The Impact of Financial Statement Audits on Non-Income-Increasing Misreporting: Evidence from Restatements

• In Event: Restatements

Abstract

Extant literature documents that managers rely on a variety of non-income-increasing techniques to manipulate earnings. However, prior research finds that the auditor is more likely to discipline firms against practicing income-increasing earnings management due to its higher litigation risk, although it remains unclear whether the auditor constrains non-income-increasing misreporting. Drawing on prior theory and empirical evidence that higher audit effort (measured with abnormal audit fees) reduces the likelihood of undetected misstatements (measured with subsequent restatements), we find that, first, higher audit effort reduces the likelihood of income-increasing misstatements, but it has no perceptible impact on other misstatements (i.e., misstatements that do not increase net income). Second, outside monitoring by sophisticated market participants and auditors’ client-specific knowledge increase audit efficacy for only income-increasing misstatements, whereas long auditor tenure undermines audit efficacy for other misstatements. Third, financial statement audits have minimal impact on even other misstatements driven by opportunism (income-decreasing misstatements motivated by income-shifting, core account misclassification, or cash flow misstatements), which constitute the majority of other misstatements. Fourth, the market reacts negatively to the announcement of both income-increasing and other misstatements, suggesting that both could distort firm valuation and hinder efficient capital allocation. In light of the recent trend that non-income-increasing misstatements have become the most prevalent type of financial misreporting, our results reveal a potential deficiency in the current state of financial statement audits.

Authors

• Jeffrey Pittman, Memorial University of Newfoundland

• Yuping Zhao, University of Houston-Houston