How Changing Economic Conditions Over Multiple Periods Affect Earnings Overstatements, Audit Risk, and Market Prices

• In Event: Exogeneous Shocks and Audits

Abstract

We analyze a setting in which the auditor designs an audit to detect a possible overstatement in reported earnings over multiple periods. The multi-period analysis allows us to examine how changing economic conditions affect the auditor’s assessment of fraud, the manager’s inclination to overstate earnings, the firm’s market price and audit risk. On the one hand, good economic conditions may promote earnings overstatement due to the market’s expectations for good earnings reports and may provide “cover” for a dishonest manager to execute a fraudulent reporting strategy. On the other hand, bad economic conditions may encourage earnings overstatement in order for the manager to maintain continued earnings growth and firm value. Our two-period strategic auditing model considers how changes in economic conditions and changes in the auditor’s and manager’s payoffs affect market price, audit risk, earnings overstatements and audit effort both within and across periods. The empirical implications of our study include: how bias is reflected in market prices through an intercept effect; the limitations of a contemporaneous research design on assessing the implications of an exogenous shock to existing economic conditions; and, how the changing expectations of future earnings affect the auditor’s allocation of effort across periods and the related implications of this allocation on earnings overstatements, market price, and audit risk.

Authors

• Evelyn R Patterson, Indiana University - Indianapolis

• Reed Smith, Indiana University - Indianapolis

• Samuel Louis Tiras, Indiana University - Indianapolis