Explaining Away Intentional Misstatements: When are Management Excuses Most Effective?

• In Event: Auditor Response to Managers' Motives

Abstract

When auditors identify a misstatement within the financial statements, they typically discuss the misstatement with client management and seek an explanation to understand how it occurred. In the event the misstatement was caused intentionally, managers may attempt to “explain away” the fraudulent misstatement by making it seem unintentional (an excuse) or by defending its appropriateness (a justification). In this study, we use two experiments—one with 58 financial reporting managers and the other with 108 professional auditors—to examine the strategies used by managers to explain away intentional misstatements and the circumstances under which auditors are prone to believe these misleading accounts. We predict and find that managers believe they can more effectively explain away an intentional misstatement caused by omission (i.e., inaction), as opposed to misrepresentation (i.e., action), but only if the explanation takes the form of an excuse. Accordingly, most managers choose an excuse, rather than a justification, when attempting to explain away an intentional omission. However, when this same excuse is provided to auditors to explain the cause of a misstatement identified during the audit, we find that they judge it to be more believable when the misstatement involves omission compared to active misrepresentation. Together, our studies suggest the specific omission-excuse combination chosen by managers to perpetrate and conceal fraud is the combination auditors are more inclined to believe.

Authors

• Erin L Hamilton, University of Nevada-Las Vegas

• Jason L. Smith, University of Nevada-Las Vegas