Academic journal article Auditing: A Journal of Practice & Theory

The Role of Incentives to Manage Earnings and Quantification in Auditors' Evaluations of Management-Provided Information

Academic journal article Auditing: A Journal of Practice & Theory

The Role of Incentives to Manage Earnings and Quantification in Auditors' Evaluations of Management-Provided Information

Article excerpt

INTRODUCTION

Auditors must evaluate the information obtained at audit planning to determine the nature, extent, and timing of audit work to be performed. In many cases, planning information takes the form of explanations and other information from client management (Hirst and Koonce 1996). Management-provided information is especially important when the auditor investigates accounts that are subjective and based on estimates, because the auditor's ability to obtain reliable information from other sources is limited in such cases. Given the importance of subjective accounts and estimates in financial reports (e.g., FASB 2001a; Lev and Zarowin 1999; Lundholm 1999), the quality of earnings may be compromised if the auditor fails to appropriately evaluate management provided information.

In this paper, we experimentally examine the effects of two contextual factors on auditors' evaluations of the persuasiveness of a management-provided explanation for a significant fluctuation in an account that requires considerable estimation. These two factors are, first, whether the explanation is quantified (i.e., put into numbers) and, second, whether the client manager is likely to distort the information (i.e., the manager has incentives to manage earnings). These two factors were chosen because they provide important cues to the quality of management-provided information and, in turn, earnings quality. We draw on research on persuasion (Friestad and Wright 1994) to argue that these factors will jointly influence auditors' judgments.

Investigating this issue is important because we know little about how auditors respond to attempts by managers to persuade them as to the acceptability of their financial reports (however, see Nelson et al. 2002). Previous research from a persuasive perspective in auditing has focused on how auditors are persuaded by other audit-team members (e.g., Rich et al. 1997; Tan and Yip-Ow 2001), rather than by management. Previous research on auditors' reactions to management explanations for unexpected fluctuations has largely focused on steps that auditors can take to reduce the extent to which auditors are persuaded by management explanations. For example, Heiman (1990) demonstrated that providing auditors with alterative explanations reduces the persuasiveness of a management explanation. Koonce (1992) demonstrated that auditors are less persuaded after writing down reasons why management's explanation might be incorrect. While research has also examined how the accuracy (Bedard and Biggs 1991) and sufficiency (Anderson and Koonce 1998) of management representations influence auditor judgments, no auditing research that we are aware of manipulates features of the explanation, such as whether it is quantified, that management could use to influence persuasion.

In this study, we examine how auditors react to quantified versus non-quantified management representations for an important, subjective account. A quantified explanation provides potentially important information to the auditor about whether the explanation is sufficient in magnitude to be responsible for the fluctuation. We predict that whether the auditor is more persuaded by a quantified explanation will depend on management's incentives to engage in earnings management. In particular, when a manager has low incentives to manage earnings, we expect that auditors will view the potential for managers to misrepresent information as small. Because the quantified explanation shows sufficiency of the manager's explanation and is unlikely to be misrepresented in this setting, auditors should find a quantified explanation more persuasive than a non-quantified one. In other words, auditors are expected to reduce their judgments about misstatement risk and increase their willingness to rely on the manager's explanation for planning purposes in this case. In contrast, when the client manager has high incentives to manage earnings, we expect that auditors will be skeptical about the motives behind the quantified explanation and, as a result, will expect the numbers to have been manipulated to suit the manager's purposes. …

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