The Cascading Effect of Dispositional Inferences: The Effect of Real Earnings Management on Auditors' Evaluations of Management's Estimates

• In Event: Materiality

Abstract

Prior research often asserts that, because real earnings management (REM) does not violate Generally Accepted Accounting Principles (GAAP), it is not likely to draw auditor scrutiny. However, informed by Correspondent Inference Theory, we predict and find that observing REM can affect auditors’ decisions in audit areas unrelated to REM. This study reports the results of an experiment in which auditors evaluate quantitatively immaterial audit differences arising from management’s subjective estimates. We manipulate the presence versus absence of REM, and whether or not the audit difference is qualitatively material (i.e., it affects the client’s ability to meet an earnings target). Prior research indicates that auditors are reluctant to adjust quantitatively immaterial audit differences that are qualitatively material (e.g., Libbey and Kinney 2000). However, our results indicate that, when a quantitatively immaterial audit difference affects the client’s ability to meet an earnings target, auditors have a higher propensity to propose an adjustment. Further, we predict and find that, regardless of whether or not the audit difference impacts the client’s ability to meet its earnings target, auditors are more likely to constrain management’s estimates in the presences of REM. Finally, consistent with the notion of a cascading effect of dispositional inferences, we find that auditors’ perceptions related to the aggressiveness of management’s operating decisions and the aggressiveness of management in general are causally linked and, together, mediate the effect of REM on auditors’ adjustment decisions. This study contributes to the literature by demonstrating that auditors’ altered perceptions, stemming from observing REM, can affect their treatment of audit differences and, ultimately, impact the financial statements.

Authors

• Benjamin Commerford, University of Alabama-Tuscaloosa

• Richard Hatfield, University of Alabama-Tuscaloosa

• Richard W Houston, University of Alabama-Tuscaloosa