How Auditors Can Serve as Watchdogs
In the days, weeks, and months following the BP oil spill in the Gulf of Mexico, many of us watched powerlessly, wondering what we could do to help. As accountants, our ability to assist may not seem obvious, because our professional skills are centered on numbers and equations, rather than chemical containment and blowout prevention.
There are, however, two branches of academic research that may arm auditors with the ability to make a difference, environmentally speaking. This article outlines the political cost hypothesis from the economic literature, as well as findings regarding the relationship between auditor corrections and discretionary accruals. Taken together, these two branches of research suggest the following: 1) in the wake of an environmental disaster in a certain industry, other entities in that same industry may reduce earnings, to avoid potential political and regulatory costs; and 2) auditors are less inclined to correct discretionary reductions to income than discretionary increases. In short, in the wake of an environmental disaster, managers may artificially decrease income, and auditors are less likely to correct such understatements.
The authors' hope is that by bringing to light these two related lines of research, heightened professional skepticism may be exhibited in the wake of the BP oil spill and whenever other man-made natural disasters occur. Such awareness of - and possible prevention of - discretionary incomedecreasing accruals following disasters may result in more truthful financial representation, not just in periods following environmental disasters, but in future periods as well. As described below, preventing such discretionary income-decreasing accruals may also aid policy makers in establishing regulations to deter future such disasters.
The Political Cost Hypothesis
Briefly stated, the political cost hypothesis predicts that, during times of heightened political scrutiny, companies have greater incentives to reduce potential political intrusions. Potential political intrusions include fines, costly regulations, and increased legislation. (See Ross L. Watts and Jerold L. Zimmerman, 'Towards a Positive Theory of the Determination of Accounting Standards," Accounting Review, vol. 53, no. 1, 1978, for a more in-depth discussion of the derivation of the political cost hypothesis.) For example, in the wake of an environmental disaster within a certain industry, regulations might be put in place to monitor that industry more closely or require the purchase of new and costly technology to increase the protection of the environment.
One way a company may reduce potential intrusions is by participating in socially responsible campaigns. After the BP oil spill, "positive" BP commercials blanketed television channels. Such commercials depicted BP' s actions to fix the disaster and provide aid to the thousands of people affected by the event. BP continues to project a "green" image by incorporating the color green and other natural symbols throughout its campaigns.
Another, less costly way a firm may reduce potential political intrusions during periods of heightened political scrutiny is by lowering profits through discretionary income-decreasing accruals. The impact of income-decreasing accruals may not be as visible as that of positive campaigning; it may be effective, nonetheless. By decreasing profits, a firm reduces the likelihood of being targeted for additional fines or increased regulation and legislation. As such, the political cost hypothesis predicts that during periods of heightened political scrutiny, such as in the wake of an environmental disaster, managers will resort to discretionary income-decreasing accruals to avoid potential fees and expensive regulation and legislation.
The political cost hypothesis is not just a theory conjured up in the minds of academics. It has been proved many times over, specifically, in regard to discretionary income-decreasing accruals following disasters. …