Auditor Sensitivity to Real Earnings Management: An Experimental Investigation

• In Event: Continental Breakfast - Research and Education Forum
  In Roundtable Session: Table 10: Audit Quality Indicators

Abstract

Although real earnings management (REM) is increasingly more common post-Sarbanes-Oxley Act, research regarding how auditors react when they know that clients are using REM is limited. Given that REM is prevalent and can mislead shareholders, it is important to understand how auditors respond to its use. 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. Results also show that REM’s impact on perceived tone and professional skepticism depends on management’s explanation for the operating decision related to REM. Auditors only partially rely on management’s business-related explanations for operating decisions that otherwise are consistent with REM. Additionally, we provide evidence that auditor perceptions of tone mediate the relationship between REM and risk assessments, suggesting that REM’s impact on auditor perceptions of management’s tone explains the increased level of skepticism. Lastly, additional experimentation indicates that auditors are not as sensitive to REM when the client misses an earnings target. Overall, results suggest that auditors react to REM, which in turn causes them to view the client and conduct the audit differently.

Authors

• Benjamin Commerford, The University of Alabama

• Dana R. Hermanson, Kennesaw State University

• Richard W. Houston, The University of Alabama

• Michael Francis Peters, Villanova University