Real Earnings Management: The Auditor’s Perspective

• In Event: Auditor Judgment and Decision-Making

Abstract

Academic research shows that companies manage earnings through the use of accruals, estimates, and accounting policies (i.e., accounting earnings management, “AEM”). Companies can also manage earnings through the strategic timing of investment, financing, and operating decisions (i.e., real earnings management, “REM”). Research suggests that REM is less likely than AEM to draw auditor and regulatory scrutiny, perhaps making it a more attractive alternative to AEM. However, very little is known about how auditors view the use of REM, and how they respond to REM when they are aware of it. Based on in-depth interviews of 20 experienced auditors (19 partners and one senior manager), we provide detailed insights into auditors’ perspectives concerning REM. The interviews reveal that auditors are aware of various REM techniques, and that most interviewees care about REM primarily because it may signal the use of other, less acceptable methods that clients may be using to meet targets. REM often is discovered through analytical procedures, discussions with management, or the auditor’s knowledge of the business. However, REM can be difficult to detect, and auditors typically consider MD&A disclosures related to REM to be inadequate. The presence of REM influences the audit process in many ways, resulting in adjustments to audit procedures, risk assessments, auditor skepticism, and assessments of management tone. In the extreme, auditors may resign from an engagement because of REM. Auditors view AEM as a more significant audit issue than REM, but acknowledge that REM is more difficult to detect then AEM. Finally, auditors perceive that the Sarbanes-Oxley Act (SOX) reduced AEM, with some interviewees seeing a shift from AEM to REM in the post-SOX period.

Authors

• Benjamin Paul Commerford, University of Alabama

• Dana R. Hermanson, Kennesaw State University

• Richard W Houston, The University of Alabama

• Michael Francis Peters, Villanova University