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Although real earnings management (REM) is common and potentially increasing, research regarding how auditors react when clients use REM is limited. We conduct an experiment to investigate how a client’s use of REM affects auditor perceptions, judgments, and decisions. As predicted, results indicate that, when a client uses REM to meet an earnings forecast, auditors perceive weaker management tone and have a heightened level of professional skepticism (i.e., higher risk assessments and propensity to perform additional auditing procedures). Results also show that REM’s impact on tone and professional skepticism depends on management’s explanation for the operating decision. Auditors only partially rely on management’s business-related explanations for operating decisions that otherwise are consistent with REM. Lastly, we provide evidence that auditor perceptions of tone mediate the relationship between REM and risk assessments, suggesting that the impact of REM on auditor perceptions of management’s tone explains the increased level of skepticism. Overall, results suggest that auditors recognize REM, causing them to view the client and conduct the audit differently. Given the prevalence of REM, and that REM can be used to mislead shareholders, it is important to understand how auditors respond to its use.
Benjamin Commerford, University of Alabama-Tuscaloosa
Dana R. Hermanson, Kennesaw State University
Richard W Houston, University of Alabama-Tuscaloosa
Michael Francis Peters, Villanova University