: Auditor Scrutiny, Liability & Conservatism

Abstract

Research indicates, in order to meet short-term targets, managers often make operational decisions that are detrimental to firms’ long-term value creation. With experienced corporate managers as participants, we conduct an experiment to examine whether increased auditor scrutiny – through increased inquiry and testing plus communication with the board of directors – can deter underinvestment in R&D, and whether such an effect is contingent on the consistency between managers’ decisions and peer behavior. We find that increased auditor scrutiny reduces managers’ underinvestment in R&D, but such an effect is mitigated when managers’ operational decisions are consistent (as opposed to inconsistent) with peer behavior. We also conduct a second experiment where auditors only increase inquiry and testing without communication with the board of directors. Results show that managers are not deterred from opportunistically underinvesting in R&D, irrespective of consistency with peer behavior. These findings highlight the importance of auditor’s communication with the board of directors in constraining managers’ opportunistic operating decisions. Further, our results demonstrate that the extent to which auditor actions can affect managers’ operating decisions is contingent on the consistency of such decisions with peer behavior.

Authors

• Benjamin Commerford, University of Kentucky

• Jessica Osgood, University of Massachusetts-Amherst

• Ying Wang, University of Massachusetts-Amherst