Evidence from Auditors About Managers’ and Auditors’ Earnings Management Decisions
THE ACCOUNTING REVIEW Vol. 77 Supplement 2002 pp. 175–202
Evidence from Auditors about Managers’ and Auditors’ Earnings Management Decisions
Mark W. Nelson John A. Elliott
Cornell University
Robin L. Tarpley
The George Washington University
ABSTRACT: This paper reports analyses of data obtained using a field-based questionnaire in which 253 auditors from one Big 5 firm recalled and described 515 specific experiences they had with clients who they believe were attempting to manage earnings. This approach enables us to analyze separately managers’ decisions about how to attempt earnings management and auditors’ decisions about whether to prevent earnings management by requiring adjustment of the financial statements. Our results indicate that managers are more likely to attempt earnings management, and auditors are less likely to adjust earnings management attempts, which are structured (not structured) with respect to precise (imprecise) standards. We also find that managers are more likely to make attempts that increase current-year income, but auditors are more likely to require that those attempts be adjusted, that managers are more likely to make attempts that decrease current-year income with unstructured transactions and/or when standards are imprecise, and that auditors are more likely to require adjustment of attempts that they identify as material or that are attempted by small clients.
We appreciate comments from Michael Gibbins (the discussant), Katherine Schipper (the editor), and Linda Bamber, Mike Bamber, Rob Bloomfield, Karl Hackenbrack, Frank Hodge, Steve Kachelmeier, Bill Kinney, Lisa Koonce, Susan Krische, Bob Libby, John Lyon, Steve Salterio, two anonymous reviewers, and participants at The Accounting Review’s Conference on Quality of Earnings and the Conference on Behavioral Research in Financial Reporting (both at Emory University), as well as workshop participants at the Australian Graduate School of Management, University of
Evidence from Auditors about Managers’ and Auditors’ Earnings Management Decisions
Mark W. Nelson John A. Elliott
Cornell University
Robin L. Tarpley
The George Washington University
ABSTRACT: This paper reports analyses of data obtained using a field-based questionnaire in which 253 auditors from one Big 5 firm recalled and described 515 specific experiences they had with clients who they believe were attempting to manage earnings. This approach enables us to analyze separately managers’ decisions about how to attempt earnings management and auditors’ decisions about whether to prevent earnings management by requiring adjustment of the financial statements. Our results indicate that managers are more likely to attempt earnings management, and auditors are less likely to adjust earnings management attempts, which are structured (not structured) with respect to precise (imprecise) standards. We also find that managers are more likely to make attempts that increase current-year income, but auditors are more likely to require that those attempts be adjusted, that managers are more likely to make attempts that decrease current-year income with unstructured transactions and/or when standards are imprecise, and that auditors are more likely to require adjustment of attempts that they identify as material or that are attempted by small clients.
We appreciate comments from Michael Gibbins (the discussant), Katherine Schipper (the editor), and Linda Bamber, Mike Bamber, Rob Bloomfield, Karl Hackenbrack, Frank Hodge, Steve Kachelmeier, Bill Kinney, Lisa Koonce, Susan Krische, Bob Libby, John Lyon, Steve Salterio, two anonymous reviewers, and participants at The Accounting Review’s Conference on Quality of Earnings and the Conference on Behavioral Research in Financial Reporting (both at Emory University), as well as workshop participants at the Australian Graduate School of Management, University of
References: Antle, R., and B. Nalebuff. 1991. Conservatism and auditor-client negotiations. Journal of Accounting Research 29 (Supplement): 31–59. Arens, A., and J. Loebbecke. 1997. Auditing: An Integrated Approach. 7th edition. Englewood Cliffs, NJ: Prentice Hall. Ayers, S., and S. E. Kaplan. 1998. Potential differences between engagement and risk review partners and their effect on client acceptance judgments. Accounting Horizons 12 (2): 139–153. Barth, M. E., J. A. Elliott, and M. W. Finn. 1999. Market rewards associated with patterns of increasing earnings. Journal of Accounting Research 37 (Autumn): 387–413. Beatty, A., B. Ke, and K. Petroni. 2002. Earnings management to avoid earnings declines across publicly and privately held banks. The Accounting Review (July): 515–546. Beneish, M. D. 1997. Detecting GAAP violation: Implications for assessing earnings management among firms with extreme financial performance. Journal of Accounting and Public Policy 16 (Fall): 271–309. Beresford, D. R. 1999. It’s time to simplify accounting standards. Journal of Accountancy 187: 65– 67. Bonner, S. E., Z-V. Palmrose, and S. M. Young. 1998. Fraud type and auditor litigation: An analysis of SEC accounting and auditing enforcement releases. The Accounting Review 73 (October): 503– 532. Bradshaw, M., S. A. Richardson, and R. G. Sloan. 2001. Do analysts and auditors use information in accruals? Journal of Accounting Research 39 (1): 45–74. Braun, K. W. 2001. The disposition of audit-detected misstatements: An examination of risk and reward factors and aggregation effects. Contemporary Accounting Research 18 (1): 71–100. Burgstahler, D., and I. Dichev. 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24: 99–126. ———, and M. Eames. 1998. Management of earnings and analyst forecasts. Working paper, University of Washington and Santa Clara University. Carcello, J. V., and Z-V. Palmrose. 1994. Auditor litigation and modified reporting on bankrupt clients. Journal of Accounting Research 32 (Supplement): 1–29. Davies, G. M. 1993. Witnessing events. In Memory in Everyday Life: Advances in Psychology, edited by G. M. Davies, and R. H. Logie, 367–401. Amsterdam, The Netherlands: North-Holland / Elsevier Science Publishers. Dechow, P. M., R. G. Sloan, and A. P. Sweeney. 1995. Detecting earnings management. The Accounting Review 70 (April): 193–225. ———, ———, and ———. 1996. Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research 13: 1– 36. ———, and D. J. Skinner. 2000. Earnings management: Reconciling the views of accounting academics, practitioners, and regulators. Accounting Horizons 14 (June): 235–250. DeFond, M. L., and J. Jiambalvo. 1993. Factors related to methods. Contemporary Accounting Research 9: 415–431. Degeorge, F., J. Patel, and R. Zeckhauser. 1999. Earnings management to exceed thresholds. Journal of Business 72: 1–33. Diver, C. S. 1983. The optimal precision of administrative rules. Yale Law Journal 93: 65–109. Ehrlich, I., and R. A. Posner. 1974. An economic analysis of legal rulemaking. Journal of Legal Studies 3: 257–286. Fields, T., T. Lys, and L. Vincent. 2001. Empirical research on accounting choice. Journal of Accounting and Economics 31 (1-3): 255–307. Flanagan, J. C. 1954. The critical incident technique. Psychological Bulletin 51 (4): 327–358. Francis, J., and D. Simon. 1987. A test of audit planning in the small-client segment of the U.S. Audit Market. The Accounting Review 62 (January): 145–157. ———, and J. Krishnan. 1999. Accounting accruals and auditor reporting conservatism. Contemporary Accounting Research 16 (Spring): 135–165. Nelson, Elliott, and Tarpley—Evidence from Auditors about Earnings Management 201 Gibbins, M., and J. Newton. 1994. An empirical exploration of complex accountability in public accounting. Journal of Accounting Research 32(2) (Autumn): 165–186. ———, S. Salterio, and A. Webb. 2001. Evidence about auditor-client management negotiation concerning client’s financial reporting. Journal of Accounting Research 39 (3): 534–563. ———. 2001. Incorporating context into the study of judgment and expertise in public accounting. International Journal of Auditing 5 (3): 225–236. Gibson, A. M., and A. H. Frakes. 1997. Truth or consequences: A study of critical issues and decision making in accounting. Journal of Business Ethics 16 (2): 161–171. Gifford, D. J. 1971. Communication of legal standards, policy development and effective conduct regulation. Cornell Law Review 56: 409–468. Graham, J. R., and C. R. Harvey. 2001. The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics 61 (2,3): 187–243. Greenberg, B. G., R. R. Kuebler, Jr., J. R. Abernathy, and D. G. Horvitz. 1971. Application of the randomized response technique in obtaining quantitative data. Journal of the American Statistical Association 66: 243–250. Hackenbrack, K., and M. W. Nelson. 1996. Auditors’ incentives and their application of financial accounting standards. The Accounting Review 71 (January): 43–59. Hayn, C. 1995. The information content of losses. Journal of Accounting and Economics 20: 125– 153. Healy, P. M., and J. M. Wahlen. 1999. A review of the earnings management literature and its implications for standard setting. Accounting Horizons 13 (October): 365–383. Icerman, R., and W. Hillison. 1991. Disposition of audit-detected errors: Some evidence on evaluative materiality. Auditing: A Journal of Practice & Theory 10 (Spring): 22–34. Jones, J. J. 1991. Earnings management during import relief investigations. Journal of Accounting Research 29 (Autumn): 193–228. Kadous, K., J. Kennedy, and M. E. Peecher. 2000. Auditors’ judgments of the acceptability of clientpreferred accounting methods. Working paper, University of Washington, WA. Kaplow, L. 1999. General characteristics of rules. In Encyclopedia of Law and Economics, edited by B. Bouckaert, and G. De Geest, 502–528. Cheltenham, U.K.: Edward Elgar. Kennedy, J., D. N. Kleinmuntz, and M. E. Peecher. 1997. Determinants of the justifiability of performance in ill-structured audit tasks. Journal of Accounting Research 35 (Supplement): 105– 123. Kessler, D., and M. McClellan. 1996. Do doctors practice defensive medicine? Quarterly Journal of Economics 111: 352–390. King, R. R. 2002. An experimental investigation of self-serving biases in an auditing trust game: The effect of group affiliation. The Accounting Review 77 (2): 265–284. Kinney, W. R., and R. D. Martin. 1994. Does auditing reduce bias in financial reporting? A review of audit-related adjustment studies. Auditing: A Journal of Practice & Theory 13 (1): 149–156. Lee, C-W. J., and Z. Gu. 1998. Low balling, legal liability and auditor independence. The Accounting Review 73 (October): 533–556. Levitt, A. 1998. The numbers game. Speech delivered at the NYU Center for Law and Business, New York, NY, September 28. Libby, R., and W. R. Kinney. 2000. Earnings management, audit differences, and analysts’ forecasts. The Accounting Review 75 (4): 383–404). ———, R. Bloomfield, and M. W. Nelson. 2001. Experimental research in financial accounting. Accounting, Organizations and Society 27 (8): 775–810. Loftus, E. F. 1982. Memory and its distortions. In The G. Stanley Hall Lecture Series, Vol 2, edited by Kraut, 123–154. Washington, D. C.: American Psychological Association. Mason, A. K., and M. Gibbins. 1991. Judgment and U.S. accounting standards. Accounting Horizons 5: 14–24. Mayhew, B. W., J. W. Schatzberg, and G. R. Sevcik. 2001. The effect of accounting uncertainty and auditor reputation on auditor objectivity. Auditing: A Journal of Practice & Theory 20: 49–70. 202 The Accounting Review, 2002 Supplement McNichols, M., and G. P. Wilson. 1988. Evidence of earnings management from the provision for bad debts. Journal of Accounting Research 26 (Supplement): 1–31. ———. 2000. Research design issues in earnings management studies. Journal of Accounting and Public Policy 19 (4 / 5): 313–345. Miller, M. W., and L. Berton. 1993. Softer numbers: As IBM’s woes grew, its accounting tactics got less conservative. Wall Street Journal (April 7). Moore, J. S., and A. K. Reichert. 1983. An analysis of the financial management techniques currently employed by large U. S. corporations. Journal of Business Finance and Accounting 10: 623– 645. Nelson, M. W., and W. R. Kinney. 1997. The effect of ambiguity on auditors’ loss contingency reporting judgments. The Accounting Review 72 (April): 257–274. Neter, J., W. Wasserman, and M. H. Kutner. 1983. Applied Linear Regression Models. Homewood, IL: Irwin. Ogus, A. I. 1992. Information, error costs and regulation. International Review of Law and Economics 12: 411–421. Oppenheim, A. N. 1992. Questionnaire Design, Interviewing, and Attitude Measurement. New York, NY: Pinter Publishers. Panel on Audit Effectiveness. 2000. Report and Recommendations Exposure Draft (May 31). Stamford, CT: Public Oversight Board. Parfet, W. U. 2000. Accounting subjectivity and earnings management: A preparer perspective. Accounting Horizons 14: 481–488. Pulliam, S. 1988. Besting FAS-13. Corporate Finance (December): 31. Randall, D. M., and A. M. Gibson. 1990. Methodology in business ethics research: A review and critical assessment. Journal of Business Ethics 9: 457–471. Salterio, S., and L. Koonce. 1997. The persuasiveness of audit evidence: The case of accounting policy decisions. Accounting, Organizations and Society 22 (6): 573–587. Schipper, K. 1989. Commentary on earnings management. Accounting Horizons 3 (December): 91– 102. Shavell, S. 1987. Economic Analysis of Accident Law. Cambridge, MA: Harvard University Press. St. Pierre, K., and J. A. Anderson. 1984. An analysis of the factors associated with lawsuits against public accountants. The Accounting Review 59 (April): 242–263. Stokes, M. E., C. S. Davis, and G. G. Koch. 2000. Categorical Data Analysis Using the SAS System. Cary, NC: SAS Institute, Inc. Trahan, E. A., and L. J. Gitman. 1995. Bridging the theory-practice gap in corporate finance: A survey of chief financial officers. The Quarterly Review of Economics and Finance 35 (1): 73–87. Trompeter, G. 1994. The effect of partner compensation schemes and generally accepted accounting principles on audit partner judgment. Auditing: A Journal of Practice & Theory 13 (2): 56–71. Wallace, R., and C. Mellor. 1988. Nonresponse bias in mail accounting surveys: A pedagogical note. British Accounting Review 20: 131–139. Warner, S. L. 1965. Randomized response: A survey technique for eliminating evasive answer bias. Journal of the American Statistical Association 60: 63–69. Wright, A., and S. Wright. 1997. An examination of factors affecting the decision to waive audit adjustments. Journal of Accounting, Auditing & Finance 12 (1): 15–36. Zhang, P. 1999. A bargaining model of auditor reporting. Contemporary Accounting Research 16 (Spring): 167–184.