Auditor Sensitivity to Real Earnings Management: The Importance of Ambiguity and Earnings Context Benjamin P. Commerford, Dana R. Hermanson, RichardW. Houston, andMichael F. Peters
Contemporary Accounting Research Vol. 36, No. 2 (Summer 2019), pp. 1055-1076
Overview Real earnings management (REM) involves altering transactions, such as cutting expenses, in order to meet financial targets. In recent years, REM has become more popular, as auditors appear to have restricted other ways of manipulating financial results. We explore how auditors react to REM, using an experiment administered to auditors. We use three levels of REM (none, possible REM, and explicit REM), and we also vary whether the hypothetical client exceeded or missed its profit target. We find that auditors encountering REM decrease their assessment of management’s tone, and indicate a greater chance that they would discuss their concerns with the board’s audit committee and not continue to serve the client. When the REM is explicit, auditors react regardless of the profit target, but they react to possible REM only when the target was exceeded. The key driver of auditors’ reaction to REM is management tone, suggesting that REM reflects poorly on management’s character.
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